What is the Oil & Gas Industry?
The oil & gas industry, also known as the energy sector, relates to the process of exploration, development, refinement of crude oil and natural gas. It is possible to invest in this industry directly and indirectly. An investor can choose to purchase the commodity using the spot market or futures market. Or, the investor can invest by buying shares through the stock market.
How are oil & gas prices set?
Oil and gas prices depend on the supply and demand for the commodity. As the demand for the product falls, so does the price. As prices increase, more investment goes into drilling project and inventing more efficient techniques. So, the supply for oil and gas is price driven. The Organization of the Petroleum Exporting Countries (OPEC) controls 75% of the reserves and 43% of production. Therefore, they have a large influence on the supply and price of oil. On the other hand, segments of consumption drive the demand. The main segments are industrial consumption, residential consumption, and power generation.
Quick Summary Points
- The oil & gas industry includes all the companies involved in the process of finding, drilling, extracting, refining, and distributing the commodity.
- The industry has three categories: upstream, midstream, and downstream.
- Valuation methods include using discounted cash flow to find the net present value and industry-specific ratios such as enterprise value per flowing barrel.
Upstream, midstream, and downstream
There are three components of the oil and gas industry, for each part of the value chain. Due to the complexity of each component, most companies focus on one.
- Upstream: Another name for the upstream industry is exploration and production (E&P) since this industry finds and produces crude oil and natural gas. This industry also comprises of service companies that assist the E&P processes. For example, rig operators, engineering and scientific firms, and equipment manufacturers.
- Midstream: After the upstream industry finds and produces oil and gas, the midstream companies store and transport the products. The role of midstream companies is to connect the petroleum producing areas to the population centers where the customers are. This is done through pipelines, rails, tankers, and truck. Midstream companies also have properties of upstream and downstream producers. For example, some companies might have processing plants to remove sulphur and natural gas liquids.
- Downstream: When midstream companies deliver products, downstream segment refines, markets, and distributes the end product to consumers. End products include gasoline, jet fuel, heating oil, and diesel. The end products are dependent on the complexity of the refinery. Some are capable of producing multiple types to be in line with current demands.
Reserves and Resources
Oil and gas reserves and resources are volumes that might be commercially recoverable in the future. Reserves and resources are further categorized based on estimated volumes, which help determine the potential of a field.
The three categories of reserves are proved, probable, and possible reserves. Each category has a different probability of recovery. For example, the recovery rate of a proved reserve is 90%. On the other hand, resources have less certainty relative to reserves. It is further split into contingent and prospective, with contingent resources having more potential for recovery.
Valuation methods for Oil & Gas Producers
1. Net Asset Value (NAV)
The net asset value or discounted cash flow helps determine the value of oil and gas producers. Most NAV is the present value of after-tax cash flows. To make the NAV calculation more reflective of actual value, it accounts for proven and probable reserves.
2. Trading Multiples
Trading multiples help investors compare the valuation of a company with their peers. Common multiples used are:
- Enterprise Value per Flowing Barrel (EV/ boe/d):
- Determines the value of the company per barrel of production. Helps investors compare the price of the company with the production volumes of the company
- Field Netback:
- Shows the margin created from a barrel of oil after subtracting standard costs. This indicates the profitability of the asset without taking into account taxes and interest.
- Enterprise Value to Reserves (EV/boe):
- Similar to EV per flowing barrel, but compares the price of a company with barrels still in the ground. This helps determine the future potential of a company’s assets.
- Finding, Development & Acquisition (FD&A) costs:
- Shows the cost of finding a barrel reserves and producing it.
- Recycle Ratio:
- Indicates the level of profitability of an oil or gas asset.
- Price/NAV (P/NAV):
- Calculates how much an investor is paying for the underlying net present value of the company.
Valuation method for oilfield services
Discounted cash flow is not the typical evaluation method for service companies. Instead, common methods are EV/EBITDA, P/E, and sum of the parts. The factors that influence EV/EBITDA and P/E are growth prospects, risk profile, and strength of the leadership team. Sum of parts is suitable for a company that is involved in more than one segment of the oilfield service industry.
Thank you for reading CFI’s Oil & Gas Primer. To keep learning and advancing your career, these resources will be helpful: