How to value an oil company (Part 2)

How to value an oil company (Part 2)

In Part 1 I looked at oil prices briefly, concluding that while important it is unknowable and therefore, as Warren Buffett advises, don’t spend all your time worrying about it. Instead lets worry about what we can know and that’s oil exploration and production.

Birth of an oil company

Most oil companies will start life as an explorer, usually already with some land it owns and hopes to strike lucky with. I have no interest in investing in the hopes of oil, but it is useful to know how this process works, because even oil producers will be reinvesting money into exploration, so you need to know what your money is being spent on.

Oil and natural gas exploration are usually grouped together, because they are usually found together. Geologists and geophysicists use a variety of techniques to test the ground for the presence of oil or gas, how they do it is something you and me will never fully understand but all we need to know is the basics.

  1. First they do simple and cheap tests over several areas to find any features of interest.
  2. Once these are found they then move onto more sophisticated testing which gives more detailed results of possible reserves.
  3. Finally if those results are promising an exploration well is dug to confirm the presence of oil and gas.

Now this process is very expensive which is why oil exploration is a high risk investment.

At this point (if it finds something) a company has what are called oil resources. It then conducts more testing and once it has data on the size of the field and other seismic studies it will be given a licence by the government and can now record the oil as reserves.

Reserves

Now as you may expect, knowing the exact size of reserves is impossible and we can only have a rough guess. Reserves are broken down into three categories which are fairly simple to understand.

  • Proven reserves: has 90% chance of being produced given current technology, oil prices and contract prices.
  1. Probable reserves: has 50% chance of being produced given current or likely technology at today’s prices.
  2. Possible reserves: has 10% chance of being produced under favourable circumstances

In the US companies are prohibited from mentioning probable and possible reserves in regulatory filings so be aware of this when assessing the true reserves companies have to produce from.

Oil reserves are quoted in barrels (Bbl) and gas reserves in billion cubic feet (Bcf) or sometimes thousand cubic feet (Mcf). Another abbreviation you may see is boe (barrels of oil equivalent) which can be used to sum both oil and gas.

One final important note is that the reserves are also classified based on the current price of oil. If the price of oil plummets and reserves become uneconomic to extract this could reduce the proven reserves as they are reclassified as ‘possible’ or probable’.

Ready for production

So once the company has proven reserves it is now ready for production, all these years of spending vast amounts of cash are about to bear fruit and give something back to the shareholders.

Next time I will look at how companies extract this oil, the important metrics for assessing the production and come one step closer to that valuation.

CLICK HERE TO READ PART 3

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Investing Sidekick

Founder of Investing Sidekick. Works as a research analyst and is an avid value investor, always searching for undervalued shares. An SA certified writer.

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