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Don't make this mistake when analyzing an oil company
Some investors attempt to value the common stock of an oil and gas company using familiar metrics such as price-to-earnings, price-cash-flow or similar ratios. The problem is that these metrics do not account for reserves. One such consider the PV10 instead.
Reserves are the oil and gas that the company has in the ground. They are a source of future cash flow that the company realizes when it produces the reserves and then sells them into the market.
Each unit of production reduces the value of reserves in the ground. If the company does not spend money to replace production, reserves will decline. Eventually, a company that fails to replace its produced reserves will eventually have nothing left to produce and go out of business. Companies fail to replace produced reserves because they choose not to (i.e., they don’t spend the money), they make bad decisions (i.e., they spend the money unwisely) or they have bad luck (i.e., they spend wisely but still don’t find anything). Reserve life is how many years of reserves the company has at current rates of production.
Companies with many years of reserves should be valued more highly than companies with fewer years of reserves. Long-lived reserves imply staying power: such companies can make mistakes and still recover. Companies with short-lived reserves cannot afford to make mistakes.
From a safety perspective, a long reserve life is preferable to a short reserve life. But leaving the reserves in the ground produces no return for the shareholder. Therefore, when reserves are too long-lived the company’s profitability may be too weak to keep the company out of bankruptcy.
Reserve life carries other analytical baggage. One can reasonably assume that finding new reserves costs more when oil and gas prices are high. When prices are high, lots of companies will have money to spend on new exploration and development projects. Competition will tend to push costs upwards. When prices are low, costs should fall due to less money being available.
To maximize long-term profitability, an oil and gas company should produce rapidly when prices are high and cut production when prices are low. They should do the opposite for investments in new reserves – when prices are high they should cut back, but invest more heavily when prices are low. But such a strategy would wreak havoc on reserve life: it would plummet when prices are high and extend dramatically when prices are low.
The “PV10” conveniently summarizes all of this information into a simple table. “PV10” is a present value calculation using a 10% discount rate. The SEC requires oil and gas companies to estimate the present value of future production of oil and gas, using a 10% discounting rate to account for the timing of such cash flows. One can find it by doing a word search on the term “10%” in a company’s form 10-K.
PV10 can be criticized. The 10% discount rate should bear some relation to the uncertainties surrounding a company’s reserves. The discount should be higher in when there is more uncertainty. A higher discount rate means a lower present value of reserves. may not be the best discount rate for a particular company.
Similarly, the PV10 is calculated using oil and gas prices as of a point in time. Most of the time, today’s oil and gas prices are not the same as the prices used to calculate the PV10. The present value is not a linear function of the prices of the commodities.
After making adjustments, one should compare the PV10 to the value of the reserves on the company’s balance sheet. If there is a significant difference, one can revise one’s estimate of the fair value of the stock.
Clearly PV10 is not a perfect measure, but to our thinking its a lot better than price-to-earnings or price-to-cash-flow ratios and reserve life.
This assumes that the company in question is truly an oil and gas company. If the company’s business includes other types of assets such as pipelines, refineries, chemical plants or retail gasoline service stations, the above analysis would apply only to the oil and gas portion of the company.
