Valuation practices in a Natural Resources Coverage Group

It has been interesting to see the similarities and differences between classroom methodology and industry practices when valuing oil and gas companies. Here are some key differences.

Discount Rates
CAPM is out, PV10 is in. On a cash flow basis there are two main techniques in valuing resource assets. One is a haircut technique where all Proven and Probable (2P) reserve cash flows (output * price - expenses) are discounted at 10%, and Contingent resources and Undiscovered resources (2C) (but owned acreage) cash flows are hair cut at 10 to 20%, and then they too are discounted at 10% - hence "PV10". The other methodology discounted 2P reserves at 10% and then contingent reserves at 12% or higher depending on the play.

Terminal Value
Mention a terminal value in an interview for a Natural Resource group and you've immediately put your landing possibilities in jeopardy. Gas wells produce at very predictable rates, which can be delineated into "type curves". For going forward assumptions you just have to know what type curve can be reasonably expected out of the play and package. After this you can model out production for the next 100 years if you want to; many of our models stretch beyond 2080.

Assumptions
Because PV10 is a fairly industry standard valuation method the real assumptions come into the model with prices, classifications between contingent, probable, and possible, and what Tcf values are given to land that haven't been risked (drilled with exploratory wells) yet.

Price decks generally come from 3 sources: brokerage consensus, engineer forecast, and forward contracts. To get the best value for their research everyone generally spends a lot of effort forecasting the major contracts (HHUB Gas, WTI Crude, Brent Crude), and then every other selling price is based off a differential to these contracts going forward. For instance a major Canadian gas selling price is at AECO, which generally trades at a C$0.50 discount to HHUB, thus if you have a decent idea of the expectations for HHUB, you also have a decent expectation for your local price point.

The engineers add a lot of value to the model. They provide you independent type curve estimates, price expectations, and reserve estimates that include 2P and 2C values.

Comparables
The comparable universe works much like it did in class, just the multiples are different. EV over reserves (1P, 2P, 2P + 2C),  acreage, and production are very common.

Wrinkles
An area of the model that are more complex than I had originally expected is the royalty calculation. Oil and gas firms are taxed twice, once on income after expenses, and once on production through complex royalty rate calculations. As an investment bank understanding and strategically advising our client through royalty rates is a big part of the business and after all the due diligence homework we often know more about the credit and rate reduction plans than major oil and gas companies who face these costs daily.

More to come.