Energy Prospectus

One of our members sent me an e-mail today asking me if I consider a company's debt level when I value an E&P company. He attached an article that discussed the high level of debt for many of the shale companies. IMO the article (probably written by a staff reporter) was poorly written and used a lot of very bad examples. Below is my response. - Dan
--------------------------------------------------------------------------------------------
Yes I do. I use a lower multiple of cash flows to value a company with a lot of leverage.

Let me add that the article below has several mismatches (IMHO). Debt levels should be compared to proven reserves (that is what the banks do), not to cash flows. Also, current assets should be compared to current liabilities and long-term assets should be compared to long-term liabilities. EBITDA is the current measure for estimating a companies ability to service their debt, which of course is very important. [Not to mention that comparing an E&P company to Exxon is ridiculous.] Plus, she uses a lot of really bad example like FST, GDP and Quicksilver. I bet we can find bad examples in every sector. [BTW I do think there is hope for GDP.]

The problem when a financial analyst that is unfamiliar with oil & gas accounting rules looks at an E&P company is that they see long-term assets on the balance sheet recorded at historical costs, not at current values. You need a reserve report to value an E&P company's assets.

For example, when I was at Hess we tracked over a 100 companies as possible takeover targets and we valued an E&P company's LT assets something like this:

100% of the PV10 value of the proved developed reserves (PDP)

+ 90% of the PV10 value of proved but undeveloped reserves (PDNP)

+ 50% of the PV10 value of probable reserves (P2)

+ 25% of the PV10 value of possible reserves (P3)

+ some value for raw leasehold (depended on how much we wanted it and remaining lease term)

If you took the time to do this for CLR or EOG, you would get a much higher value for their equity than just taking Assets - Liabilities looking at only the balance sheet.

My Fair Value Estimates are my "SWAG" at what I think a company's break-up or takeover value is today. It is slightly different than a price target, but close enough to compare to First Call's Price Targets.

Dan, One of my early approaches to valuing E&P companies was to take the EV (enterprise value) of a company and divide it by the bbls of oil equivalent reserves. This would give me a price that would have to be paid by an acquirer for bbls of oil equivalent.

I no longer think this approach is valid unless a company is for sale. If a company is not for sale and production does not yield enough revenue to finance development at a rate greater than depletion - the company as an operating entity is essentially self liquidating (I note that in the early days of a company self financing is not possible).

SFY comes to mind. Even with the Fasken deal RBC is concerned about financing for next year. What that means to me is that despite good drilling results the growing revenues are not sufficient to finance development at a rate faster than depletion. Ergo - SFY is self liquidating and should be sold. It is like running on a treadmill and slowly falling back to the rear of platform - from which you fall off.

Somewhere in this bucket of thought has to be a concept of critical mass which may be what is known as "free cash flow" like that you describe for DNR.

What are your thoughts on the importance of a company having clear visibility to "free cash flow"?

Bob

As long as an E&P company's proven reserves (PV10 value) are growing faster than long-term debt they will survive. High leverage does require a well run hedging program.

CLR and EOG have been outspending their operating cash flows for many years. The reason their stock price keeps going up is because they make their leasehold much more valuable year after year. EOG's position in the Eagle Ford is the most valuable piece of real estate on the planet. It is worth more than the entire market cap of the company. CLR's position in the Bakken is close behind.

I think SFY will make it. Those wells they recently announced are going to help a lot. Their year-end reserve report should support their debt level, especially if gas goes over $5.00/mcf. The sale of their Central Louisiana package will help a lot.