By: Ed Hirs – Forbes – When does $9 equal $40? When the alchemists in the oil patch present their numbers to naïve investors. Wild gyrations in the stock prices of bankrupt and near-bankrupt oil and gas companies are baffling investment professionals. Some price jumps are certainly due to short-covering, but the others? Share prices jumping 500%. What is happening? Day traders and “value investors” take to social media to tout stocks because “the company has massive reserves that will last for decades” and show their math. But their math is wrong.
Oil and gas companies can report results using terminology that invites wholly legal misrepresentation: BOE (barrel of oil equivalent); MCFE (thousand cubic feet equivalent); and PV10 (present value discounted at 10%) reserves—calculating “reserves” is another issue.
The term BOE represents the thermal equivalence of a barrel of oil, or approximately 5.8 million British thermal units (Btu). In the U.S., pipeline-quality natural gas has a Btu content between 950 and 1,150 Btu per cubic foot. In industry parlance, 6,000 cubic feet of natural gas has the thermal equivalence of one barrel of oil, a BOE. The measure BOE is useful only where energy sources are substitutes for a barrel of oil or for each other, and this came to an end in the U.S. 1970s when electricity generators ceased switching from oil to gas and back to oil depending on price. There are few dual-fuel generation facilities left today. Aubrey McLendon’s famous September 2007 letter to Connecticut Gov. Jodi Rell used the BOE measure to support his argument that natural gas was undervalued with respect to oil—receiving just 6-cents per BOE in Wyoming at the time.
The oil and gas industry persists in the use of BOE or its natural gas counterpart, MCFE, for expediency and a little sleight of hand. Oil and gas wells typically produce both oil and gas in varying proportions, depending on geology. Producers have a wide latitude to publish well production and reserves in terms of BOE or MCFE. They choose the measure that would confer the higher value if, in fact, a BOE or MCFE meant anything at all. Naïve investors fall for this sleight of hand and take the “shortcut” of multiplying BOE by the current price of crude to calculate value.
But investors have to pay attention to the cost reporting as well. Wells that are gassy have lower production costs because they tend to flow more easily and do not require expensive pumpjacks and electrically driven pumps. A producer can thereby skew a presentation. Today, with the price of oil at approximately $40 per barrel and the price of natural gas at $1.60 per thousand cubic feet, the price of a BOE of natural gas is only six times the current price or $9.60 per BOE. The SEC last issued rules in 2008 to help investors understand the difference, at a time when oil prices were approaching $147 per barrel and natural gas prices were approximately $9 per thousand cubic feet—when everyone was again trying to report anything that came out of a well as a BOE. Of course, by the end of 2008, as the price of oil fell to $32 per barrel, producers ran to report everything in the more valuable natural gas equivalence.
In the current environment, a solid clue to the underlying asset mix is the lifting costs. Gassier producers report relatively lower lifting costs than those who primarily produce oil.
Reserves Reporting – What Can Go Wrong?
Coupled with the confusion of BOE reporting is the art of reporting oil and gas reserves according to industry definitions and the regulations of the Securities and Exchange Commission. Reserves are not to be confused with “resource” quantities that some companies tout and self-define. Reserves are the oil and gas inventories to be pumped and drilled. Because one cannot simply count reserves in a physical warehouse, they are inferred and calculated by the producers who then employ independent engineers and accountants to attest to the veracity of the assessments. At the micro-level of one well, the future economic production of the well is projected by engineers under a number of assumptions. The first step is to consider the absolute amount of oil and gas that can be drained from the rock. The second step is to consider how much of the resource can be drained at an assumed price greater than the assumed cost of production, the EUR or Estimated Ultimate Recovery. The third step is to verify that the producer has the financial ability to drill and produce the well. The fourth step, according to long-standing custom and practice is to calculate the PV10, present value of the net income of the well discounted at a 10% rate. Overly enthusiastic assessments at any step can lead to bad outcomes as The Wall Street Journal detailed in 2019.
At its simplest level, the value of reserves is a function of price and quantity. Quantity is itself a function of price and the cost of producing the quantity. This leverage or gearing means that any oil or gas price increase for marginal producers can lead to exponential increases in reported reserves setting hearts aflutter for traders. Price declines can lead to spectacular bankruptcies. Companies with large inventories of low cost production plod along without the adrenalin rush of the marginal shale patch producers who live on the edge.
Do Investors See Ponzi’s Legacy?
The use of PV10 is mandated by the Securities and Exchange Commission for public companies to offer comparability of reserves across companies. While the SEC did not intend the 10% discount rate to represent the reporting companies’ cost of capital, the implication cannot be denied. It is nonsense to think that a PV10 valuation of ExxonMobil XOM’s reserves is comparable to a PV10 valuation of Chesapeake’s reserves. The value depends upon the assumed price received, the company’s capital structure and management, and not just on the recoverable quantity of hydrocarbons trapped in the rock.
Stepping up from one well to a field with perhaps hundreds of locations to drill, reservoir engineers assess and project the EUR for the field. In order to get to the field level, the engineers must assume that the producer has access to capital necessary over the next five years(!) to drill and complete the wells. For those public and private producers whose monthly existence is contingent on bank lines and equity infusions rather than wellhead production, reserves may be ephemeral. Without continued access to capital, producers cannot continue to drill wells, Ponzi’s legacy. Reserves evaporate. Not because the oil and gas vanished, but because no one will advance drilling capital to the current owner of the asset. In such case, the discount rate is 100%, and the asset is worth zero.
Oil Reserves: A Partial Solution
Reserve “determinations” are point estimates based on last year’s average commodity price as per the SEC for public companies or price projections for those raising capital today. The process is reminiscent of the measure of VAR, value at risk. Solemn pretenders to Einstein’s university chair utilize supercomputers to pronounce an entity’s total financial exposure to the markets. For example, the VAR for Enron immediately prior to its bankruptcy was just $60 million. LTCM also projected great profits, as long as the world behaved according to its spreadsheets.
Multiple studies point to the association of lower capital costs with greater industry transparency. Taking a page from The Daily Racing Form, it would be easy to handicap producers’ reserve estimates. Just as horses are rated according to track conditions, producers can simply plug in different wellhead prices for oil and gas to forecast the reserve valuations under different price assumptions. For oil, one could require a ladder of reserve valuations starting with a price of $10 per barrel and increasing by increments of $5 per barrel. For natural gas, one could start at $0.50 per mcf and increase by $0.10 per mcf. The investing public would see that Company A has zero value reserves at wellhead prices below $45 per barrel but $2 billion at wellhead prices at $65 per barrel. The investors could then run their own scenario analyses. Would only OXY had performed such an analysis.
Until then, day traders beware!