An Introduction to project economics, portfolio, and acquisition and divestiture in oil and gas sector.
How to do upstream oil and gas asset evaluation, An Introduction to project economics, portfolio, and acquisition and divestiture in oil and gas sector.
This article should not be taken as a guide to pick oil and gas stocks, but those who are interested in upstream business development and in particular acquisition and divestiture (A&D), may find this introduction useful. The content only presents an overview; a lot more can be discussed to cover this field in depth. Also there are variations to the upstream evaluation methodology that may differ from a company to company, but in essence they are to high degree close to what is outlined here. I would be glad to respond to your questions/comments on this subject (SYD at NAFT dot ca).
First and foremost, valuation can be done at asset (or field), license, country, geo-market, or corporate level (complete company takeover).
Methodology: Present Value of Expected cash flow of reserves per share (PVECFR per share) is the common methodology for assessing or ranking the performance and viability of an oil and gas company in generating future cash flow. More often the investment community run this over proved reserves (usually considered at 100% although this is a P90 figure) and probable reserves (50%) than only proved reserves.
Usually the present value of the expected cash flow will be run with weighted average cost of capital (WACC), 10% and an expected average rate of return of the peer group (say 15%) for sensitivity analysis. While the WACC may be used internally to assess the extent of the financial healthiness of the company, the expected average rate of return of the peer group can be used for comparison, ranking and M&A purposes. The price of oil and gas can be fixed at the date of analysis, or an average of past 12 month can be used (now SEC’s direction).
Cost: The cost elements (F&D, drilling and completion, lifting cost, interest) can be also extracted from the annual reports, or the average peer industry. In the case that that company holds a diversified portfolio of assets or this is type of an operator that has focus on a certain type of play the indicative cost figures from its peer group can also be considered. The average peer capital intensity can be used to estimate the Capex estimate for the development projects. Secondary sources of information and data from public domains can be used for cross check and validity purposes.
Late life cost/revenue: There are few cost and revenue elements that should be added at the late life of an asset or company. The cost elements at the late life are including but not limited to decommissioning, demobilization, plug and abandon of the wells (P&A), reclamation, potential union and cost of releasing/relocating the personnel, legal and governmental dues and levies at the end of the projects and so on. On the revenue side there would be some residual (or salvage) value associated to surface facilities, infrastructure (roads, pipelines, rights of way, airport, etc.), land, properties, licenses and so on that their value should be estimated and phased out at the end of the project.
Risks: The level of risk associated to a certain asset needs to be reviewed and quantified. For example in one of the divestment rounds in Canada that ExxonMobil presented to the market there was an old gas processing facility with several old gas wells (one component out of the package of 5 assets promoted for sale). The subject field was known for having high H2S content which immediately introduced several risks to the acquisition package. The risks that the evaluation team identified included potential risk of higher P&A cost of suspended gas wells (casing corrosion and borehole integrity issues, potential risk of hard to assess cost of remediation and reclamation of the gas processing plant in relation to age and the H2S, and social/image impact of owning of a H2S gas facility in proximity of communities. In such cases, some companies choose to avoid the risk and develop a partial bid by keeping the high risk components out, while other bidder may try to quantify the cost of the risk mitigation measures and consider those costs in. The risk of the latter approach is to lose the case due to overly higher bid.
Evaluation: With the production profiles (P+P), price estimate and the cost and investment profile a business case will be developed and series of sensitivities will be run to get the PVECFR for the most-likely (ML) scenario and the range of potential sensitivities based on the variation in the commodity price forecast, range of reserves uncertainty and range of uncertainty in cost and Capex profile. The PVECFR per number of outstanding ordinary shares of the company can then be compared to the current transactions of the company share in the market to determine if the company is under or overvalued.
In the case of a complete company takeover the evaluation should also include the tax pool of the target company and other fiscal or technological credits (or dues) that the company has in relation t the host government.
Other factors: There are other strategic and financial/economical factors that should be considered to support a thorough evaluation and the bid package for a target asset or company. Usually the executive board, controllers and the final decision maker(s) would expect to see these in the recommendation-to-bid package.
- Supporting current strategy (e.g. entry to a play, country access, know-how, etc.)
- Potential for improving current portfolio through economy of scale, or synergy
- Technology, patent, know-how, processes, human capital
- Mid/down stream assets, access to market
- Processing capacity to improve Opex of current assets
Financial ratios and index:
- Profitability Index (PI)
- Production and net back profile
- Net income per boe production; Net income per boe reserve (2P)
- Capex profile
- Debt to present value ratio
- Gearing ratio
- Reserve Recycle Ratio (RRR)
- Reserve Life Index (RLI)
- Capital Intensity
- Capital employed and return on capital employed
- FCF profile
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