Valuation Methodologies

in the Oil & Gas Industry

In many ways, the quest for energy resources has shaped modern history. Since the Industrial
Revolution, energy and its supply have driven civilization forward. Despite the development of
alternative sources such as nuclear, wind and solar, the oil and gas industry remains a major
source of energy around the world.

The oil and gas industrys value chain is classified into three distinct segments or sectors:

UPSTREAM MIDSTREAM DOWNSTREAM

(also known as exploration
and production, or E&P)

The oilfield services segment can also be considered a distinct segment, which serves the
upstream oil and gas companies.

Figure 1 Midstream (transportation, processing, and storage)

+ Oilfield Services Contract Drilling Seismic/Geophysical OCTG

& Equipment Pressure Pumping Fluids & Drill Bits Rig Equipment
Completion Services Compression Offshore Equipment

1
2016
Three standard valuation approaches the Income Approach,
the Market Approach and the Asset Approach typically are
applied in valuing companies in the oil and gas industry. The
first step in choosing the appropriate valuation approach is to
understand the sector of the value chain in which the subject
company operates. For each sector, certain considerations must
be taken into account.
Upstream
The upstream sector, commonly referred to as the E&P sector,
participates in the search for and the recovery and production of
crude oil and natural gas. Activities within the upstream sector
include searching for potential underground or underwater oil and
gas fields, drilling exploratory wells, and drilling and operating
wells that recover and bring to the surface crude oil, natural gas
and related liquids. Examples of global E&P companies include
Exxon Mobil Corporation, Royal Dutch Shell plc, and BP plc.
Midstream
The midstream sector starts at the gathering system, which
collects oil and gas from the wellheads. Gathering systems
range in size from small systems that process gas close to the
wellhead, to large systems consisting of thousands of miles of
pipes that collect from hundreds of wells. At the processing plant,
various products (for example, natural gas liquids like ethane and
butane) are separated from the oil and gas. Examples of large
midstream companies include Enterprise Products Partners L.P.,
Kinder Morgan Inc., and TransCanada Corporation.
Downstream
Companies in the downstream sector are involved in refining
crude oil and in selling and distributing natural gas and crude
oil derived products such as liquefied petroleum gas, gasoline/
petrol, jet fuel, diesel oil, other fuel oils, asphalt, and petroleum
coke. The downstream sector includes refineries, petrochemical
plants, petroleum product distribution companies, retail outlets,
and natural gas distribution companies. Examples of large
downstream companies include Valero Energy Corporation,
Sunoco Inc., and Citgo Petroleum Corporation.
Oilfield Services
Oilfield services companies are important industry players
that provide support services drilling, cementing, surveying,
treating (e.g., with acids or chemicals), and perforating to
upstream oil and gas producers on a fee or contract basis. An
increasingly popular way in recent years for companies to extract
oil and gas from shale formations, such as the Permian Basin in
West Texas, the Bakken Formation in North Dakota, and the Eagle
Ford in South Texas, is hydraulic fracturing, or fracking. Creating
fractures in formations that allow oil and gas to be released.
Examples of large oilfield services companies include Halliburton
Company, Schlumberger Limited, and National Oilwell Varco.
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Upstream Valuation Considerations
E&P companies primary assets are their oil and gas reserves
that is, hydrocarbons below the surface that have not yet been
produced and are economically viable to extract. Reserves can
be classified into two main categories: proved and unproved
reserves. Proved reserves are quantities (volumes) of oil or
natural gas that are recoverable in future years from known
reservoirs under existing economic and operating conditions.
Within the category of unproved reserves, probable reserves
(referred to as 2P reserves when aggregated with proved
reserves) have a 50% probability that reserve quantities will be
higher than estimated and a 50% probability that the reserves
quantities will be lower than estimated, in accordance with
the engineering definition of the American Petroleum Institute.
Possible reserves (referred to as 3P reserves when aggregated
with proved and probable reserves) have a 10% probability
that reserves quantities are higher than estimated and a 90%
probability that reserves quantities will be lower than estimated.
Reserve Reports and Reserve Valuation: The value of an E&P
company may be estimated by calculating the fair value of its
reserves and then aggregating this with the value of other net
assets on its balance sheet, assuming those net assets have
been assigned market value. Reserve reports, generally prepared
independently by petroleum (or reserve) engineers, are used
for this purpose. These reports provide the gross quantities
expected from wells, net such quantities to the subject companys
ownership interest, and estimate future prices, operating
expenses and capital expenditures. Essentially, a reserve
report is a discounted cash flow (DCF) model for a companys
reserves, on a pre-income tax basis, and it typically includes
the present value of the projected income based on various
benchmark rates, frequently ranging from 10% to 25%.
Below is a list of key items to consider in reviewing a reserve
report and its underlying assumptions:
What price deck (commodity price forecast) was used for the
reserve report? (Note that engineers do not typically build the
effect of hedges or other derivatives into their DCF model.
The projections may be aggressive if the NYMEX strip pricing
is significantly lower than the oil and gas prices used in the
reserve report.)
How do the projected volumes compare with historical
production volumes? If they are materially different, determine
