Vantage Point Advisors’ Energy Blog January 2021

Wells Fargo Securities Supports
NAV Metric to Value E&P Companies [1]

In 2021, many investors are looking forward to a cyclical recovery that boosts energy commodity prices.  Over the past 12 months, S&P’s Oil & Gas Exploration & Production ETF (“XOP”) was down about forty percent, while the DJIA was up 6% and the S&P500 Index was up 15%.

Company and asset valuation analyses typically are presented in the framework of:

  • a cost approach,
  • a market approach, and/or
  • an income approach, usually in the form of a discounted cash flow (“DCF”) analysis.

Despite a number of assumptions required, Wells Fargo Securities suggests that a discounted cash flow model of E&P reserves is “the most preferable methodology for absolute valuation as it encapsulates most of the key drivers and risks inherent in the shale business.”  The result of this analysis is a Net Asset Value (“NAV”) for the company.  Unlike the cost approach and market approaches, only the income approach captures the critical elements of future free cash flow, growth and market risk as a valuation model.

Some specific assumptions built into the investment bank’s internal NAV models are:

  • A focus on the sustainability of free cash flows rather than terminal value assumptions based on perpetual growth or assumed unlimited reserves.
  • A limitation for undeveloped reserves up to 10 years out.
  • An exit value or terminal value based on a “capitalized FCF” measure to capture the value of longer-term cash flows – but at a “maintenance” level of spending and production. This rewards operators who focus on sustaining cash flows (and associated return of capital) rather than accelerating reserve value.
  • Wells Fargo notes that in their models, only ~25% of NAV is derived from terminal assets while ~52% is linked to undeveloped reserves to be exploited in the next 10 years.

A key takeaway of these assumptions is the continuing theme of E&P companies viewed as income-creating investments, as compared to growth company expectations in the past.

WTI Strip Prices Increase

Over the past month, spot prices and near-term futures prices for the WTI contract increased by about $2.00 per barrel.

Oil Price Outlook

The price distribution below shows the crude oil spot price on January 4, 2021, as well as the predicted crude oil prices based on options and futures markets.  The blue lines are within one standard deviation (σ) of the mean, and the red lines are within two standard deviations.

Based on these current prices, the markets indicate that there is a 68% chance that oil prices will range from $40.50 and $59.50 per barrel in mid-April 2021.  Likewise, there is about a 95% chance that prices will be between $26.00 and $76.00.  By mid-June 2021, the one standard deviation (1σ) price range is $38.50 to $63.00 per barrel, and the two-standard deviation (2σ) range is $24.00 to $85.00 per barrel.

Key Takeaways

Remember – option prices and models reflect expected probabilities, not certain outcomes, but that doesn’t make it any less useful.  If someone asks you longingly if oil will be over $85 per barrel again soon, you now can respond with “the markets indicate there is a 97.5% probability that oil prices aren’t expected to get there by this June, so I wouldn’t count on it.”

For more information, contact:

Gregory E. Scheig, CPA/ABV, CFA, CMA
Vantage Point Advisors
Managing Director / Energy Practice Leader
Certified Mineral Appraiser
180 State St., Suite 225, Southlake, TX 76092

214.254.4801

gscheig@vpadvisors.com

[1] Wells Fargo Securities, December 10, 2020 Equity Research, “Weekend Drill Down: What Is The Right Metric For Shale 3.0 (Part 2)?”