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.

Connecting Valuation with Entrance Timing

My Investment Management and Trading Strategies class has moved into the trading strategies portion of the curriculum, and we have been talking a lot about the tradeoff between execution costs and opportunity costs. This discussion has helped flesh out some of the classic arbitrage examples behavioral investors like to point out, as we quantify the frictions in the efficient market system which can give rise to these mispricings. While the big mispricings are interesting to study, I think the magic lies in all of the small mispricings.

It struck me in class that the biggest weakness of any valuation activity is the time period of applicability. On one had you have the trade-off every science deals with. The more exact the measurement, the more time the measurement takes, and thus the staler it gets. But finance struggles with another application hurdle; even if you can solve for the 'true' price of an asset instantaneously, you have no idea when the market price will move to that value or if in fact it ever will. You are subject to two independent risks, the market can stay wrong or get 'wronger' (move against you), or your true price estimate becomes untrue as information enters the market about the asset and the valuation changes.

You might say, sure but we do know that the market moves to the true price in the long run. I'd agree, but that true price is always changing. If the market price of X is higher than you think it should be, you might short X. Let’s say X is trading at 15, and you think it's worth 12. Your expectation is that X will drop from 15 to 12. You might even hedge your short with a long on the S&P to protect from systematic changes in the stock’s value, and only short the 'firm specific' valuation of the stock. What is to say the following doesn't happen: positive idiosyncratic information enters the market, and the market and true price rise to 17. The S&P doesn't change (by much) because only the stock reacted to the firm specific information, your short is a loss of $2, and your hedge didn't protect you. Even with absolute knowledge about the true price, you can lose money.

I think this is why some very successful asset managers seem to know very little about valuation, or sometimes even seem to care about it. Successful investment seems to be much more about the interaction between the market price and the true price over time. Decent money managers can get by with only knowing how one of the sides works. Traders only focus how the market price changes over time, 'deep value' investors focus intently on the derivation of the true price and somewhat haphazardly jump in when they feel the spread between the market price and the true price is big enough to warrant the risk of jumping in. A true master of investments should know both.

I'm trying to develop a checklist for investments that will focus my efforts on balancing these two fields. It will need to balance both fundamental and behavioral considerations. As luck would have it some much brighter minds are working on accomplishing exactly that!

Investment Banking Pay

I need to preface this by saying I don't actually know. I have a rough idea of what my first year compensation is, but I'm guessing on the performance bonus, and the hours per week are estimated from what analysts at wallstreetoasis.com are saying from my area and division.

I decided to try to map out the first 10 years, and I was fairly aggressive with my progression. My hour per day estimates are below.

So I'm thinking 2 years at Analyst, 3 at Associate, and then through VP to Director by the end of 10 years on the job. I know it's possible, I'm not sure if its plausible, but we have to start somewhere. I expect to be working 70 hour weeks as an Analyst, however I know that 100 hour weeks are possible. I set a lower bound at 45 hours, there is now way the deal could get sweeter than that, and if I'm only putting in 45 hour weeks its because my team has no work, so I'm likely both not looking at a good bonus and possibly out of a job.

Now for the numbers.

My sensitivity assumptions are subjective, should be viewed as upper and lower bands, not any statistical deviation measure derived from actual data sets. My expectation growth assumptions however are not entirely made up, there are lots of web resources that estimate salary scaling over time, I primarily used payscale.com.

So whats the story. The upper graph shows clearly that i-banking is a 6 figure foray with bulge bracket banks, a mind boggling figure for any starving student. Of course this is all pre-tax, but it's nothing to complain about. The lower graph however tells the real story; one that is a common find for anyone seriously considering the industry. The pay per hour can be less than great. I suggest you read this mergers and inquisitions article, to hear the horror stories of i-bankers making less than McDonalds wages in the crunch.

Now we aren't heading into a recession, especially not in commodities which is my area of work, so I should be hitting above $20 an hour, but there is no real reason to expect my pay to be that much higher. My "good" forecast assumes some pretty legendary bonus numbers, I really think I'm going to be hitting close to my expectations, especially early on. All this tells us that i-banking has its proving ground period, just like every other competitive entry level position in business. The salary numbers are big, but the hours put in at the office can be legendary; just look at all the i-banking blogs that talk about that exact topic!

It is sure to be an interesting couple of years.