Variant Perceptions

Category: oil

Growth math

The most powerful force in the universe is compound interest – Anonymous, wrongly attributed to Albert Einstein and Mark Twain

The greatest shortcoming of the human race is our inability to understand the exponential function – Albert Bartlett, Professor of Physics

This lecture  tackles  the mathematics of compound interest, inflation, health care costs, finite resources, peak oil, ethanol, global warming all at once. The rest of the lecture is here with parts 4 to 6 being particularly interesting. The rule of 70 is a great shortcut and YouTube  a great time sinkhole.

Vodpod videos no longer available.
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Oil discoveries by decade

From the utterly appropriate remembrance of Matt Simmons’ contributions to our understanding of the energy future. We will miss you Mr. Simmons.

Update: You might also want to read this 2005 interview that includes behind the scene details of his visit to Saudi Arabia in 2004 that inspired Twilight in the Desert

Another thing Matt is known for is his educational graphics about “what is really going on” with respect to oil extraction. For example, in his talk at the 2009 ASPO – USA conference, he shows this graphic of the amount of conventional oil discovered by decade. It is pretty clear from the above graphic that “conventional” oil discoveries have declined since the 1960s, suggesting that most of the oil in liquid form in the world has already been discovered. While one can argue that there are other kinds of oil (oil sands, oil shale, and other non-conventional oil) that are not included in this graph, these other oil sources can be extracted only very slowly (and at great expense). Because of this, we cannot expect their growth in extraction to offset a decline in conventional oil production.

The Oil Drum: Matt Simmons, Author of “Twilight in the Desert” and Peak Oil Speaker, Dies at Age 67

US oil production and GOM in historical context

I hesitate to add any comment to this chart. The implications for a potential ban on drilling in the Gulf Mexico and future oil prices should be clear. You may want also see how the most important Mexican oil gusher is doing. From the always interesting The Oil Drum.

More on the Gulf of Mexico

So how dependent is the USA on ultra deepwater production? I ask that question to have a sense on the government’s flexibility for a short term production moratorium and tough new regulation. This scenario is what the market seems to be predicting as an almost certainty. Well, this is how relevant is the Gulf of Mexico crude production:

30% of crude oil production and 19% of its reserves. If you include all liquid fuels the numbers are better but still big, with offshore GOM representing 8% of production and 15% of reserves. If you also consider that ultra deepwater production is not marginal anymore the probability of a production moratorium without real evidence of widespread negligence and corruption is probably low .

Long term, onshore reserves are a real alternative. It  comprises a large percentage of the US crude reserves but it includes secondary recovery techniques like waterflooding that may be more expensive to extract. So expensive regulation of ultra deepwater drilling may be forthcoming.

The outlook for natural gas in the Gulf of Mexico once again surprises. Perhaps counter intuitively, its lower environment impact and less dependency could make it a target for grand standing and short term measures.

Some natural gas GOM E&Ps like McMoRan Exploration have been hit as a consequence of the Macondo blowout and the suspension of exploratory drilling. MMR production is mostly in shallow water but their exploratory efforts are in ultra deep gas.

No position

Gulf of Mexico and Ultra-Deepwater

In that Macondo forgotten even by the birds, where the dust and the heat had become so strong that it was difficult to breathe, secluded by solitude and love and by the solitude of love in a house where it was almost impossible to sleep because of the noise of the red ants, Aureliano, and Amaranta Úrsula were the only happy beings, and the most happy on the face of the earth. –  Gabriel Garcia Marquez, Cien Años de Soledad

I thought it was important to put in context the  numbers of ultra-deep water exploration in the Gulf of Mexico after a possible market overreaction to the Macondo blowout. The market has left no prisoners, not only taking concern for British Petroleum and Transocean, but also all the contract drillers (Noble, Ensco, Atwood Oceanics, Hercules Offshore, Seahawk Drilling) and some exploration and production companies like ATP Oil and Gas and McMoran Exploration. I particularly recommend Toby Shute’s articles on the investment implications of this disaster.

This graph from a recent EIA post(US Energy Information Administration) tells a clear story of dependence on deep water and ultra-deep water production as shallow water production reached its peak in the nineties and began its decline. So drill all you want, but the USA is becoming more dependent on more difficult to find and more costly to produce reserves. And I have not even talked about the cost of potential  new regulation.

This is one more indication that energy prices may fluctuate but there is only one trend: up. And this is the present. If you want a peek into the future, let me introduce the proven reserves in the Gulf of Mexico.


