📈 How oil and gas deals are priced

For investors looking for a way to turn a small bet on oil prices going higher into potential gains, you might consider buying junior oil stocks, oil futures, or options contracts… but each has its risks. 

• Trading physical oil in the short and medium term can be difficult and costly. 

• Futures and options can be complicated and extremely risky for investors who do not have a deep understanding of the derivatives markets. 

• While oil stocks may appear to be surging, they tend to be far more volatile than most investors can stomach.

But what if there was a way to make a bet on oil that offered the downside protection of real assets, the more predictable cash flow of real estate, and the upside potential of technology stocks?

Even better, what if you could buy into this investment opportunity at a discount to market value?

Chances are, you’d be looking at what could rightfully be considered the value investor's “sweet spot.” 

And just in case you’re wondering what the Patron Saint of Value Investing, Warren Buffet, thinks about energy stocks… 

Berkshire Hathaway added $588.7 million – more than 10 million shares – to his bet on Occidental Petroleum (OXY) between Dec. 11-Dec. 13 @ ~$56/share; then, another 5.18 million shares on Dec 19th, and another 4.3m shares on Feb 1, 2024.

With ~$15 billion of total capital invested into OXY since 2019 – a ~28.2% stake of this $53 billion company – thanks to OXY’s dividend, Berkshire receives ~$218.3 million in annual dividend income from this position. 

According to Berkshire’s 2023 letter to shareholders

Just to be clear, we’re not making any sort of buy/sell recommendation on OXY…

But if one of history’s best investors has major positions in oil and gas stocks – Berkshire’s fifth largest position is Chevron and sixth largest position is Occidental Petroleum – we take notice.

So, before you go hunting for “value” in the volatile energy sector – especially in smaller, private oil and gas projects…

The #1 thing you must understand is how oil and gas assets are valued, what types of corporate milestones drive valuation, and the many ways management may return capital to investors.

That’s the topic of today’s issue of Private Capital Insider.

Let’s get into it,

-Jake Hoffberg

P.S. Interested in investing in oil and gas? Pytheas Energy – an AI-powered, early-stage oil and gas producer operating in Texas – is raising capital on the Equifund Crowd Funding Portal. 

Go here to review their offering page and learn more.

P.P.S. Want more investor education on oil and gas stocks? If so, be sure to check out our previous coverage on the sector. 

• Is oil and gas a good investment?

• Oil, Gas, and the Texas Paradox

• Texas, Oil, and the Myth of Renewable Energy

• How AI investors can ride the oil and gas boom

• Investing in American “Craft Oil” Producers

A Brief Primer on Investing in Oil and Gas: Why Family Offices are getting in when institutions are getting out

One of the themes we’ll come back to over and over again in Private Capital Insider are the major problems small balance investors have when putting capital to work in private deals. 

Generally speaking, we can think about these challenges across five categories: 

1. Access: Getting access to the top funds is already hard for professional investors with hundreds of millions of dollars under management. You – the average retail investor – have almost no chance of getting invited into the “club.”
   

2. Underwriting: Even if you did have access, you likely don’t have the time or resources required to perform any substantive due diligence.
   

3. Check Size: Even if you did have access and could underwrite the deal, you may not have enough money to meet the minimums (or if you do, it’s probably a significant portion of your investable assets).
   

4. Liquidity: Even if you could get your money in a deal, most retail investors don’t want to get locked up for 7-10+ years.
   

5. Fees: If you are investing through fund vehicles, fees over the life of the fund can seriously eat into returns. In order to produce a 15% net-of-fee return, an investor in a fund vehicle needs to have the manager produce a gross-of-fee return of 22-24%+ (depending on fee structure).

All said and done, this does not paint a favorable proposition for retail investors looking to diversify into private markets on their own.

For this reason, it’s highly likely that retail investors will rely on some sort of relationship with an intermediary/promoter/advisor of some sort to “introduce” them to the types of investment opportunities they are looking for.

However, before we jump head first into a sexy sounding “single stock” opportunity – especially an early stage investment opportunity in the private markets…

We think it’s a good idea to be aware of all the available options you have to express your investment thesis to establish an appropriate “benchmark.”

Why? Because inevitably, you’re going to have questions – like “is this a good investment opportunity?” or “how much should I invest?” – that can only be answered relative to your other available options (called “Opportunity Cost”).

For example, if you believe there’s money to be made in energy stocks due to rising oil and gas prices, and you’re looking for a way to get “exposure” to this theme…

Generally speaking, you’ve got four major strategies to choose from: 

• Passive – Buy and Hold Sector-Based ETFs: The idea here is to “hire” a manager to do the stock picking for you.
  

