Professional Documents
Culture Documents
Marcus Wolters
1/1/2010
DISCLAIMER
The behavior in crude oil and natural gas prices from the start of 2007 through 2009 provided a unique opportunity to see not
only how the markets responded during the economic turmoil but also to assess the impact on the E&P firm and provide a
landscape for 2010. From the events of 2008 we were reminded the importance of placing E&P fundamentals firmly ahead of
commodity price projections in assessing the future health of the sector. The high commodity price environment in the first
half 2008 brought with it a whole new set of profitability and growth expectations and those optimistic outlooks needed to be
looked at in more realistic terms since then.
Q3 '07
Q4 '07
Q1 '08
Q3 '08
Q4 '08
Q1 '09
Q3 '09
Q1 '07
Q2 '07
Q2 '08
Q2 '09
Long-term Debt Grew Through 2008
The E&P sector added over $30 Billion in debt before the economic
crisis took over in late 2008. The long-term debt level has hit a U.S. E&P Sector
Long-term Debt
plateau since then. E&P firms could have used the high cash flow ($US Billions)
period to pay down some debt and set themselves up for a more $120
sober pricing environment with a healthier capital structure – but now $100
some are ill-positioned with weaker profiles and operating in a low $80
price environment. Due to the combination of frozen credit and the $60
E&P sector leery of adding debt in the low-price period, many firms $40
kept their exploration and development programs in-line with cash $20
Q2 '07
Q4 '07
Q1 '08
Q2 '08
Q4 '08
Q1 '09
Q2 '09
Q3 '07
Q3 '08
Q3 '09
equation, has recovered through 2009 - for the E&P sector in general,
increasing commodity prices through 2009 has been the incentive.
Average Price Received Collapsed Rapidly Post Q2 ‘08 U.S. E&P Sector
Average Price Received
The U.S. E&P sector is heavily weighted towards natural gas ($US per BOE)
production – roughly two-thirds of production is natural gas. The $80 $74
$72
average price received by the E&P firm ($US per BOE) was cut in half $70 $62
$59 $57
by Q2 ’09, and is recovering. But because of the high gas weighting, $60
$49 $49
this needs to be examined a bit closer. While crude oil prices plunged $50
$46
$39 $41
mid-year 2008 and since recovered somewhat, natural gas prices have $40 $36
not and the historical relationship between the two is broken. One of $30
the reasons is that natural gas supply dynamics have changed
Q1 '07
Q2 '07
Q4 '07
Q1 '08
Q2 '08
Q1 '09
Q2 '09
Q3 '09
Q3 '07
Q3 '08
Q4 '08
sample of 90 U.S.–based E&P firms, the sector’s SEC PV10 5.3 5.6
4.8 4.9
Standardized Measure was reduced in aggregate by over $125 Billion
3.6
between ’07 and ‘08. And notwithstanding the issues surrounding the
2.0
use of the SEC PV10 as it is determined today and the inherent
conservatism in evaluating proved reserves, this was a strong
indicator that the underlying asset value had fundamentally changed.
2002
2003
2004
2005
2006
2007
2008
At the same time, the sector took reserve and asset impairment
Proved Developed Reserves
charges of over $40 Billion in 2008, which dwarfed any previous years’
impairment charges.
Production Groups
ii
To make better sense of the U.S. E&P landscape, the sector is split (or stratified) into production sub-groups , and this helps
show the characteristics of asset size - an important function in E&P analysis. Not one single E&P in our universe avoided the
affects from the downturn in product prices. As the table below suggests, larger producers (Intermediate and up) are back to
where they started in 2007. The average market value of Junior producers is far less now than what it was at the start of 2007.
Commodity Focus
Isolating crude producers and comparing them with gas producers U.S. E&P Sector
provides another aspect into how commodity price patterns affect Market Cap Growth/Decline since January 2007
Oil Focus versus Gas Focus
market value. This is particularly useful in sensitivity analysis under 250%
iii
various price environments. 200%
Oil Focus
150%
The figure to the right compares 10 E&P’s with a high crude Gas Focus
100%
production focus (75% of production, on average) versus 10 E&P’s
50%
with a high gas focus (95% of production). The market value of oil-
0%
focused E&P’s doubled in eighteen months only to lose that and more
-50%
in the next seven.