PD: You have probably noticed that the natural gas story is different. Subject for another time

Long ATPG


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.

Parallel

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.

New Picture

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

Valuation of Oil and Gas Reserves Part 2 ($CFW)

Now the fun part, how do we go about valuing the reserves. A good place to start is with an estimate of the Enterprise Value (EV) valuing all securities at market. That way we get to compare on an equal level companies with different capital structures.

In this case, we will consider the debt and preferred at par, given that this is not a distressed company. There is no excess cash but there are hedges that are liquid investment that can be sold at market so we will subtract them from the calculation

  • Debt: $43.7 million
  • Preferred Stock: $25.1 million
  • Common Equity: $50.2 million
  • Hedges: $14.6 million
  • Enterprise Value: $104.4 million

Multiples

A first approximation to valuing CFW is to use multiples of Enterprise Value. The usual rule of thumb is the 1/3 rule: on average a barrel of undeveloped oil reserve is worth around 33% of the current oil spot price. At current prices that would be $22/BOE. There have been some transactions at close to $20/BOE but let’s be conservative and use $10/BOE.

  • Proved Reserves: 49.1 MBOE
  • Value of Proved Reserves: $490 million

That is almost five times the enterprise value. But hey, we are talking about waterflooding, a capricious process where we have uncertainty on its timing and its results. So let’s be conservative again and value only the proved developed

  • Proved Developed Reserves: 10.1 MBOE
  • Value of Proved Developed Reserves: $101 million

Interesting result, it indicates that at current prices we can buy Cano for just the value of their proved developed reserves. So anything, and I mean anything, that the Panhandle undeveloped waterflooding decides to give us is free. At this price Cano is a free option on the success of the proved undeveloped, probable, and possible reserves.

Comparables

Another way of looking at this is to compare its enterprise value per proved reserves versus other companies. As an example I will compare it to Breitburn Energy Partners -BBEP, a company notorious for Seth Klarman’s investment, with a substantial proportion of gas reserves that are worth less than oil reserves, and currently undervalued against its MLP peers

Cano Petroleum

  • EV/Proved: $2.1 /BOE
  • EV/Proved Developed: $10.3 /BOE

Breitburn Energy Partners

  • EV/Proved: $9.8 /BOE

I have run these numbers against other companies and Cano Petroleum still looks cheap. Have also found other undervalued prospects but will leave them for another occasion.

I suppose my discounted cash flow friends are complaining that these methods are meaningless, since they do not take into account prices, costs and value of time. For you we are going to go through a third method in the next post, the most popular, the standardized measure and PV-10,

Disclosure: Long CFW

Canta y no Llores Cantarell

If you are an oil investor and you are not following the dramatic news coming from Mexico, I recommend you to wake up, get out of bed and get a new news source. Just look at this dramatic chart:

Cantarell decline_0

via The Oil Drum | If We Can’t Get Oil from Mexico . . ..

What is Cantarell? Hey you really need a new news source. This is from the Financial Times in 2007

In 1976, the future of Pemex, Mexico’s state-owned oil monopoly, looked as bright as it ever had. The discovery of Cantarell, a huge oil complex located in the Gulf of Mexico, assured abundant supplies of crude for the foreseeable future and cemented the country’s place as one of the world’s most formidable oil exporters.

For the best part of three decades oil from Cantarell flowed fast and furious – so furious, in fact, that by 2004 its average daily volume of just over 2.1m barrels ranked it the world’s second-fastest-producing oil complex after the Ghawar field in Saudi Arabia.

via FT.com / Reports – Mexico: ‘Delicious dream’ in decline.

The decline is very important and not only for Mexico, well the Economist explained it all also in 2007

CANTARELL, in the Gulf of Mexico, was once the world’s biggest offshore oilfield, holding over 35 billion barrels of the black stuff. Now, after nearly three decades, it is running out. At its peak in 2004 it produced 2.1m barrels of oil per day (b/d), making up 60% of Mexico’s total output. That figure has already fallen by more than 500,000 b/d and could fall by another 200,000 b/d by the spring.

This is a worry for both Mexico and the world. Although Mexico contains less than 1% of the world’s proven oil reserves, it is the sixth-largest producer. Its output of 3.1m b/d is well above that of Venezuela or Kuwait. And although oil no longer dominates the Mexican economy—even at recent high prices it provided 16% of exports in 2006, down from 68% in 1982—it lubricates the public finances, contributing nearly 40% of federal revenues.

via Mexico | Running just to stand still | Economist.com.