why this is the case.
Are proved undeveloped reserves (PUDs) included in the
analysis? Are probable and possible reserves included in the
projections? What drilling and capital expenditure assumptions
were used in developing the projections associated with
the PUDs?
Were plug and abandonment costs considered? Liabilities
related to plug and abandonment costs are also referred to as
asset retirement obligations.
Valuing E&P Companies: E&P companies are commodity
businesses that have limited control over the prices they receive.
They may vary their production and capital expenditures based
on current and future price expectations, and they can hedge
their production by using the futures market. As discussed
earlier, the DCF method under the Income Approach is one of the
primary approaches used to value an E&P companys oil and gas
reserves. The value of the reserves is incorporated into the Asset
Approach and the E&P firms balance sheet is marked to market
using the Net Asset Value Method.
The Market Approach may also be an appropriate method
of valuing an E&P company, depending on the availability of
comparable publicly traded companies or M&A transactions
(at either the asset level or the entity level). When analyzing
historical or projected financial metrics to use in the Market
Approach, consideration should be given to some unique
aspects related to the accounting of E&P companies. Financial
statements of E&P companies prepared in accordance with
generally accepted accounting principles (GAAP) may use
either successful efforts or full-cost accounting for oil and gas
reserves. These accounting methods differ in their treatment of
specific operating expenses namely, exploration costs related
to carrying and retaining undeveloped properties, collecting and
analyzing geophysical and seismic data, and drilling exploratory
wells. Rather than considering EBITDA (earnings before interest,
taxes, depreciation and amortization) as a primary pricing metric
for E&P companies, analysts usually consider EBITDAX, which
is a companys EBITDA before exploration costs for successful
efforts. For full-cost firms, exploration costs are embedded
in depreciation and depletion, so EBITDAX equalizes both
accounting types.
The first step in employing the Market Approach is the selection
of appropriate guideline companies. Some of the important
screening criteria are the following:
Size (in market capitalization or reserve volumes)
Gas/oil mix (the percentage of reserves or production
represented by natural gas versus oil)
Reserve life (proved reserves divided by the previous years
or current years production; also known as the reserves-to-
production, or R/P, ratio)
The ratio of PUDs to total proved reserves (an indicator of how
much of the reserve base is currently generating EBITDAX)
Areas/basins of operation (e.g., onshore versus offshore
activities; specific geographies or shale plays)
Once guideline companies have been selected, the following
pricing metrics may be considered:
Enterprise Value (EV) / proved reserve quantities (i.e., EV /
barrels of oil equivalent, or BOE)
EV / daily production
EV / EBITDAX
3
Due to the frequency of reserve acquisitions and divestitures
among the publicly traded E&P companies, which could distort
valuation indications, a forward- or current-year indication
of reserves, production, and EBITDAX should be used. The
development of forward- or current-year metrics, however, often
requires a time-consuming review of press releases and other
sources of information.
Midstream Valuation Considerations
Conventional variations of the Income and Market approaches
(e.g., DCF and EBITDA-based multiples) may be appropriate
in valuing midstream E&P companies, which are frequently
incorporated as master limited partnerships (MLPs).
An MLP is a limited partnership that is publicly traded on a stock
exchange qualifying under Section 7704 of the Internal Revenue
Code. It combines the tax benefits of a limited partnership with
the liquidity of publicly traded securities. MLPs traditionally
pay out almost all available cash flow on a regular basis. They
generally offer higher yields, stemming from their legal and tax
structures as well as from the underlying companies operating
business. Most publicly traded companies are structured as C
corporations that pay entity-level corporate taxes, but MLPs pass
through their taxable income to their unit holders rather than
incur taxes at the entity level. As a result and in contrast to C
corporations, which must pay corporate income taxes, and whose
shareholders are subject to taxes on any dividends received
MLPs avoid double taxation and offer higher distributions and
yields to investors. Traditionally, MLPs have provided distribution
growth by increasing the volume of products processed on
existing assets, reducing costs through improved operations and
scale, making accretive acquisitions, developing new assets, and
capitalizing on new trends.
To obtain the tax benefits of a pass-through entity, MLPs
must receive their income from qualifying sources, such as
the exploration, mining, extraction, transportation, storage,
distribution, and refining of oil and gas, and the production of
alternative fuels such as biodiesel. To qualify for MLP status, a
partnership must generate at least 90% of its income from what
the Internal Revenue Service deems qualifying sources. The
vast majority of MLPs are pipeline businesses, which generally
earn stable income from the transport of oil, gasoline or natural
gas. More specifically, energy MLPs are defined as those
that own energy infrastructure including pipelines, storage,
terminals, or processing plants for natural gas, gasoline or oil
in the United States. MLPs frequently acquire assets used in the
midstream segment, and their access to capital markets and low
costs of capital on a pretax basis create a compelling valuation
proposition in the transaction markets. Energy MLPs available
yields make them an actively sought-out investment option in a
low interest rate environment. (See Figure 2)
 Alerian MLP Index vs. S&P 500
Figure 2
Total Returns (w/Reinvested Dividends)

