How do valuations get set for oil and gas companies? I ask because I’m seeing very fast-rising valuations in the junior and intermediate oil sector that I cover. I have seen junior oil producers valued at $200,000 per flowing barrel recently – more than triple the peer group average.
Industry statistics concur. A December 24th report by Peters & Co., a Calgary-based securities firm that is an oil and gas boutique, showed that the average purchase/sale price for oil weighted production in Q4 2009 was $100,000 per flowing barrel.
This is up more than 50% from the Q3 valuation of just over $60,000. (Oil and gas equivalent is the way the industry puts the two commodities into one valuation, usually at 6:1 ratio of gas to oil).
The report showed that valuations for natural gas weighted purchases also jumped up more than 50% in Q4, from $35,000 per flowing boe to $54,700. These numbers have an immediate impact on junior and intermediate stocks across the board, as you’ll read.
(There are several ways to value oil and gas companies, but I find the price per flowing barrel to be the simplest. It’s easily calculated: market cap + debt (or minus cash) divided by the daily production level of the company, in barrels per day.)
What is driving these fast rising valuations? It’s
1) an increasing oil price and
2) improving technology – especially multi-stage fracking – that is allowing producers to retrieve more oil and gas, more quickly, in each well. This increases cash flow, which increases stock prices.
3) Lower risk oil reservoirs—especially with the new “tight” oil and gas plays—drilling success rate is often 95%-100% now.
The market follows these transaction prices closely, and then transfers those individual transaction valuations over to companywide valuations (the stock price). They have a huge – and immediate – impact on stock prices.
Research analysts would quickly calculate the valuation of all the producers in those areas based on the price of the most recent sale, and decide who is undervalued or overvalued.
The market saw a perfect example of that this week when Berens Energy (TSX: T. BEN, Stock Forum) was bought by Petrobakken (TSX: T.PBN, Stock Forum) for $90,000 per flowing boe, for its Cardium oil production and land package in Alberta. Over the next two days the market re-rated (upward) many of the other juniors in the Cardium (see my story on this) to be much closer to that valuation. It meant a 20-30% move for some stocks in a couple days.
So I really wanted to understand – when two companies sit down to sell production and land package, how do they decide on a price? I spoke with Neil Roszell, CEO of Wild Stream Exploration Inc. (TSX: V.WSX, Stock Forum) to give me a valuation analysis in simple terms:
“Overall, a buyer would pay 90-100% of the base independent engineering value of an asset,” he told me, “subject to internal review that agrees with the numbers, and then evaluate the risked upside of the undeveloped reserves not in the engineering report and pay some portion thereof.”
As an example, he said to assume that base production in a hypothetical North American oilfield is worth $60,000-$80,000/boepd.
So if Company X has 500 boepd of production with reserves, the independent report might say it’s worth $35 million (500 x $70,000/boe).
Plus, they have a further 10,000 net acres of undeveloped land. To decide on the upside evaluation of that undeveloped land, the buyer would decide how much of it is prospective, and divide that by 640 to get the number of sections (or 1 square mile: there are 640 acres in 1 section or 1 square mile) times (x) the number of wells per section times (x) the Net Present Value (NPV) of each well.
Here is the math arranged like a grade school sum:
Base production value + (Raw acreage x prospective % / 640 x wells per section x NPV per well
= Valuation per flowing boe
Then, the buyer and seller split that number – the buyer will pay a portion, or an agreed percentage, of that undeveloped land upside, from the seller.
For this example, we’ll say 70% of the land is prospective for horizontal drilling, after the buyer’s technical review.
So 10,000 acres x 70% /640 = 11 net sections x 4 well per section = 44 net possible wells. The potential value of the drilling is 44 x $3,000,000 NPV/well = $132 million.
That would make the total possible value of the deal worth $167 million ($35 million for base production + $132 million for undeveloped land), or $335,000 per flowing boe ($167M/500 boepd).
Roszell said a likely bid would be to pay the $35 million + some percentage of the $132 million. If the two parties agreed at 25%, (which equals $33 million) then the deal would look like this: $35 million + 33 million = $68 million or $136,000 per flowing boe ($68 M/500 boepd).
The buyer is looking to turn the $68 million paid into $150-$170 million of value, thereby giving their investors a longer term double.
To recap, besides the increasing oil price, the market is seeing these significantly higher valuations because the NPV of these wells has been increasing, especially as improvement in technology – specifically multi-stage fracking – has greatly improved economics. Plus the high IP rates in the new tight oil and gas plays heavily increase NPV.
And as I’ve mentioned in several stories, the industry is still finding ways to increase recoveries, cash flows and NPVs. It’s an exciting time to be investing in the energy sector.
Another reason for high valuations is that these unconventional plays are geologically quite consistent, so the seller is wanting – and getting – more of that near-certain future cash flow. The probability of the buyer producing the maximum theoretical potential of that land is very high. With consistent geology and 3D seismic, buyers have nowhere near the risk they did in deals done a decade ago.
That’s why I’m seeing transactions done as high as $175,000 and $200,000 per flowing boe. And it’s having an immediate, positive, impact on junior and intermediate oil stocks in Canada.