Oil and Gas IB Interview practice

Recent History

TBD

The Four Verticals

1) Upstream 2) Midstream 3) Downstream 4) Oilfield Services

Upstream Overview

Firms in the upstream space are referred to as exploration and production (E&P) companies. They find the hydrocarbons (exploration) and decide whether or not to drill a well and extract the minerals from the ground (production). They contract service providers (OFS companies) to provide the equipment- everything from helicopter transportation to offshore rigs to the drill bit- and actually drill the well.

Upstream Valuation Methodologies

NAV, precedent transaction, trading comps, LBO, and Sum of the Parts (SOTP, used for vertically integrated supermajors)

Major independent E&P (upstream) companies

Apache, Continental Resources, Whiting, EOG Resources, Devon, Occidental, and Chesapeake Energy

Net Asset Valuation (NAV)

E&P companies are valued based on their reserves; being a non-renewable resource, the reserves of upstream companies have a finite life. DCF cannot be used because a basic assumption of DCF is that cash flows are projected into perpetuity. NAV assumes that the company's reserves will not increase and that they will produce 100% of the reserves until they are zero. A company will provide its bankers with detailed reserve data (typically from an ARIES database), which can be used to run through a basic NAV model.

Single Well Economics: The Type Curve

Engineers at E&P companies project the decline in production over the life of a well. This is used to project future production for valuation purposes. Production is an important measure of financial performance for E&P companies because it determines gross revenue; when combined with costs, the cash flow and profitability of a company can be determined and used for valuation.

EV/EBITDAX

Enterprise value to Earnings before Interest, Taxes, Depreciation (and Depletion), Amortization and Exploration

We exclude exploration expense for two reasons: 1) different E&P companies use different accounting methods, and 2) the industry is asset heavy, so exploration expenses are going to be extremely high; we exclude them in EBITDAX to better compare companies' financial health

EV/2P

Enterprise Value over (Proven + Probable reserves). Helps you understand how well a company's resources will support its operations and growth.

EV/Daily Production

"Price per flowing barrel". Calculated by taking Enterprise value over barrels of oil equivalent per day. Compare to peer group to see if trading at premium or discount.

Reserve Categories

There are three common categories of reserves (the three P's) based in the likelihood of extraction; uncertainty is due to financial, technical, or legal difficulties. Proved reserves (P1), Probable reserves (P2), Possible reserves (P3)

Proved reserves (P1)

Those with 90% certainty of extraction. Further broken down into PUD (proved, undeveloped), PDP (proved, developed, producing), PDNP (proved, developed, not producing)

Price differentials

The difference between spot price and the price that you sell your product for given a specific location

Reserves are measured in barrels (for oil) and cubic feet (for gas).

Accounting Method: Successful Efforts

the E&P company will capitalize the cost of exploration only if the well is successful; otherwise, the cost will be expended: smaller independent companies often use this method so cash flows are more stable

Accounting Method: Full Cost

The cost of exploration will be capitalized regardless of the success of finding oil and gas; large companies use this method

Possible reserves

Those with 10% certainty of extraction

Midstream Overview

The vertical that pertains to all activities and processes that facilitate the transportation of oil, gas, natural gas liquids, and refined products between the well and the end markets. Midstream activities include gathering; transportation via pipeline, truck, railcar, or tanker; natural gas processing; and storage. They often lock in long-term contracts (think 5-10 years) with E&P companies for a certain amount of production at a certain price; this typically makes them more stable than upstream companies; hence, creditors are more willing to lend to them and this vertical tends to have the highest leverage. The boost in US oil and gas production has created significant demand for additional midstream infrastructure.

Midstream Major Players

KinderMorgan, Enbridge, Enterprise, Magellan, and Energy Transfer Partners. Master Limited Partnerships (MLPs) are very common in this space.

MLPs

A publicly-traded limited partnership corporate structure that is tax advantageous (like a limited partnership) while also highly liquid (like a publicly traded company). MLPs are required to pay out nearly all of their cash flows to unit holders in the form of a distribution; they are not double taxed like C corporations. MLPs have a low cost of capital and typically trade at high multiples. MLPs are restricted to entities that transport or store natural resources that generate "qualifying income," which is why so many pipeline companies are structured as MLPs; they have stable income and less uncertainty of timing and volume of cash flows. Sponsors that control the GP can create an MLP with a small asset base, then drop down assets into the MLP to create scheduled and built-in-growth;this is favorable to the sponsor because IDRs increase the portion of cash flowing to the GP (from 2% to up to 50%) at each threshold that is met. Similar to REITS or BDCs, MLPs are pure financial engineering. They are merely a legal entity and have no employees. Asset drop downs from a sponsor into the MLP typically require a fairness opinion for the obvious conflict of interest (the interests of the GP vs LP); these are typically rendered by independent investment banks.

MLP Valuation

MLPs are valued using their distributable cash flow. Distributable cash flow is the cash available to common unit holders after payments to the GP; calculated as EBITDA-interest expense-capital expenditures. Common valuation methodologies include DCF, Discounted Dividends Model, precedent transactions, trading comps, and LBO.