Q2 '07
Q3 '07
Q1 '08
Q2 '08
Q4 '08
Q1 '09
Q3 '09
Q1 '07
Q4 '07
Q3 '08
Q2 '09
averaged 1.3 from Q1 ’07 to Q2 ’08, grew to 2.8 by Q2 ’09, implying 6.00
Junior
that debt comprised a much larger share of total Enterprise Value. 5.00
The figure to the right shows that as the production size increased, 4.00
Intermediate
market cap was less and less affected. 3.00
2.00
But it is no coincidence smaller producers experienced the largest
1.00
divergence. It can be shown historically that the variance in share Senior Super Independent
price risk/return of smaller producers is much wider than larger 0.00
Q2 '07
Q3 '07
Q1 '08
Q2 '08
Q4 '08
Q1 '09
Q3 '09
Q1 '07
Q4 '07
Q3 '08
Q2 '09
production groups to begin with. And since 2007, smaller producers
added debt at a much faster rate than larger producers, causing wide
mismatches in capital structure. In the span of just over 2 ½ years the
U.S. E&P Sector
average debt to cap increased from 35% at Q1 ’07 to 58% at Q2 ’09, Debt to Capitalization (%) by Production Group
and this served to make the impact of the fall in share price even more
65%
pronounced. Junior
60%
Intermediate
55%
The question remains: how long will it take for this highly-leveraged
50%
sector to return to normal? It is clear the credit risk profile for the 45%
entire sector has already been in decline even prior to 2007, but the 40% Senior
negative price shock that occurred so swiftly in 2008 (the brunt of it in 35%
30% Super Independent
six months) only compounded the problem. Moving into 2010, the
25%
capital structure of the E&P sector has fundamentally shifted; this will
Q2 '07
Q3 '07
Q1 '08
Q2 '08
Q4 '08
Q1 '09
Q3 '09
Q1 '07
Q4 '07
Q3 '08
Q2 '09
take a significant amount of time to correct itself.
since Q1 ’09) this widely used metric will have a difficult time in 2010 2.0
0.0
stabilizing within bounds that once were considered appropriate.
2002
2003
2004
2005
2006
2007
Q1 '08
Q3 '08
Q4 '08
Q2 '09
Q3 '09
Q2 '08
Q1 '09
long-term, unless there is a more serious initiative to move 4.6 4.6 2006
3.8 2007
structurally away from coal-fired electricity generation to natural gas
2008
fired generation, demand growth will be mitigated. 2.0
Debt versus Reserves: From 2004 the relationship between debt and
Debt to PDR SEC PV10 to debt
reserves has been deteriorating. While Debt per BOE reserves has
been increasing, the actual value of the reserves has been decreasing (see figure on previous page). This will almost necessarily
place capital structure and strategic limitations on future earnings potential.
which is still much lower than the average of 56% in prior years. This 47%
will take time to recover, especially in light of the commodity price 40%
38%
outlooks that might prevail for 2010. The production and ad valorem 32%
2002
2003
2004
2005
2006
2007
Q1 '08
Q2 '08
Q3 '08
Q4 '08
Q1 '09
Q2 '09
Q3 '09
Return Measures: Return on Equity (along with P/E and other return-
related metrics) became un-measurable in 2008 and not much better
in 2009. Net earnings in 2008 were extremely poor for the year and 2009 results, although stronger than 2008, are lower than
in years past. Over 40 E&P’s reported losses in 2008 and the aggregate sector net income was $1.29 Billion. This was due in
large part by the size of asset impairment charges that were taken. By comparison the exact same set of E&P firms reported
net income of $18.9 Billion in 2007. The expectation for the sector in 2010 is that key return, profitability and netback metrics
will not likely return to the levels seen in ’02-’07, and valuation metrics will also continue to be lower.
Drilling and Production: Operating costs on a BOE basis in 2009 are lower than in 2008, some of this driven by lower Production
Taxes due to low commodity prices. This is a plus. But this will likely not compensate for the stagnant and low natural gas
prices which will suppress netbacks. Drilling costs have been lower as well from 2007-2008, which strengthens the F&D cost
and enhances the recycle ratios. Drilling activity, however, will not likely recover to ‘07 – ‘08 levels and reserve and production
growth will be limited.
