Oil & Gas Specific IB Questions

1. How are energy and natural resource companies different from normal companies?

1. cannot control price of "product" only production

2. Asset-centric

3. Different accounting

4. Depleting Assets

5. Cyclical

2. What are the different segments of the oil and gas industry?

1. E&P

2. Midstream

3. Downstream

4. OFS

3. What are Production and Reserves and why are they so important for these companies?

Reserves - nat resources in the ground that can be extracted in the future. Key input into a Net Asset Value (NAV) model

Production - key driver for rev/expense in a model

4. How would you value a natural resource company?

1. Public Comps

2. Precedent transactions

- Screen based on production & reserves

- EV/EBITDAX, EV/Proved reserves, EV/production

3. DCF for midsteam/OFS, but NAV for E&P.

Value from an E&P comes from its assets, while a DCF may show a low valuation because of high CapEx

5. What are common metrics and valuation multiples for energy and natural resource companies?

Metrics: Proved reserves, Daily production, oil mix

multiples: EV/EBITDAX, Proved reserves/annual production, EV/production, EV/reserves

6. How do we measure Production and Reserves?

Oil - barrels, MMBbls

Nat Gas - MMcf, Bcf, Tcf

7. How do you convert between different types of energy, such as oil, gas, and natural gas liquids? Why do we need to convert them in the first place?

You convert based on how much energy a barrel of oil (or natural gas liquids, or synthetic oil, and so on) produces and how much energy 1,000 cubic feet of natural gas produces

• 1 Bbl of Oil = 6 Mcf of Natural Gas

If you convert to oil units, you get Barrels of Oil Equivalent (BOE) and if you convert to gas units, you get Thousand Cubic Feet Equivalent (Mcfe).

8. Explain the difference between successful efforts and full cost accounting.

Successful efforts - Expense dry holes (IOC)

Full Cost - Capitalized dry holes in PP&E (Independent)

successful exploration is capitalized in both

9. Why would a company ever want to use successful efforts accounting? It seems like full cost accounting is much better in terms of net income and therefore EPS.

This statement is not necessarily true. Yes, full cost companies often have higher operating incomes and net incomes, but high impairment charges may reduce both of those and actually make them lower.

In general, small and startup companies prefer the full cost method and larger and more diversified companies use successful efforts because it's easier for the larger companies to absorb the unsuccessful exploration expense

10. Let's say a successful efforts company has a successful exploration expense of $100 and a dry hole, or unsuccessful exploration, expense of $100. Walk me through how the 3 statements change when we record these expenses.

On the income statement, operating income falls by $100 because of the unsuccessful exploration expense. Assuming a tax rate of 40%, net income is down by $60.

On the cash flow statement, net income is down by $60 so cash flow from operations is down by $60; the successful exploration expense of $100 is recorded under cash flow from investing, so that is down by $100 and the net change in cash at the bottom is down by $160.

On the balance sheet, cash is down by $160 but PP&E is up by $100 because of the $100 in additional successful exploration expense, so assets are down by $60.

On the other side, shareholders' equity is down by $60 because of the $60 decrease in net income, so both sides balance.

11. Let's say a full cost accounting company has a a dry hole worth $100 and a successful exploration well worth $100. Walk me through the 3 statements once again.

There are no changes to the income statement for a full cost company. On the cash flow statement, cash flow from investing falls by $200 because both the successful and unsuccessful exploration expenses are capitalized, and so cash is down by $200 at the bottom.

On the balance sheet, cash is down by $200 but PP&E is up by $200 because of the capitalized exploration expenses, so neither side of the balance sheet changes and it remains in balance.

12. Let's say we're comparing 2 companies, 1 that uses successful efforts and 1 that uses full cost. How can we normalize EBITDA to make the numbers truly comparable?

Similar to the EBITDAR metric for airlines and retail companies, you can calculate EBITDAX - Earnings Before Interest, Taxes, Depreciation/Depletion,

Amortization, and Exploration - by adding the Exploration expense on the income statement to EBITDA.

For full cost companies, EBITDAX is the same as EBITDA because they don't record an Exploration expense on their income statements at all - but for successful efforts companies EBITDAX will always be higher.

If you did not do this, EBITDA would seem higher for full cost companies - but that reflects different accounting standards rather than actual cash flow.

13. How is an oil and gas company's capital structure different from a normal company's capital structure? What impact does that have on the valuation?

Generally, oil & gas companies carry significantly more debt than "standard" companies in other industries like technology. They may have over a dozen different tranches of debt, often in the form of high-yield debt with bullet maturity.

They do this because they constantly need to find and acquire new reserves, and they may not always have sufficient organic cash flow to do so.

