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Till now in this blog I have mostly valued Tech businesses using the DCF technique. As the Capital expenditures were very limited hence calculating Free cash flow (FCF) was somewhat simple. I simply subtracted Capital expenditures from Cash flow from operations (CFO) to get the Base Free cash flow. But Oil & Gas businesses involve large Capital Expenditures. In fact most of the time we would see that the businesses pretty much put back most of the Cash flow from operations back to business as Capital Expenditures. Plus the businesses are highly leveraged too. This blog post looks into the basics of Oil & Gas business and the valuation technique that one needs to follow.
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First and foremost I would like to again remind you that the basic objective of an Oil & Gas business is the same as any other business. It’s to generate Cash. But the large Capital expenditures increases the asset base and hence the earning power. Let us consider the following example. Bob invests $1 million in leasing a piece of land that has oil wells. The oil well has enough oil to generate revenues of $2 million , assuming Oil is at $75 / Barrel. Overall cost of operations including all taxes are $700,000. Thus the net cash generated = $2 million - $700,000 = $1.3 million. The investment return is ($1.3 million - $1 million) / $1 million = 30% . Thus one can easily say that Bob made a very sound investment as $1 million investment generated 30% return. The valuation of the business looked very simple, so what is it that complicates the valuation? In the above example we assumed that the Investment in the oil well was a one time deal and once all the oil from the well is produced the business is closed down. In real world Oil&Gas businesses don’t operate that way. Whenever they generate profit, they plough it back to lease more wells, thus if we apply this theory in the above example , Bob would buy a well in year 2 , 3 and 4 and in year 5 would buy 2 wells because he would have extra $1.2 million ($300,000 x 4). If we assume that the Oil price remains constant at $75 / barrel and Bob’s cost structure is same, the valuation still is somewhat straightforward. But in real world the oil prices and cost of operations can change drastically in a short amount of time. Year 2014 was a classic example where oil prices dropped more than 30% in 6 months. Whenever oil prices go down the Revenues also goes down. But the cost structure remains the same. Because they are mostly all fixed cost. With reference to above example, Bob has 2 oil wells in Year 5. If we assume that oil price is $75 / barrel and the costs are $700,000 / oil well. The net profit is $2 million - $1.4 million = $600,000. But if the oil falls to $50 / barrel, then the revenues would fall by 33% {($75 - $50)/ $25} . Instead of generating $2 million, the business would generate $1.33 million in revenues ($2 million - ($2 million x 33%)) , as the costs are at $1.4 million, so suddenly we are seeing a net loss of $67,000 ($1.33 million - $1.4 million). The business that seemed very lucrative now seems a lemon. Thus we can see that in an Oil & Gas business , the assumption of price of oil makes a huge difference in the value of the business. So the valuation will consist of following steps. STEP-1 Figure out the current Oil generating Capacity. (A) STEP-2 List down the current assets like Cash , Accounts receivable . (B) STEP-3 Calculate the overall liabilities. (C) STEP-4. Figure out the operating cost per barrel. (D) STEP-5. Calculate the Tax rate (T) STEP-6. FINAL VALUATION : Assuming the price per barrel is P1 , the value of the business is {(A x P1) – D} x {1 – T} + {B – C} |