Benchmark Commodity Price Drivers: The factors that determine the price of a barrel of crude have drifted further beyond
supply/demand fundamentals. For example, with crude hovering at about $US 70 per Barrel, the discussion is not so much
these days about supply/demand fundamentals but rather how playing WTI against the U.S. exchange rate will affect price and
exchange rates.
Until there is clearer understanding of the price drivers, from a fundamental standpoint we cannot forecast the price of WTI
with any great confidence solely on the basis of supply/demand. And there have been recent events to indicate that WTI might
be losing its power while still being the key North American benchmark price. For example, Saudi Aramco recently announced
it will use the Argus Sour Crude Index for its U.S. deliveries over WTI as it better reflects the crude characteristics. In addition,
Gulf Coast pricing/volumes are more liquid and transparent. Kuwait has followed in the same footsteps. Moreover, WTI prices
will continue to be distorted from time to time against other crude prices and remain volatile in the near-term because of local
distortions and the actual trading point – Cushing, Oklahoma – is land locked.
WTI versus Henry Hub: The relationship between oil prices and natural
Henry Hub U.S. E&P Sector
gas prices continues to diverge and weaken (see right). Before 2005 WTI versus Henry Hub, 1999 - 2009
WTI
the relationship between WTI and Henry Hub was fairly predictable: ($US per MMBtu Basis)
25
natural gas prices would move roughly in tandem with oil prices. Since
20
then a number of factors have transformed the nature of the North
15
American natural gas market, and oil prices no longer have the same
drawing power: 10
Jul-00
Jul-01
Jul-02
Jul-03
Jul-04
Jul-05
Jul-06
Jul-07
Jul-08
Jul-09
Jan-99
Jan-00
Jan-01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
MacKenzie Valley) supplies, which were once considered the Source: Bloomberg
1 Barrel = 5.825 MMBtu Data Source: Bloomberg
solution to the dwindling continental supply base, have really
th
New SEC Reserve Reporting Standards: From www.sec.gov: On June 26 , 2008 the SEC announced that it has proposed revised
oil and gas company reporting requirements to help provide investors with a more accurate and useful picture of the oil and
gas reserves that a company holds. The new reporting standards become effective January 1, 2010. The rule proposal reflects
the significant changes that have taken place in the oil and gas industry since the adoption of the original reporting
requirements more than 25 years ago. The proposed rule changes incorporate improved technologies and alternative
extraction methods, and enable oil and gas companies to provide investors with additional information about their reserves.
The more that precise, first-hand information from oil and gas companies is available to investors and the marketplace, the less
that the marketplace is forced to rely solely upon information provided by speculators.
The enhanced reporting standards will add a broader aspect of valuation with respect to reserves on a standardized basis.
Some the key changes include:
Permitting use of new technologies to determine proved reserves if those technologies have been demonstrated
empirically to lead to reliable conclusions about reserves volumes.
Enabling companies to additionally disclose their probable and possible reserves to investors. Current rules limit
disclosure to only proved reserves.
Allowing previously excluded resources, such as oil sands, to be classified as oil and gas reserves. Currently these
resources are considered to be mining reserves.
Requiring companies to report the independence and qualifications of a preparer or auditor, based on current Society
of Petroleum Engineers criteria.
Requiring the filing of reports for companies that rely on a third party to prepare reserves estimates or conduct a
reserves audit.
Requiring companies to report oil and gas reserves using an average price based upon the prior 12-month period-
rather than year-end prices, to maximize the comparability of reserve estimates among companies and mitigate the
distortion of the estimates that arises when using a single pricing date.
In addition to the SEC working paper there are several very good opinion papers on the proposed reserve reporting standards.
remain stagnant - the more important price marker for the E&P sector
$80,000
is always natural gas. It was argued previously that the WTI/Henry
Hub relationship is has weakened in this era, so it is harder to explain $40,000
the increase in the multiple when natural gas prices are far less
$0
robust.