The prospects for the Mexican Oil industry and Pemex in particular do not look very bright. The New York Times shows that every once in a while it can still do great reporting:

Government interference is only part of the story. Pemex has been hamstrung by years of short-sighted management aimed at extracting the most cash for the government treasury — Mexico’s president and Congress must approve the company’s budget, its output, investments and exports each year. By law, Pemex is closed to any outside investment, shutting it off from private capital and expertise.In addition, Pemex has not reinvested enough for decades and, because it faces no competition at home, has lagged behind many of the industry’s technical advances. Its labor union has locked it into rigid work rules and siphoned off hundreds of millions of dollars for unexplained benefits. And that does not even touch on the widespread corruption and waste.

via Output Falling in Oil-Rich Mexico, and Politics Gets the Blame – New York Times.

Another wasted opportunity for Mexico and I only hope that Lula reads history. Who was that Mexican president that said something like that the challenge for Mexico was to “administrar la abundancia” of Cantarell?

Valuation of Oil and Gas Reserves Part 1 ($CFW)

Inflation fears and surprising China activity has injected new dynamism on energy E&P stocks. Exploration and production (E&P) is all about finding and exploiting oil and gas reserves. Exploration is a risky hit or miss activity, like internet or biotech startups, and most big oil exploration efforts have been value destroying for their shareholders. At the same time, there are some good track records like Contango Oil and Gas and ATP Oil and Gas, that I hope to discuss in the future, and shale natural gas exploration had its share of successes too.

I will focus instead my attention in the production part of the equation and its main asset: reserves. Oil and gas reserves are a measure of the probability of future production using current technology and oil and gas prices. I will use Cano Petroleum a 79% oil E&P as an example. I own CFW but this is not a buy recommendation I am using it to illustrate the valuation process.

CFW Reserves

The first step is to collect the total reserves from the last 10K (yearly results), 10Q (quarterly results), corporate presentation, or in this case a recent 8K (material event). The booking of reserves is done according to a set of rules developed by the Society of Petroleum Engineers –SPE. The three categories of reserves generally used are proven, probable, and possible reserves:

  • 1P proven reserves : reasonably certain to be producible using current technology at current prices in a reasonable time frame (5 years). That reasonably certain definition is tricky, from what I could find the estimate should be close to 90% of being produced.
  • 2P probable reserves : reasonably probable of being produced. In oil and gas lingo, close to 50% probability.
  • 3P possible reserves : having a chance of being developed under favorable circumstances having a 10% certainty of being produced.

In the case of CFW, the study was done by a third party Miller & Lents, a known reserve engineering firm, and I could only find details on the proved reserves. Proved reserves are also qualified as developed producing -PDP, proved developed non-producing -PDNP, and proved undeveloped -PUD.

You are probably asking where is the disclosure of CFW’s probable and possible reserves. Any public company listed in the USA has to state its reserves with the SEC; the SEC in turn prohibits mentioning probable or possible reserves in their fillings. The oil and gas industry is not immune to disclosure abuses and we can not discount them in the future. However, several companies mention them in company presentations. The following is an example of Harvard Natural Resources –HNR- on its probable and possible:

HNR

CFW uses waterflooding, a secondary recovery technique, and a large part of its reserves are proved but undeveloped. During primary production the average oil field produces only 30 percent of the oil in the reservoir, a waterflood is often tried later. Some of the characteristics of this technique:

  • Capricious results and time consuming.
  • Investment upfront
  • Costs decrease over time

Reserve engineers assigned proved undeveloped PUD reserves based on recoverables of 8-9% for the Panhandle and the Cato fields. That is low if you look at some of the analogue field results like the East Schaeffer waterflood that recovered 15% and initiated back in 1966 with obsolete technology and tactics. We can see the Cato reserves are responding, moving reserves from PUD to PDP and increasing production

Crude oil production was up 6% as compared to the third quarter and 21% compared to the prior year fourth quarter due to increased production from the Cato Field.

The Panhandle, the firm’s largest operating area, is not. When CFW began flooding the Panhandle field it picked Cockrell Ranch that is surrounded by successfully flooded acreages. Management was too bold last year about how the Cockrell Ranch flood would perform and, besides the stock tanking, they have been sued.

But the third party engineering firm confirmed the reserves one month ago did it not? Is this a variant perception opportunity? It could be if the valuation provides some margin of safety and the risks are under control. In part 2 we will run some multiples and provide valuation sensibilities based on Cockrell Ranch potential results .

Disclosure: Long CFW