• Semi-Passive – Create your own basket: Maybe you like the idea of a diversified basket of stocks for the “energy” allocation in your portfolio, but you want something more customized than the currently available products.
  

• Active – Day trading options, futures, and leveraged ETFs: Just in case oil and gas stocks aren’t volatile enough for you, there’s no shortage of “lottery ticket” style opportunities for short term bets.
  

• You Only Live Once – Bet it all (or just way too much) on a single stock: As bad of an idea as this is, we find it’s surprisingly common that individual investors put WAY too much money into a single position they may not fully understand.

Which strategy is right for you? Again, this is another question that can only be answered relative to your financial goals and asset allocation model (i.e., what percentage of your portfolio are you looking to allocate to energy?).

For example, in a world where more than 1,600 institutional investors have soured on energy and are actively divesting from the sector – By 2022, $22 trillion had been divested from fossil fuels across public and private markets, with over $40 trillion assets now committed to divestment, representing almost two-thirds of the total global pension fund assets under management ($56 trillion)...

Family offices are stepping up to fund oil and gas plays, as this “forced selling” creates an obvious buyers market with the chance to pick up quality assets at attractive valuations. 

According to Joe Flack, attorney for Jackson Walker, 

According to Mike Vlasic, whose family office has invested profitably in oil and gas for decades,

According to one of the Vlasics’ early partners, Frank Lodzinski of Earthstone Energy,

And just in case you’re not convinced this is actually happening, be sure to check out this Digital Wildcatters Podcast with the head of Stephens Inc’s Energy practice.

To be clear, just because family offices are investing in upstream oil and gas plays doesn’t mean you should. 

But if you are considering an Upstream investment – and ideally one where you can get in at an attractive valuation – let’s talk about how these assets are priced.

An Introduction to Valuing Oil and Gas Stocks

The oil and gas industry's value chain is classified into three distinct segments or sectors: 

1. Upstream (also known as exploration and production, or "E&P") extracts feedstocks used to produce fuels and petrochemicals
   

2. Midstream moves and stores feedstocks and finished products
   

3. Downstream processes crude oil and natural gas into finished products

We’re going to stay focused on Upstream for this article, as this is the most likely type of company you’ll see in private markets.

Generally speaking, 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. 

Reserves can be classified into three main categories:

• P1 – Proved Reserves: quantities of oil or natural gas that are recoverable in future years from known reservoirs under existing economic and operating conditions

• P2 – Probable Reserves: quantities that have a 50% probability that the reserves quantities will be lower than estimated, in accordance with the engineering definition of the American Petroleum Institute 

• P3 – Possible Reserves: quantities that 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, generally prepared independently by petroleum (or reserve) engineers, are used for this purpose. The reserve report is essentially a discounted cash flow model for a company’s oil and gas reserves, on a pre-income tax basis. 

The report typically includes the present value (PV) of the projected income based on various benchmark rates, frequently ranging from 10% to 25% discount (often referred to as PV 10 to PV 25).

While the discounted cash flow model is a mainstay of valuation techniques, flowing barrels per day (BPD) is a key metric used by oil and gas companies in both operational and valuation contexts. 

Essentially, BPD represents the volume of oil or gas produced daily from a particular well, field, or asset. For this reason, BPD is crucial for assessing the production capacity, revenue potential, and overall performance of oil and gas assets. 

Here's how upstream oil and gas companies utilize BPD as a valuation metric:

• Production Forecasting: BPD serves as a fundamental input for production forecasting. Oil and gas companies use historical production data, reservoir analysis, and well performance metrics to estimate future production levels.
  
  By projecting the expected BPD output over time, companies can assess the revenue generation potential and make strategic decisions regarding asset development, investment, and operational planning.

• Revenue Estimation: BPD directly impacts revenue generation for oil and gas companies. The daily production volume, along with prevailing commodity prices, determines the revenue stream derived from the sale of oil and gas products.
  
  Companies use BPD as a basis for revenue forecasting, budgeting, and financial planning. Higher BPD levels typically translate to increased revenue potential, assuming stable or favorable market conditions.

• Asset Valuation: BPD plays a significant role in the valuation of oil and gas assets, particularly producing fields or reserves. When assessing the worth of an oil or gas asset, investors, analysts, and industry professionals consider the current and projected production levels.
  