This difference doesn't directly impact the valuation, but it's one of the reasons why P / E multiples are not as meaningful for natural resource companies: a higher-than-normal interest expense can distort what P / E tells you.

I'm looking at a successful efforts company's cash flow statement right now, and they're adding back the dry hole expense in cash flow from operations and then counting it as part of their CapEx under cash flow from investing.

Why are they doing that?

There is inconsistent treatment of the dry hole expense among successful efforts companies (they should expense it)

But in real life, some companies actually add back the expense under cash flow from operations and then subtract it out again under cash flow from investing, therefore capitalizing it and adding it to their PP&E number

Unfortunately there's no rhyme or reason to this - it's just an inconsistency and something you have to be aware of when analyzing the financial

statements

Walk me through what happens on the 3 statements when the asset retirement accretion expense goes up by $100

If the expense goes up by $100, operating income on the income statement falls by $100 and net income falls by $60 assuming a 40% tax rate.

On the cash flow statement, net income is down by $60 but the asset retirement accretion is a non-cash expense, so you add it back and cash at the bottom is up by $40.

On the balance sheet, cash is up by $40 so total assets are up by $40; on the other side, the asset retirement obligation is up by $100 but shareholders' equity is down by $60 due to the reduced net income, so both sides are down by $40 and the balance sheet balances.

What is an asset retirement accretion expense?

Relates to the asset retirement obligation, a liability on a natural resource company's balance sheet - it reflects how much it will cost to shut down the oil/gas fields of that company in the future

Why might a natural resource company use hedging, and how do you incorporate it into a 3-statement model for the company?

With hedging, a company uses derivatives to provide "insurance" against a sudden drop in commodity prices

(Think of hedging as options to cover price swings, but you loose out on the premiums)

Hedging seems like a good idea to smooth out a company's revenue - why do many natural resource companies, especially large ones, choose not to use it?

that if commodity prices rise, the company would not realize the full benefits.

Difficult to scale - there are not enough derivatives available to cover all Exxon's production.

Let's say we're looking at an energy company that uses derivatives for hedging purposes. They record a realized gain of $60 and an unrealized gain of $40. Walk me through the 3 financial statements.

On the income statement, you record both the realized gain and the unrealized gain, so operating income is up by $100 (normal companies may list these under pre-tax income, but for energy companies they are usually part of operating

income). Net income is up by $60 assuming a 40% tax rate.

On the cash flow statement, net income is up by $60 but you subtract the unrealized gain because it's non-cash, so cash is up by $20 at the bottom.

On the balance sheet, cash is up by $20 and the derivatives line item on the assets side is up by $40 due to the unrealized gain, so total assets are up by $60. On the other side, shareholders' equity is up by $60 because of the net income increase, so both sides balance.

Why do energy and natural resource companies have high deferred tax expenses? How can we estimate them in a model

they have high PP&E balances and they depreciate PP&E differently for book and tax purposes - that

difference creates deferred tax liabilities (DTLs) or deferred tax assets (DTAs).

You could attempt to estimate these differences, but it's almost impossible unless they give you detailed numbers for everything - so you usually just assume a percentage for current income taxes and a percentage for deferred income taxes, based on historical averages.

What are common non-recurring charges and add-backs for energy and natural resource companies?

When you're calculating EBITDA and EBITDAX,

The usual

1. DD&A, (depreciation, depletion & amortization)

2. Stock-Based Compensation

3. Restructuring-type

Oil and Gas:

1. Asset Retirement Accretion (a form of amortization)

2. Non-Cash or Unrealized Derivative (Gains) / Losses

3. Impairment Charges and PP&E Write-Downs (more common with full cost companies)

4. (Gain) / Loss on Sale of Assets

5. Environmental Remediation

How do you take into account the uncertainty of commodity prices when projecting revenue for a natural resource company?

You create scenarios for different prices

Generally you assume that the prices stay the same each year, i.e. that it's $40 per barrel in years 1 through 5 of the low case. Otherwise it gets confusing to assess the impact of different prices on the model.

How do you determine which expenses on the 3 statements are linked to Production and which are not?

Stated in financial statements as "trends with production"

Common expenses that trend:

1. Production expense

2. Sales taxes

3. Transportation

4. DD&A (unit production depletes reserves)

5. Accretion of asset retirement obligation

Which two additional items may be used to calculate enterprise value in an O&G company

1. Subtract Net Value of Derivatives: For companies that use hedging and therefore carry derivatives on their balance sheet, the net value of the derivatives might count as a cash-like item

2. Add in Asset Retirement Obligation: it reflects the cost required to shut down oil fields and wells in the future, discounted to its present value. (debt-like item.)

How is an oil & gas company's capital structure different from a normal company's capital structure? What impact does that have on the valuation?