2000
1800
1600
GROWTH OF $100

1400
1200
Alerian
1000
MLP
800
Index
600
400 S&P 500
200
0
Jan-96
Jan-97
Jan-98
Jan-99
Jan-00
Jan- 01
Jan-02
Jan-03
Jan-04
Jan-05
Jan-06
Jan-07
Jan-08
Jan-09
Jan-10
Jan-11
Jan-12
Jan-13
Jan-14
Jan-15
Jan-16
Source: Yahoo Finance and Alerian

As such, in evaluating valuations for midstream companies, to benefit from higher crack spreads in the near term, thus
consideration should be given to yield data and trends for increasing their valuations. Another important factor affecting
the subject company. Amid the current downturn in oil and the crack spread is the relative proportion of various petroleum
gas commodity prices and the decline of the industry overall, products produced by a refinery. The mix of refined products is
midstream public companies yields have increased, but these also affected by the blend of crude oil feedstock processed by a
higher yields are due primarily to lower valuations rather than to refinery. Heavier crude oils are more difficult to refine into lighter
growth in distributions. products such as gasoline.

Downstream and Oilfield Services As with downstream companies, conventional variations of the
Income and Market approaches (e.g., DCF and EBITDA-based
Valuation Considerations multiples) may be used to value oilfield services companies.
As with E&P companies, lower oil and gas commodity prices
Conventional variations of the Income and Market approaches
decrease oilfield services companies valuations. In an
(e.g., DCF and EBITDA-based multiples) may be appropriate
environment of lower commodity prices, such as the one we are
in valuing downstream companies. Although lower oil and
currently experiencing, E&P companies significantly cut their
gas commodity prices adversely impact the valuation of E&P
capital expenditure budgets related to exploring and producing oil
companies, the valuation of downstream companies, such as
and gas. These budget reductions directly impact clients demand
refiners, often benefits from lower prices of the commodity
for an oilfield services companys products. Although volatility in
feedstock. The crude oil that E&P companies produce serves
commodity prices affects oilfield services companies valuations
as a primary feedstock for downstream companies, and
in general, certain oilfield services companies may suffer more
lower feedstock prices may result in higher crack spreads for
than others due to reductions in E&P capital expenditure budgets.
downstream companies. Crack spread is the differential between
the price of crude oil and the price of petroleum products
extracted from it that is, the profit margin a refinery can expect
when it cracks crude oil. As a result, in the current oil and
gas industry environment, downstream companies are expected