Downstream Overview

The vertical that pertains to the refining, processing, marketing, and distribution of oil, natural gas, and NGLs. Petroleum products include plastics, petrochemicals, asphalt, and several classes of fuel. This vertical has the lowest profit margins out of the four; because of this, it is dominated by a small number of large players like Chevron, Marathon Oil, and Valero. Downstream is a slow and stable business; transaction activity is limited.

Downstream Major Players

Separated into Integrated and Independent. Integrated companies involved in downstream activities include Exxon, Chevron, Shell, BP. Independent companies include Andeavor, Valero, Marathon.

OFS Major Players

Schlumberger, Baker Hughes, Halliburton, and Weatherford

Oilfield Services Overview

OFS companies provide equipment and special services to companies at any vertical. Services can include everything from the supply of rigs, actual drilling of wells, fracking, transportation of rig workers, seismic testing, and the maintenance of equipment. These companies do not actually produce oil; they are contacted by other companies.

OFS Valuatuon

Common valuation methodologies include DCF, precedent transactions, trading comps, and LBO. For valuation purposes, they resemble a traditional industrial corporation, rather than an oil and gas-specific company. The OFS vertical is the most sensitive to changes in commodity prices; they are dependent on the other three verticals and are the first to be affected by price declines. Many of the smaller service providers have not weathered the price decline.

Two types of MLP members

Limited Partners: typically hold around 98% of units, initially; LPs are passive investors who supply capital and receive periodic distributions

General Partners: hold around 2% of units, initially; the GP managed the day-to-day operations and is incentivized to grow the value of the MLP through IDRs.

Incentive Distribution Rights (IDRs)

The GP's portion of claim to cash flows grows over time as the MLP grows and hits certain thresholds laid out in the partnership agreement.

Lower 48 Oil & Gas Plays Overview

An oil and gas reservoir is created when hydrocarbons are trapped beneath relatively less-porous cap rock; reservoirs naturally occur in layers beneath the surface of Earth. E&P companies use drills to penetrate the cap rock and extract the minerals.

Permian Basin

A large oil and gas play in West Texas and Southwest New Mexico that includes the Midland, Delaware, and Central Basins, among others. Most resilient US shale region following the crash of price; much of the recent drilling and acquisition activity has been in the Permian. Acreage is highly sought after by E&P companies; the basin has highly accessible shale reserves, low production costs, and attractive economics. The basin is often referred to as a "layer cake" of several oil-bearing formations; when a company has exhausted production in one formation, they can simply use the same well and drill down into the next formation. Pioneer Resources, Parsley Energy, Concho Resources, RSP Permian, and Diamondback Energy are major players in the region.

Acquisitions and Divestitures

Oil and gas is a capital intensive industry, particularly in the upstream vertical. Much of the transaction activity is in the acquisitions and divestitures space. E&P companies aim to optimize their portfolio of producing assets; they achieve this through the A or D of assets. A&D is essentially M&A except at the asset level, as opposed to the corporate level. Investment banks that advise on A&D deals have a dedicated team of engineers that work together with the bankers. There is usually no control premium paid for the assets.

Restructuring

The prolonged downturn in oil and gas prices has forced many energy companies into bankruptcy; most will go into Chapter 11 (reorganization) to restructure the debt on their balance sheet to avoid liquidation (Chapter 7 bankruptcy). There are many parties involved with often conflicting interests in a restructuring. Two sides that an investment bank would advise in a restructuring. 1) Debtor- the company that is in financial trouble; the legal and financial advisors will represent the interests of the equity holders of the company. 2) Creditor- the group to whom the company is indebted; often, the group of creditors organize and hire one legal and one financial advisor; many times, they would like to have their debt converted to new higher-lien debt or to equity before reemerging from bankruptcy; distressed debt investors operate in this space. Most investment banks that advise on restructurings are independent advisories.

BOE

barrel of oil equivalent; all reserves are converted to BOE to measure the amount of energy producible

Consensus

the consensus monthly forecast of the price of crude oil among private sector companies; often used as a price case in valuation

Contango

a market condition in which future commodity prices are greater than spot prices; the higher future price is often associated with storage and insurance of the commodity

Crude oil

the natural occurring state of oil before it is refined

Cushing, OK

the major American trading hub for crude; the delivery location and required price settlement point for all NYMEX WTI futures contracts

Decline rate

the rate at which well production is expected to decline; not constant

Derrick

the actual drilling rig apparatus above a well that moves and lowers equipment

Dry hole

a well that is incapable of producing sufficient quantities to justify completion

Fractionation

the process of separating NGLs from pure natural gas

Hedging

using derivatives on commodity prices for a period of time by hedging

Henry Hub

a natural gas distribution hub in Louisiana; the required price settlement point for natural gas futures contracts on the NYMEX

High splits

when the IDR split between GP and LPs reaches 50/50, the highest tier

Hydrocarbons

in this case refers to coal, oil, and natural gas

IDR split

the split of distribution rights between GP and LPs

IOCs

international oil companies; refers to international super majors like ExxonMobil

