Valuation of oil and gas reserves Part 3 ($CFW)
Multiples and comparables are good for ballpark estimates. However, in the oil and gas industry, as in most commodities, the cost structure is crucial. It gives protection in these cyclical industries and is usually the only possible competitive advantage. One way of adjusting for this factor is to calculate the cost per BOE and make a qualitative assessment. However, in the Cano case it distorts the issue given that most of the investments and costs are upfront so its marginal costs are very high and decrease precipitously over time.
An alternative method, and the most used, is the standardized measure that is an estimate of the discounted after-tax net cash flows of proved oil and gas reserves discounted at 10%. That measure can be compared to the Enterprise Value to get an estimate of the margin of safety. The PV-10 is the same measure pre-tax and you must be careful because management usually emphasizes it in their presentations over the standardized measure since it makes them look better.
Where do I find these metrics? They are calculated once a year and reported in the 10-K right next to reported reserves and is required for all public E&Ps.
The standardized measure is still controversial since it requires future cash inflows to be calculated by applying year-end oil and gas prices no matter how atypical they may be. That raises two issues
- It assumes continuation of existing economic conditions, specifically prices, that can severely misevaluate reserves when faced with steep backwardization or contango or (i.e. natural gas)
- When comparing companies is critical to review price assumptions given that they could report in different periods (oil assumptions in June 2008 were approximately $140 per barrel and in December 2008 was closer to $40)
Sometimes the companies disclose the flows per year so you can adjust it, but that is not always the case.
So how this all applies to our case Cano Petroleum –CFW? Let’s run the numbers and comparing them against Parallel Petroleum’s –PLLL- that received recently a $483M buyout offer from Apollo Management with support of management.
PLLL was facing a borrowing redetermination given that it was highly leveraged and decided to look for support in a financially strong partner. Apollo had tried to buy Legacy –LGCY- a couple of months ago but Legacy’s management decided to do a 180 degrees after oil prices recovered this year.
Even though Parallel closed its fiscal year in December, they made a standardized measure update for the quarter ending in June. Both Cano and Parallel therefore used the same price assumptions: $69.89/bbl and $3.71/mcf that also seems reasonable as an estimate going forward.
We can also see that Cano is priced well below their standardized measure and that its distressed peer was bought at a premium to that same metric. The issue is how fast Cano is going to convert those PUDs from the Panhandle to PDPs. Today Cano announced yearly results and the waterflooding of Cockrell Ranch is still not responding. The current price should provide sufficient margin of safety for waiting.
In the next part we will analyze a case in the natural gas industry to see how steep contango can affect the estimates of the standardized measure.
Disclosure: Long CFW