4
 Oilfield Services & Equipment
Figure 3
Segment Average EV/EBITDA Valuation Multiples

Oilfield Services & Equipment - Diversified Oilfield Equipment Manufacturers and Suppliers

16.0x 16.0x
16.0x 16.0x
14.0x
14.0x
14.0x 14.0x
14.0x 14.0x 12.6x 12.8x
12.6x 12.8x
12.0x 12.0x
12.0x 10.7x 12.0x
10.7x 10.3x
10.3x
10.0x 10.0x 9.4x
10.0x 8.9x 10.0x 9.4x
8.9x 8.3x 8.3x 8.1x 8.2x
8.3x 8.3x 8.1x 8.2x
8.0x 7.6x
7.6x 8.0x
8.0x 7.1x
7.1x 8.0x
6.6x
6.6x
6.0x 6.0x
6.0x 6.0x

4.0x 4.0x
4.0x 4.0x

2.0x 2.0x
2.0x 2.0x

0.0x
0.0x 0.0x
0.0x
CY 10
CY 10 CY 11
CY 11 CY 12
CY 12 CY 13
CY 13 CY 14
CY 14 CY 15
CY 15 LTM Jan-16
LTM Jan-16 CY 10
10 CY 11
11 CY 12
12 CY 13
13 CY 14
14 CY 15
15 LTM Jan-16
Jan-16
CY CY CY CY CY CY LTM

Oilfield Services Contract Drilling

16.0x
16.0x 16.0x
16.0x
14.0x
14.0x 14.0x
14.0x
12.0x
12.0x 12.0x
12.0x
9.9x
9.9x
10.0x
10.0x 9.1x 10.0x
8.3x 9.1x 10.0x
8.2x
8.2x 8.3x
8.0x 7.3x
7.3x 8.0x 7.3x
8.0x 8.0x 7.3x
5.8x
5.8x 5.8x
6.0x 5.3x
5.3x 6.0x 5.8x
6.0x 6.0x 4.5x
4.4x 4.2x 4.5x
4.4x 4.2x 3.6x
4.0x 4.0x 3.5x 3.6x
4.0x 4.0x 3.5x

2.0x
2.0x 2.0x
2.0x
0.0x 0.0x
0.0x 0.0x
CY CY
CY 10 CY
CY 11 CY
CY 12 CY
CY 13 CY
CY 14 CY
CY 15 LTM
LTM Jan-16
CY 10
10 CY
CY 11
11 CY
CY 12
12 CY
CY 13
13 CY
CY 14
14 CY
CY 15
15 LTM
LTM Jan-16
Jan-16 10 11 12 13 14 15 Jan-16

Figure 3 presents the variations in EBITDA valuation multiples for Shishir R. Khetan, CFA
the different types of oilfield services companies. Managing Director
Valuation & Financial Opinions
Summary
+1.713.221.5119
Although the three standard valuation approaches Income, skhetan@srr.com
Market and Asset are applicable for companies in the oil
and gas industry, each segment within the industry value chain Naveed Yahya, CFA
has its own unique operations and characteristics, making Senior Vice President
certain approaches and methodologies for the valuation of
Valuation & Financial Opinions
these businesses more appropriate than others. In addition,
modifications to the methodologies and certain commonly applied
+1.713.221.5147
valuation metrics are required, depending on where in the oil and nyahya@srr.com
gas industry value chain the company operates.

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should not be used in lieu of, professional advice. The publisher assumes no liability for readers
use of the information herein and readers are encouraged to seek professional assistance with
regard to specific matters. All opinions expressed in these articles are those of the authors and
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