2002
2003
2004
2005
2006
2007
Q1 '08
Q2 '08
Q4 '08
Q1 '09
Q2 '09
Q3 '09
Q3 '08
Operating costs and production taxes are lower in 2009 than in 2008,
which increase EPS, and this in turn helps explain some of the increase U.S. E&P Sector
in share price and market cap. Along with the collapse in commodity Operating Cost per BOE Trend, E&P Sector
($US per BOE)
prices came a related drop in costs – drilling, chemicals, wireline,
15.40 15.90 15.60
seismic etc. 13.30 14.00
12.30 12.80 12.90 11.60 11.10 11.80
Q2 '07
Q4 '07
Q2 '08
Q4 '08
Q1 '09
Q2 '09
Q3 '09
Q3 '07
Q1 '08
Q3 '08
leveraging can be put into E&D activities again.
Lease Operating + Production and Ad Valorem Taxes
Table 3: Market Capitalization per Daily BOE Production: Trend by Production Group ($US per BOE)
2002 – 2007
Q2 ’08 (Peak) Q1 ’09 (Low) Q3 ’09 (Current)
Production Group Average
In and by itself, this level of analysis is not sufficient to make a particular “call” on a single E&P. Fundamentals provide the
strong backbone to do comparative assessments and gauge trends in the E&P sector: It sets the framework.
The reality is that oil & gas prices are highly cyclical, have been for many years, and analysis has to be addressed with this idea
in mind. It must be emphasized the E&P sector and its firms are rather at the mercy of the market when it comes to oil & gas
prices – factors that are driven more by economic and geo-political events and largely out of the firm’s control. And most short-
term and long-term decisions E&P firms make will take a commodity price view into consideration. But wouldn’t it make sense
to assess the E&P sector and its companies less on terms of prices and more on the workings of the firm?
What was needed were methods and analysis that stripped out the revenue factor and examined the underlying drivers that
dictate how E&P firms react to price environments. The P5 Index and its counterpart the L5 Index was developed using
selected key drivers based on the principle that assessing the parts of a company’s operations – reserves management,
iv
operations and capital management – together can provide strong indicators of total performance .
3 Year Reserve Replacement Cost Reserve management performance. The three-year measure is used as it
($US per BOE) captures the reserve development life-cycle better than a one-year
measure.
Long-term Debt to Proven Reserves The prudent use of debt to build reserves.
($US per BOE)
SEC PV10 Value to Total Debt The future value of reserves compared against the current debt levels.
BOE Production Growth – 1 Year The effectiveness of the firm to increase production levels.
Production Replacement – 1 Year The effectiveness of the firm to grow reserves in tandem with
producing them.
Comparing Firms with Strong Fundamentals versus Firms with Weak Fundamentals
Taking the tops and bottoms and then comparing them gives us the range of quality that we can assess for the whole E&P
sector. The table below shows the differences between the five “best” E&P firms and the five “poorest”:
Market Cap versus Daily Production: Not a single U.S. E&P was left
U.S. E&P Sector
unaffected when crude prices collapsed in mid-2008. Regardless of Performance Group Comparison
Market Cap per BOEQ - 2007 through 2009
performance ranking, market values fell by the same magnitude
$200,000
across the board. Q1 '07 Q3 '09
$150,000
The E&P sector bottomed in the first quarter of 2009. Based on the
sample of 84 U.S.-based E&P’s, the average Market Cap per Daily BOE $100,000
1. The variables that drive the sensitivity must be highly relevant to the problem. This sounds intuitive, but sometimes
the choice of variable misses the business case. For these tests, three variables were used: oil price, natural gas price
and lease operating costs.
2. The range for each variable should be within a “possible outcome” for the time frame considered.
3. The starting data must reflect the most recent results. In these three cases, Q3 ’09 results are the starting point.
4. The results could be assessed from different viewpoints – for this paper, Production Groups were examined.
Changes: Oil Prices increased by 50%, natural gas prices increase $USD per Daily BOE Production
U.S. E&P Sector - Sensitivity Analysis
50%, operating expenses increase 20% Market Cap per Daily BOE
2010 Price Spike, Moderate Cost Pressures
Result: Market Cap per BOEQ rises ~60% on average. Growth in 104,000 Base Case
smaller producers is stronger than larger producers. Scenario
76,500 76,200
69,200
This is not unrealistic. Based on the sample, on average, the price 54,100
59,500
50,000
44,800
received for natural gas in Q3 was $4.34 per Mcf and the average
price for crude oil was $63.74 per Barrel. A 50% increase over the
year would result in natural gas at $6.50 and crude oil at $95.50.
