Economics of Independent Oil & Gas Businesses

With the recent crash in oil prices from $100 per barrel to around in $50 per barrel , there is a lot of talk about identifying value opportunities in the Independent Oil & Gas sector. Thus thought of first analyzing the economics of this sector in general.

HOW DOES AN INDEPENDENT OIL AND GAS BUSINESS MAKE MONEY? Core asset of an Independent oil and Gas business are its Oil properties. The business makes money by Extracting oil from its oil reserves and selling it in the market. The difference in Selling price of oil and the total cost to extract the oil is the net cash the business generates from its operations. As the oil reserves deplete the business also has to re-invest its profits to buy new reserves. Most of the costs associated for generating oil is fixed per barrel of oil. Thus as the Oil prices increases the business generates more cash from operations. The increase in oil prices also brings in more players in the industry and hence the prices of oil properties also increase. So if the existing business has to keep up its oil reserves then it has to pay premium prices to buy new oil properties. In theory , the only smart way out of this vicious cycle is to only buy additional properties when the oil prices are its lowest end. But the institutional imperative holds back the corporations to do this. Instead they are fine paying high premiums to maintain their reserves , otherwise declining reserves will not give a good image to the analyst community. CASE STUDY: ANADARKO PETROLEUM: To portray the above mentioned points lets analyze Anadarko Petroleum. Its one of the largest Independent Oil & Gas producers. As of Dec-31-2003 the company had proved reserves of $2.5 billion barrels. Its current assets was $1.3 billion and Total liabilities was $5.1 billion. Thus the net liabilities (Total liabilities – Current assets) = $5.1 billion - $1.3 billion = $3.8 billion. As of Dec-31-2013 the company had proved reserves of 2.8 billion barrels. Its current assets was $7.8 billion and total liabilities was $32 billion. Thus the net liabilities (Total liabilities – Current assets) = $32 billion - $7.8 billion = $24.2 billion. Thus within 10 years the company incurred an additional $20.4 billion ($24.2 - $3.8)of liability to just increase its reserves by 300 million barrels. (2.8 billion - 2.5 billion).The market value of these reserves has fallen by 50% in last 6 months alone. This showcases a very poor business Economics, hence I plan to stay away from Independent Oil & Gas companies and put the entire industry to NO THANKYOU list.

CASE STUDY of a business with shallow moat - Digital music

I love digital music , its so easy and convenient and gives us so much choice. Fast internet and access to pretty much unlimited content through Youtube has opened up doors for techies like me to create our own software to listen to music. I listen to music thru a small software I develoved re-using some of Google's freely available code. Its called Relaxingtunes. Once in a while I get some advertisements but I am fine with it. The story might seem great for consumers , but for any investor in this market this might be worrisome , because it showcases such a shallow moat.

