Oil and Natural Gas Reserves

Wednesday, November 01, 2006

What is the Standardized Measure of an Oil and Gas Company?

The Standardized Measure is defined as the present value of the future cash flows from proven oil and natural gas reserves, minus development costs, income taxes and existing exploration costs, discounted at 10%. Note that all oil and gas firms that list on an US exchange must provide the Standardized Measure in their filings with the SEC, according to FASB 69. see: http://www.fasb.org/st/summary/stsum69.shtml

How is the Standardized Measure calculated according to FASB 69? In order to Calculate the Standardized Measure, the oil and gas firm will forecast production by year in future years of ONLY proven reserves -- not probable and possible reserves --and then will subtract certain costs and income taxes (at a constant income tax rate, which could change if the government decides to tax higher profits at oil and gas firms due to high prices). To the extent that the company has a strong exploration and development program, in which they find reserves at a higher rate than they produce them (in other words, a high "replacement ratio") the Standardized Measure will not reflect this potential.

The Standardized Measure is defined as the present value of the future cash flows from oil and natural gas reserves, minus development costs, income taxes and existing exploration costs, discounted at 10%. The result will be a number in dollars, for large companies, in the billions, and for smaller oil and gas firms, in the millions. The company, in order to calculate the Standardized Measure, assumes a constant price for natural gas and oil in future years -- unusually the year end price of oil and natural gas (but not always, I have indicated the exact price of gas utilized by the firms in my chart in this blog). In 2005 prices for natural gas utilized by companies range from $8.00 per mcfe to $11.00 per mcfe and prices for oil range from $45 to $65 per barrel.

The Standardized Measure is highly sensitive to the price of oil and natural gas assumed in the calculation -- for example, several companies have used a price of $10 per mcfe for natural gas for the standardized measure at the end of 2005, compared to a price of under $6 in 2004 -- an increase of almost 70%! Oil prices also generally (but not always) have been assumed by companies at around $60, up from around $45 in in 2004, an increase of 33%. The increases in oil and gas prices contributes to a very large increase in the Standardized Measure. Further, two companies with similiar resource bases may use widely different price assumptions for oil and natural gas, leading to very different Standardized Measures.

What doesn't the Standardized Measure include that it should?

The Standardized Measure does not include effects from oil and natural gas price hedging, costs from interst on debt, general and administrative costs, and new exploration costs, and does not include special taxes in future years. To the extent that a Company has an effective or uneffective hedge program (read: has hedged gas production in the $9 range for years to come verses not doing so) the Standardized Measure will not reflect this. Also, if the company has a large debt load, and high administrative costs, and/or an uneffective exploration program, the Standardized Measure will be higher than it "should" be.

The question arises: does the Standardized Measure "overvalue" or "undervalue" the true value of the proven reserves in future years, notwithstanding oil and gas price changes and future exploration, due to the items that it does/does not include? There are arguments on both sides:

For those who say the Standardized Measure "overvalues" point to:

- Lack of inclusion of administrative costs
- Lack of inclusion of interest costs from debt
- No new exploration costs
- No inclusion of increased/special taxes

Those who state the Standardized Measure "undervalues" proven reserves point to:

- 10% discount rate is too high in an era of low interest rates

(again, this undervalued/overvalued debate above does not include the impact of probable and possible reserves -- reserves that will be discovered in future years -- the Standardized Measure excludes probable and possible reserves)

Why is the Standardized Measure important?

The Standardized Measure is one very important tool for investors to understand if the oil and gas firm is undervalued. All public oil and natural gas firms can be compared to a candle, in that as they produce oil and natural gas, they "burn" their resources. If an oil and gas firm does not find new resources -- "wax" -- in furture years -- they will "burn" through their resource base. Assuming an oil and gas company finds no new resources besides proven in future years (note a large assumption), and the assumptions of future development costs and income are accurate, the value of the company should be (in an efficient market) roughly equal to the Standardized Measure. Further, to the extent that the market value of the firm is above or below the Standardized Measure, the stock can be considered overvalued or undervalued, respectively.

An illustration is useful here to show the usefulness of the Standardized Measure. Let's say Candle Firm has a candle that will burn for ten years. Candle Firm has no plans to find or buy any new candles. Candle Firm knows that after ten years, the candle will be gone. Candle Firm knows that every year in the future, they will burn 1/10th of the candle, and every year their income from the candle will be equal to the amount they burn times the price of heat they produce, minus their costs and taxes. Candle Firm can forecast the income from their resource over the next ten years, and then discount it to the present using an appropriate discount rate. This should be the value of the Candle Firm.

In the chart of public companies in this website, 86 public companies listed on US exchanges have been analyzed, with standardized measure to enterprise value provided(enterprise value equals market capitalization minus debt plus cash). All other measures equal, a higher standardized measure to enterprise value indicates the oil and gas firm is more undervalued.

In practice, the standardized measure to enterprise value is a good starting point for analysis for investors, as the diligent investor will go further and analyze the quality of oil and gas reserves, the exploration program, cost control, forecast possible future price of oil and gas, analyze the company's hedging program, financial strength, access to drilling rigs, geographic regions and potential, political risk, possible acquisitions, and analyse the competitence and ability of the management team.


At 9:42 PM, Blogger anna said...

Excellent! Many thanks for simplifying the concept.

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