  Higher BPD figures indicate greater production capacity and revenue potential, which can positively influence the valuation of the asset. Valuation methodologies such as the Income Approach often incorporate BPD projections to estimate future cash flows and derive the present value of the asset.

• Comparative Analysis: Oil and gas companies and investors often use BPD as a basis for comparative analysis. When evaluating different assets or investment opportunities, stakeholders may compare the BPD metrics to assess relative production efficiency, reservoir quality, and operational performance.
  
  Comparative analysis helps in identifying high-performing assets, optimizing portfolio allocation, and identifying potential acquisition or divestiture targets.

• Operational Performance Evaluation: Monitoring BPD provides oil and gas companies with insights into the operational performance of their assets.
  
  Fluctuations in BPD levels may indicate changes in reservoir dynamics, well productivity, or production efficiency. By tracking BPD metrics over time, companies can identify operational challenges, optimize production processes, and implement strategies to enhance asset performance and maximize production yields.

Similar to other industries, as the company increases in size and scale, investors are often willing to assign higher multiples as the certainty of future cash flow increases.

This means that as the company begins to grow in size and scale, the valuation multiple on BPD may potentially increase.

According to Pytheas Energy’s management team,

However, while BPD is a useful “look back” metric of historical production and growth/decline, it cannot be relied on in a vacuum for valuation, as it does not take into consideration future production/future cash flow for distributions.

For this reason, to establish a more precise valuation, we also have to consider revenue, margins, targeted yields and distribution model – as well as how these values may change over time as the business matures in size.

However, it’s important for investors considering an E&P investment to understand what this type of valuation model is sensitive to – namely, fluctuations in commodity prices and production rates.

Let’s start with commodity risk…

If oil prices increase (decrease), this has the potential to increase (decrease)…

• the value of the underlying properties

• the cash flow from the assets acquired

• The overall liquidity in the market for these assets

If you want to learn more about oil price forecasts, be sure to check out some of our other coverage on the topic.

[Editor’s note: Our view at Equifund is we think oil prices are likely going to continue to trade above $80 – with a potentially clear path to $100+ – for the next few years]

However, because every investment is subject to the market forces that determine the commodity price, it’s a risk we just have to accept. 

In order to manage commodity risk, the major thing we need to keep an eye on is the average price of oil and gas required to produce at a profit (referred to as the “all-in sustainable cost” or AISC in the mining world).

While this commodity risk has the potential to create plenty of volatility that could blow up the investment opportunity…

Oil has to be one of the best commodities to own in a rising inflation environment (as energy prices tend to be a significant driver of inflation).

However, assuming oil prices remain above the AISC of the field, the main thing we’re looking at is management’s ability to improve production. 

Now let’s talk about execution risk…

Every E&P has essentially the same “Fix and Flip” business model –  buy low, sell high, and don’t lose too much money in between.

Fundamentally, this means we need to believe in Management’s ability to originate (and close) deals, manage the property, and dispose of them at a profit. 

On the buying and selling side…

One of the nice parts about buying oil and gas assets is that there’s a very “bright line” method for determining asset values – the reserve reports

Unlike other early stage companies where much of the valuation is speculative, based heavily on the future value of the intellectual property or technology, with much of the value relying on an often aggressive forward looking forecast…

All producing wells come with a reserve report that  more or less tie future production to historical production rates – which, in turn, sets the fair market value for the asset. 

While asset-light businesses (i.e., technology companies) might have the ability to grow rapidly and deliver extraordinary returns, they offer little downside protection for investors.

Conversely, asset-heavy businesses (i.e., oil and gas companies) have actual assets on the balance sheet that provide downside protection. 

Not to mention, when you’ve got a highly in-demand commodity like oil and gas, there’s basically always a willing buyer somewhere.

For the sake of simplicity, let’s just say that buying and selling oil and gas assets is relatively straightforward, and everyone is equally as good at it.

This means the true “value creation” mechanism for shareholders lies in Management’s ability to improve output of the wells. 

For a lot of obvious reasons, there’s a level of excitement around how artificial intelligence can help with this.

Looking for an AI-powered oil and gas play?

If so, you might be interested in checking out Pytheas Energy – an upstream oil and gas producer that is currently raising capital on the Equifund Crowdfunding Platform. 

[Disclaimer: By law, Equifund cannot make any buy/sell recommendations, provide individualized investment advice, or otherwise “endorse” any specific investment opportunity – especially ones listed on the Equifund Crowdfunding Platform due to the obvious conflicts of interest. Please do not make any investment decisions based solely on the information published in this article.]