Junior Intermediate Senior Super Independent
This could be a situation that would reflect the U.S. economy
regaining momentum and increasing demand for energy: air travel on
the increase, miles driven increasing –overall demand for refined
products increasing. Natural gas prices would increase at the same
rate with normal seasonality, keeping the WTI/Henry Hub ratio steady.
Changes: Oil Prices decrease by 20%, natural gas prices decrease $USD per Daily BOE Production
U.S. E&P Sector - Sensitivity Analysis
20%, operating expenses decrease 5% Market Cap per Daily BOE
2010 Price Collapse, Operating Costs Ease
Result: Market Cap per BOEQ decreases ~27% on average. Impact on 76,500 Base Case
smaller producers is stronger than larger producers. Scenario
54,300 54,100
50,000
44,800
Reflects possible “double dip” fall in commodity prices. Costs would 39,100 37,000 34,900
ease primarily as sliding scale production taxes would decrease. This
scenario would capture a lower bound of valuations based on price
and cost sensitivities.
Junior Intermediate Senior Super Independent
A 20% drop in crude prices would roughly equate to $51.00 per barrel
for the year. A 20% drop in natural gas prices would equate to roughly
$3.50 per Mcf.
Table 7: Market Cap to Daily BOE Production: 2010 Outlook by Production Group
Production Group Q3 2009 (Actual) 2010 High Price Case 2010 Low Price Case
Junior $54,000 per BOEQ $104,000 per BOEQ $54,300 per BOEQ
Final Comments
The U.S. E&P sector has clearly come off its early 2009 lows and the outlook for 2010 appears to be more robust. But several
questions will remain on the table which will affect valuations. For example:
Will the continental gas oversupply subside? In the short term, the main factor will be weather related and if North
America will experience a colder than normal temperatures in winter and/or the summer season will be warmer.
How will new government/environmental policies translate into reduced energy consumption? This is a longer-term
consideration, but valuations will be effected nonetheless.
Will the credit markets continue to ease?
Data Summary
The primary goal in building this information backbone is not simply to be able to construct a data system that compares any
company to any other company (there are scores of free internet services that do just that), but rather to be able to position a
company or sub-group within the U.S. E&P sector in a proper perspective.
The system used to gather, calculate and stratify the data from the various was developed using a combination of Microsoft
Access, Microsoft Excel and Visual Basic 6.0. Data has been compiled and processed for U.S. based E&P firms annually since
2002, and quarterly information has been processed since Q1 2007.
Effective analysis is impossible without a foundation of reliable information, and this requires a rigorous approach to
identifying, arranging and processing data. Data was collected and validated in groups with respect to how the data fits
categorically. It is essential that the data collection system is efficient as the data and information is the backbone to our
research. In terms of data sources and requirements, the table below shows where the data is sourced from and how the data
is categorized:
Reserves Reserve Reconciliations, Daily Production, PV10 SEC 10-k, SEC 10ksb, SEC 10-Q
Values, BOE & McfE conversions
Operations Drilling, Land Positions, Operating Oil & Gas Wells, SEC 10-k, SEC 10ksb, SEC 10-Q
Employees
Financial Balance Sheet, Income Statement, Statement of SEC 10-k, SEC 10ksb, SEC 10-Q
Cash Flows, Oil & Gas Capital Expenditures, Debt
Maturities, Shares Outstanding
Other Share Prices, Company Activity, Industry Activity Company websites, newswires, The EIA, E&P
associations.
Companies Surveyed
Drawing from a sample of just over 95 publicly traded U.S. based E&P companies the final analysis was based on 84 firms. The
main factors that reduced the sample to 84 firms were data quality issues: very small E&P firms with small market
capitalizations or firms that had listing requirement issues were taken out of the sample:
Financial Recap
Based on the sample of 84 companies:
Cumulative operating and net income was wiped out in two quarters, Q4 ’08 and Q1 ‘09
Asset impairment charges exceeded $40 Billion at year-end 2008 and continued through the first quarter 2009.