A moat is a deep, broad ditch, either dry or filled with water. In olden days it was use to surround a castle to provide it with a preliminary line of defence. The deeper and wider the moat, more secure was kingdom. The definition of moat might resemble olden times, but the significance is still relevant in the Business world where it signifies the barriers to entry. Boeing co is an Example of a business with deepest moat . Its pretty much certain that even 20 years down the line we will still need airplanes to travel long distances in short time , unless and until Telepathy takes a bigger leap… one can also be pretty much certain that Boeing would still be a dominant player in manufacturing jet engines. Its because of the complex engineering that goes with developing jet engines . William Boeing , a pioneer of aerospace industry started the company in 1916. For nearly a century the company has steadily progressed in perfecting the design of an aircraft engine. For anyone to compete against them would at least need to spend few decades to even come close to building an aircraft engine. Thus we can see how the complex engineering makes Boeing’s moat so valuable. Standing in other end is Digital music , to be fair its not alone , there are scores of other types of businesses whose moat is shallow or practically insignificant. The interesting point here is that even a great business like Apple can get crushed if it enters a business with a shallow moat. Steve Jobs is accredited for his genius of re-inventing the music industry by developing itunes software. Very few people know that the original software was not developed by Apple. Apple bought SoundJam MP , developed by Bill Kincaid in 2000. The software was renamed as itunes. The real success behind itunes was Jobs’ negotiation skills with music executives. Before the year 2000, the music industry had enjoyed decades of success by collecting large royalties from sales of records, cassettes and CDs . But by 2000 their business was under fire because of folks like Napster that had introduced file sharing software where individuals could download songs and share it with their friends. The music industry was looking for a savior and Jobs stood up for them. He convinced them to embrace the new digital world and showed them how they can profit from it by selling the digital rights of their songs to itunes. The formula worked , because consumers liked the ipod hardware and didn’t mind chipping in couple of bucks for a song to enjoy their favorite song in their favorite device. Thus it was a win-win combination . As the ipod franchise grew so did the itunes business. In the year 2013 we saw the first cracks in itunes business model. Global revenues fell by 2.1% and in 2014 the drop has been 14%. The reason is very simple , consumers were able to enjoy the same music via a flat monthly subscription of $10. Just imagine if someone would offer you to eat as many sandwiches as you want for a monthly subscription of $25 and the sandwiches exactly taste like SUBWAY. I am sure you would choose the flat fee model. In Food business its not that easy to replicate the product, that’s why the SUBWAY franchise has survived. This does not mean that I am a great fan of restaurant business. I will cover its pitfalls some other day. Coming back to apple’s story , it was forced to shell out $3 billion to buy Beats music and plans to use it for itunes' re-launch in 2015. Apple’s core assumption with this ordeal is that enough folks would sign in for the $10 per month subscription to avoid the advertisements that come with scores of FREE digital music softwares. But the writing is in the wall that Apple is trying to tread an upstream that’s getting tough each and every day. Worldwide revenues from selling recorded music was $15 billion in 2013 , 50% down from their peak figures of 2000. Subscription based digital music seems to be a silver lining for the music industry. Revenues have increased 28% in the first half of 2014. But the good story ends here only. Pandora recently announced their quarterly results stating its user base grew by a small clip of 5.2% to 76.5 million active users, and it cautioned its investors for a tough competitive environment. Spotify also dropped its prices last month and gave promotions like sharing the account in a family at a discounted rate. Spotify has around 40 million users out of which 10 million are paying customers. Story gets worse overseas. In Sweden the pace of total downloads has kept up the market, but the number of paid customers is very negligible, quite obvious I guess , folks in the Nordic have ample patience to tolerate few seconds of advertisements. Reference – WSJ article on Apple – “A sad song for itunes sale” Part-1 of article  Part-2 of article CONCLUSION : To me its quite evident that Apple has overpaid for Beat’s acquisition. The total purchase price consideration for these acquisitions was $2.6 billion, which consisted primarily of cash, of which $2.2 billion was allocated to goodwill, $636 million to acquired intangible assets and $258 million to net liabilities assumed. Concurrent with the close of the acquisition, the Company repaid $295 million of existing Beats outstanding debt to third-party creditors. In conjunction with the Beats acquisitions, the Company issued approximately 5.1 million shares of its common stock to certain former equity holders of Beats. The restricted stock was valued at approximately $485 million based on the Company’s common stock on the acquisition date. The majority of these shares, valued at approximately $417 million, will vest over time based on continued employment with Apple. The $2.2 billion Goodwill is a sitting duck with a high probability to appear as an impairment charge in the next few years. Following are Buffett’s remarks from his 1985 shareholder’s letter that nails down the above point. "When a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.” Nothing has since changed my point of view on that matter. Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks."

Alibaba - Example of a Complex business structure

Why I am not following Alibaba? - You can notice that Alibaba is not part of my watch list. There is no doubt that Jack Ma has done a wonderful job in building Alibaba which boasts of some very deep moat. But the business does not pass one of the basic guiding principles of Value investing philosophy , which is that the business structure should be easy to understand and predictable.A picture is more valuable than 1,000 words....Following picture denotes an example of the complexity sorrounding the business structure.