Generally carry significantly more debt (multiple tranches with plenty of HY debt w/ bullet maturities)

Constantly need to find and acquire new reserves, and they may not always have sufficient organic cash flow to do so

Which non-standard metrics may apply to comps in the O&G industry?

1. Proved reserves

2. Production

3. Reserve Life ratio

4. EBITDAX (bank dependent)

What is Reserve life ratio?

Proved Reserves / Annual Production

Let's say that one of my public comps has a Reserve Life Ratio of 15 and another has a Reserve Life Ratio of 10. Which one will have higher EBITDA and EBITDAX multiples, and why?

All else being equal, the one with the Reserve Life Ratio of 15 will have higher EBITDA and EBITDAX multiples. A company with 15 rather than 10 can

generate profits for a longer time period and may not need to explore and acquire as frequently.

Investors would reward that by valuing the company with the higher Reserve Life Ratio more highly.

What are the flaws with looking at revenue multiples and P / E multiples for natural resource companies?

rather than reflecting how much the company is producing or expanding, revenue multiples usually just reflect prices for oil.

Nat Resource companies often have high interest expenses, high deferred tax numbers, and high non-cash charges such as DD&A and Impairment.

Could you create a standard DCF for natural resource companies? How is it different?

There are 5 potential differences:

1. You will have additional non-cash expenses (e.g. Asset Retirement Accretion)

2. You would use Daily Production, EBITDA, or EBITDAX for the terminal exit multiples

3. For the Gordon Growth method usually you assume a negative rate long-term growth because oil & gas assets get depleted over time and there's only a finite amount in the ground.

4. You could use the oil & gas industry standard 10% discount rate rather than calculating WACC.

5. For the sensitivity tables you would look at commodity prices as one of the variables rather than revenue growth or EBITDA margins; other

variables might be the discount rate and terminal growth rate or terminal multiple.

Walk me through a NAV?

Assumptions: never increase existing reserves (no additional CapEx so eventually runs out of reserves)

1. Pick a starting number for the Reserves - usually this will be Proved Reserves (1P), but you could also go with 2P or 3P in more aggressive models.

2. Project Production and Realized Prices. - decline curves

3. After-Tax Cash Flows = Revenue - Production -

Development exp. - Taxes.

4. Calculate the Net Present Value of the After-Tax Cash Flows.

5. Add the value of undeveloped land and the value of the other business segments such as chemicals, midstream, and downstream.

6. Work backwards from EV to calculate Equity Value

It's similar to a DCF but there's no Terminal Value, which is arguably a good thing, and there's a much smaller CapEx expense since you assume no future expansion.

Why a NAV over DCF?

1. A DCF values a company at the corporate-level, but natural resource companies are balance sheet-centric and should be valued based on their assets instead.

2. Natural resource companies often have extremely high capital expenditures that reduce their Free Cash Flow and may even make it negative; this distorts a traditional DCF and sometimes turns it into nothing more than a simple Terminal Value calculation.

Arguably the NAV is more conservative than the DCF as well, since you assume that the company stops producing after a certain point in time rather than the constant growth implied by a DCF.

what are some of the flaws with the NAV model?

1. projecting far into the future so can be heavier on far-future assumptions (life of the reserves)

2. Commodity prices are impossible to predict

3. Only applicable to E&P

Why not subtract SG&A or DD&A in a NAV?

1. Corporate overhead is not included because you are valuing strictly on an asset-by-asset level

2. Assuming no growth capex so no matching DD&A

Do you think natural resource companies are good targets for leveraged buyouts? What are the advantages and disadvantages?

Disadvantages:

1. unstable, unpredictable cash flows due to commodity prices

2. Huge capex needs

3. Already have high debt loads

Advantage:

1. hard asset bases that can be used as collateral (but still linked to commodity prices....)

Do you use EBITDAX for a natural resources LBO?

No - EBITDAX is only used to normalize between succefful efforts and full cost accounting

EBITDA is the standard for LBOs and debt profile

List some single well model assumptions (10)

1. r = 10%

2. D&C = $5MM to $10MM (drilling, completions & facilities)

3. Royalty burden = 25% in Texas (12.5% on federal lands)

4. All revenue is subject to Net Revenue Interest [working interest% * (1-royalty burden)]

5. All cost is subject to WI%

6. Variable cost of ~$1.10 bbl

7. Fixed cost step down from $24k/month for first 15 months then $8k/month after (after 15 months the decline curve levels off)

8. Taxes: VAT = 2.5%; Oil Severance = 4.6%; (NG severance = 7.5%)

9. Differentials: oil = $3; NG = 11%

10. Economic limit is when prod. cost = prod. rev

Is your DCF real or nominal?

Nominal...you aren't talking about inflation anywhere