Average Daily crude Oil & NGL Production by Production Group (‘000 Barrels per Day)
2007 2008 2009
Q1 '07 Q2 '07 Q3 '07 Q4 '07 Q1 '08 Q2 '08 Q3 '08 Q4 '08 Q1 '09 Q2 '09 Q3 '09
Junior 1.1 1.2 1.3 1.4 1.6 1.7 1.6 1.7 1.8 1.9 1.7
Intermediate 9.6 10.6 10.8 11.2 11.5 12.1 11.4 11.8 12.1 12.5 12.1
Senior 35.1 36.0 36.4 38.8 40.8 40.9 40.4 39.8 39.2 39.8 40.2
Super Ind. 154.1 160.6 153.9 155.9 156.3 145.9 145.8 154.2 162.8 175.7 165.5
Brief Glossary
The contents and expressions used in this report are written at a fairly advanced level. In order to avoid possible confusion,
tabled below is a list of some terms that have been used by themselves and used interchangeably throughout the report:
BOEQ: Daily Oil & Gas Production in Barrel of Oil Equivalent (BOE) Terms
th
McfE: Mcf Natural Gas Equivalency: 1 Barrel Oil = 1/6 Mcf Natural Gas
Enterprise Value or EV: Market Capitalization + Total Long-term Debt – Cash & Cash Equivalents
3 Year Reserve Replacement Cost: ∑ Oil & Gas Capital Expenditures Most Recent 3 Years l
∑ Extensions, Discoveries, Acquisitions and Improved Recoveries, 3 Years
Note: Reserve Replacement Costs are also calculated with Revisions – but due to the high fluctuation in Revisions
reporting over the past few years, it was felt the RRC without revision was the appropriate metric to use.
Operating Netback ($US per BOE): Average Price Received – Lease Operating Expenses – Production, Ad Valorem Taxes
Author’s Bio
Marcus Wolters
Over fifteen years of oil & gas and energy analysis experience:
o Summer Intern Positions:
1991: Amoco Canada Production Company
1992: Research Assistant, University of Calgary, Department of International Finance
1993: Crestar Energy Inc.
o Career Positions:
Ziff Energy Group (1994-1997)
Royal Bank of Canada, Global Energy Group (1997 – 2001)
Enbridge Pipelines Inc. (2001-present)
o Current position: Senior Advisor, Commodities Forecasting Group, Enbridge Pipelines Inc.
Areas of specialization:
o Oil & Gas fundamentals
o Credit risk assessment
o Production analysis and forecasting
o Statistical analysis and corporate benchmarking
o Economic modeling
o Database design
Education:
o University of Calgary, Finance (1988-1992)
o University of Western Ontario, Statistics (1992-1993)
Contact Information:
o Email: mwolters@telus.net
o LinkedIn Profile: http://ca.linkedin.com/in/marcwolters
Notes
i
The U.S. universe comprises 84 publicly traded American based E&P’s. For the full detailed list, please see the section
“Companies Surveyed.” Throughout the report, outliers and extreme values were removed from the analysis where it was
deemed appropriate. Unless otherwise stated, all analysis was developed in-house. All data was obtained from its original
source: the United States Securities and Exchange Commission (www.sec.gov). Share prices obtained from Yahoo! Finance.
Presentations, news releases, outlooks and other relevant operational information obtained from company websites.
Institutional ownership data obtained from Thomson-Reuters.
ii
The sample of 84 U.S. E&P firms was divided into four production sub-groups: Junior, Intermediate, Senior and Super
Independent. This widely accepted approach is very useful in examining many aspects of the E&P sector, from financial analysis
to operations. The production sizes are tabled below:
iii
The “Oil 10” and “Gas 10” E&P companies were determined by ranking the universe of 84 publicly traded E&P companies on
the basis of oil production and gas production, not revenue weighted and indifferent to the size of the firm or any performance
considerations:
iv
Performance measurement: Junior producers are not included in these types of performance assessments. The 2008 “P5”
and “L5” E&P firms are tabled below:
v
Key industry measures are assessed from first principles through to valuation measures: Input Metrics look at the drivers of
what defines the E&P sector: the efficient management of oil & gas resources and the efficient exploitation of reserves.
Corporate Metrics provide guidance as to how the sector (as well as the individual company) manages its capital, asset and
manpower requirements to give working strength to the reserve base. Output Metrics provide the tools which place a value on
the individual company and the sector - trend analysis becomes an essential component in market valuations, returns and
margins.