Liquefied natural gas (LNG)

not the same as NGLs; natural gas mixed with ethane and converted into liquid form for ease of storage or transportation

Maintenance capex

the cost necessary to maintain EBITDA at current levels

NGLs

Natural Gas Liquids that are often found mixed with oil and natural gas in a reservoir; not the same as liquefied natural gas

NOCs

national oil companies; oil companies that are owned by national governments; account for close to 3/4 of global production. Ex: Saudi Aramco, ADNOC, NIOC (Iran)

OPEC

Organization of Petroleum Exporting Countries; an economic cartel consisting of twelve major oil-exporting countries; major players are Saudi Arabia, Iran, Russia, and Venezuela; OPEC aims to set the price of oil by agreeing on supply levels; its decision on Thanksgiving in 2014 to continue increasing in production is a precipitating factor in the slide of prices

Peak oil

the theoretical day that oil reaches its maximum global production level, after which production will decline

PV-10

the after-tax present value of proved reserves discounted at 10%

Rig count

the number of rigs operating at any given time in the US; rig count data is often provided by services company Baker Hughes

SCOOP/STACK

two plays in the Anadarko basin of Oklahoma that have recently attracted investment; horizontal drilling activity has picked up in these plays

Shale

a form of sedentary rock that contains crude oil or natural gas

Spot

the current market price (as opposed to futures price) at which the commodity can be bought or sold for immediate delivery; spot prices for oil are for barrels in Cushing, OK, while spot for natural gas is at Henry Hub in Louisiana

Strip

the average price of a certain number of futures contracts; 12 month strip will be the average price of futures contracts for the next twelve months from today; strip will often defer from spot prices, reflecting sentiment of the direction of prices

Supermajor

vertically-integrated international oil companies like Shell

Take or pay

an agreement in which the buyer (often a pipeline company) will agree to pay the seller (often an E&P company) for a set amount of product at a set price, regardless if the buyer takes possession of it

Trend

used synonymously with the term play to describe an area rich with hydrocarbons

Well

the boring drilled into the ground through which oil and gas flow to the surface

Wellhead

the equipment at the surface of a well that controls the pressure

Working interest

a party's equity interest in a project before reduction for royalties or production share owed to other parties

WTI crude

West Texas Intermediate crude oil; the commodity underlying futures contracts traded on the CME and NYMEX; WTI is the benchmark for the price of US crude oil; it is lighter and sweeter then Brent crude, and is closely traded to Brent and the OPEC Basket; WTI is usually traded at a discount to Brent, though the lifted export ban on US crude has made the spread tighter

What is the trading price of WTI? Brent? NYMEX natural gas?

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Why does WTI trade at a discount to Brent?

WTI orignates from Texas, Louisiana, or North Dakota, and thus is usually landlocked making transportation costs higher. Brent comes from the North Sea and can be shipped around the world using tankers.

Which vertical has the highest beta? The highest leverage? Highest profit margins?

Betas: OFS(1.54), Upstream(1.27), midstream(0.94), downstream (0.81)

Highest leverage: midstream or downstream bc they are the least risky

Margins: ??? maybe Upstream?

What are the 3 P's?

3P is the sum of all proven and unproven reserves.

-Proved (1P) (P90) - reserves have 90% chance of being produced under the current conditions.

-Probable (2P)(P50) - reserves that have 50% chance of being produced.

-Possible (3P)(P1) - reserves that have 10% chance of being produced.

1P = proven reserves

2P = proven + probable reserves

3P = proven + probable + possible reserves

What is the difference between full cost and successful efforts accounting?

In full cost accounting, the cost of exploration will be capitalized regardless of the success of the well (larger companies). In Successful Efforts, the well will only be capitalized if the well is successful. Otherwise, the costs are expended (used by smaller companies in order to maintain stable cash flows).

Why do E&P companies pay so little in taxes?

oil&gas companies usually build up "tax pools" = credits that can be claimed against income - as a result of their capital spending programs on drilling wells an building facilities

-sometime 75% of taxes are deferred due to sky-high depreciation, depletion & amortization and because companies record them differently for book and tax values

Walk me through a basic NAV model.

Find the present value of cash flows from existing producing assets by assuming no new exploration and depleting their reserves to zero - sum up these asset PVs - this is your Asset Value

Subtract claims to other stakeholders and other corporate effects - subtract net debt (debt minus cash), subtract the present value of decommissioning liabilities (to clean up and plug the sites when production is done), subtract the present value of corporate costs (sales, general and administration), add the value of the hedge book (the hedges the oil and gas company has in place - this can make a big difference)

What are some multiples you would look at for an E&P company?

EV/Daily Production

EV/EBITDAX

What is unconventional drilling?

More expensive alternative to conventional drilling, but it allows you to extract more oil through a combination of horizontal drilling and fracking.

Explain what fracking is and how it has affected the prices of oil and gas.

Hydraulic fracturing, or fracking, increases the rate at which oil can be extracted from the ground. Since this increases supply, fracking helps to lower oil prices on a global scale. For example, when fracking was combined with horizontal drilling in 2014, supply went way up and thus prices crashed.