OIl and Gas - NAV model

I understand the gist of the model. You are valuing the company at the asset level instead of the corporate level. The NAV model I’m talking about assumes zero reserve replacement and then you calculate the cash flows from the oil extracted from the reserves, not the multiple one. At the end you get a NAV/share which is suppose to be the fair value.

What I don’t understand are the following:

  1. Why do most models I see use a cash tax-rate of 12%?

  2. Isn’t it super unrealistic to assume zero reserve replacement, as this would drastically undervalue the company. Understandably capex isn’t included either, but still. Doesn’t it make more sense to assume some growth based on R/P ratios, and subtract the related expenses, ie development and exploration to the model? And then decrease the R/P ratio depending on when you think they’ll reach peak production.

A lot more I don’t understand but these are just some questions on top of my head. Thanks for any help.

  1. This I’m not sure of, I wouldn’t do so in my models. Taxes on exploration, particularly in Canada (where I see you’re from), is complex. Most explorers don’t pay any tax for a bazillion years. That said, you’ll need some kind of tax rate and it will vary depending on the jurisdiction of the resource (and sometimes even the field may get certain tax breaks).

  2. Development of additional reserves requires capex (workovers, water floods, horizontals, etc). If you go down the route of adding Capex and determining growth, you’re building a DCF essientially. The NAV is valuable as it shows what the company is worth based on what it has spent to date, without additional capex. Extra capex (and therefore reserve growth) will require owner contributions, so they aren’t part of the instrinsic value of the share today.

In other words, the NAV of the share today does not include growth due to future owner equity contributions (such contributions can be deferred dividends… ie. retained earnings growth). It’s important in comparisons because I can give either company A or B more money to grow reserves, but the actual value of the share is what they’ve found with the contributions TO DATE. But remember NAV is just one piece. Maybe company B has a lower NAV, but better growth opportunities. NAV is a piece of the puzzle, it’s not the whole puzzle.

Perhaps I’ll explain this better tomorrow after some sleep, but that’s a high level.

Thanks. So am I correct to say that NAV is not the fair value of the company? After all, you are dismissing their cash flow growth from discoveries (for the forseeable future).

And can you comment if this is a good way to use NAV:

Company A,B,C and company D have same NAV, same r/p ratio, same oil/gas mix, smiliar plays geographically, in essence very similar. Yet company B is only half the value of company A,B and C. Therefore company B could be undervalued?

Not very practical in real life but would this be a correct conclusion given the information?

It could be fair value, depending on how you approach it. By convention companies report NAV discounted at 10%. I doubt that’s appropriate for most producers. You then have operational risks. I’m less confident of your ability to realize your reserves from Kurdistan than Alberta. In your example, you neutralise most risks, so I would agree that company B would be undervalued versus its peers. But of course in life risks are never equal. Management is everything in oil and gas, especially with juniors where the money is made. Also, the composition between 1P and 2P reserves can be different and different investors may risk or discount that differently. Its not an accounting metric that you can determine absolutely. The measure is full of assumptions and variables. Also keep in mind the real alpha is made when companies add reserves, something NAV doesn’t really address. You want managers working for your money that add to NAV regularly with less capex than their peers. You’ll get, say, a 10% IRR maybe on a producing well. The IRR on a new development can be 100% if a company nails a strong producer and adds 1P and 2P res You make money finding oil and producing it, not just producing what’s already been found. One of my investments spent $0.11/share in CapEx to add $0.80/share in NAV. That wasn’t in NAV the day before that discovery was announced. So you need to be cognizant of your managers ability to find oil. Companies that do that well will be at a premium to those that don’t. In your example, company B might be plagued by dry wells and poor execution.

Thanks again.

Regarding your last paragraph, isn’t it possible to project that through past filings? Kind of like what I mentioned in the first post.

Also, I still fail to comprehend why just NAV would be fair value. As you mentioned, companies do spend capex to find additions to add to their reserves. NAV doesn’t take that into account.

Another thing is corporate expense. What if we are paying the CEO $500M per year? I don’t believe SG&A is a factor of NAV? I guess it would make sense if another company would purchase reserves at NAV, but for the company itself I don’t understand how NAV will fairly value the company.

Well where is that Capex coming from? Additional debt or equity. Spending $50M with an estimated IRR of 10% means you need to raise equity (or debt) of $50M. The result? No impact on NAV. Asset up PV $50M, liability up $50M. The fair discount rate on new expenditures should be equal to its expected IRR. Capex additions of reserves are only incremental to NAV if the PV of the asset turns out to be greater than the outlay. Correct on SG&A. Consider it a management fee to manage your oil assets. Some “funds” have a higher MER than others. Some earn it, some don’t.

And not sure how you can project exploration success other than hoping those with good skill continue to have good skill. You can look at track records and that’s wise to do. But when your drilling a well, there is always an element of luck involved. Not to mention conditions that add to cost, or create delays like unexpected rock conditions, water availability, crew costs, early spring break up, late freeze up, etc. Its a crapshoot really.

Okay I suppose the book value of the additions would be the same as the increase in liabilities ( or equity). But aren’t we trying to find the true value by conducting NAV analysis? Like you said in the previous post, you would hope that the increase in assets (PV of future cash flow as determined by NAV) would be greater than the associated capex, which is what makes them attractive to investors.

Going back to SG&A, since it does have a significant impact on the valuation, I can’t just say NAV/share would be a fair value for the company’s stock right?

Also how would the tax situation work out? I understand that it’s very complex accounting wise, but do bankers actually spend all that time analyzing the nuances or is there a standard out there?

Finally, is there any primers available online on oil and gas valuation? I read the primer by DB on the industry, it doesn’t tell you much about valuation techniques though.

Thanks again.

AICPA is hosting an O&G valuation webinar on June 3. I’ll be attending it. It might have some of the answers you’re looking for. Look in their website under the Forensic & Valuation section.

Thank you. Will look into it!