Maynard Holt, co-president of Houston-based investment bank Tudor, Pickering, Holt & Co., has noticed a phenomenon in E&P company valuation that is as interesting as it is counterintuitive. Single-basin, easily valued operators are trading at a premium to larger, multiple-basin companies. Holt thinks this will persist for a variety of reasons, impacting offerings, M&A and daily stock prices for some time to come.

Portfolio theory suggests that larger companies should be less risky operationally, if for no other reason than they spread risk across multiple projects in several basins. At best, larger companies should have benefits of scale in the field compared with smaller operators. But that is not how investors see it.

“As you run the spectrum from single-basin company to those in multiple basins, countries, and business units, the business logic is improving,” says Holt. As companies grow, they diversify risk, develop a portfolio of projects, and are more able to weather changes in regulation and capital markets.

Additionally, larger companies have the size and scope necessary to capture the attention of service providers and can invest in projects beyond the capability of smaller entities.

“The irony of this is that investors aren’t paying you for that. Instead, investors seem to be penalizing you,” says Holt.

“The list of opportunities is perhaps as long as it has ever been, in terms of liquids-oriented, oily U.S. investments,” says Maynard Holt, copresident of Tudor, Pickering, Holt & Co.

Partly to blame is the age-old maxim that investors want to know what they own, he says. For example, a standalone Permian-focused company, or even a standalone deepwater exploration company, is easy to understand in terms of its assets and exposure to risk.

Also, some investors might rather build their own asset portfolio and risk exposures “synthetically,” by buying single-basin pieces one at a time.

If you build it

But a more likely explanation for the divergence of valuation is the delta created by an information gap. An analyst or investor’s ability to understand what they own is easier when there is just one basin to model. Building a net asset valuation (NAV) model becomes increasingly difficult as the subject company becomes larger and adds more disparate assets.

Taking a company’s assets by various categories, risking them, spacing them out in time, and calculating various discount rates and returns on capital are all common processes in valuing a company for purchase. But a public observer is, obviously, never privy to perfect information, says Holt. The complexity of the process and the NAV model as a proxy for company value has, in his opinion, impacted corporate valuations.

“As the world has drifted away from cash-flow multiples toward NAV, it has hurt valuation. It’s a reasonable, rational move, but it leads to discounting of the larger enterprise because it is harder to model,” Holt says.

“It may be time for pushback on some traditional methods of valuation to gut check this analysis.” But even using the best technique, fed with perfect information, part of the investment equation still will not allow differently sized companies to come to valuation parity.

“This is where the rubber really hits the road. You can take a multibasin company that is huge, and put thousands of man hours into an NAV of all of its projects, and show it to the world on a billboard on Interstate 610. There is some part of the investment community that is never going to buy the stock. There is still going to be a discount.”

This is, to a degree, the uncontrollable human aspect of investing. It’s not just about value; it’s about people wishing to manage their own risk and buy exposures à la carte. It is a preference problem, driven by expectations that are not entirely without merit, he notes.

When an investor buys a share of any company, in order to make money, someone else—whether investors or another company—has to pay more for the share. Holt says the odds of that happening are consciously or subconsciously factored in to small and large companies by investors, and smaller companies usually win.

“Say there is a small company trading at 75% of its 3P NAV and a big company trading at the same, and everything is equally likely to happen from a probabilistic standpoint,” Holt says. “One company is simply bigger than the other. I think an investor is not indifferent between those, because he views the probability of someone coming along and buying the big company as less than the probability that the small company trades up.

“Perhaps quite rationally, the volatility of this stock is higher, because the probability that some event happens to the upside or downside is higher than for the larger stock.” Interestingly, this is also why investors would find it compelling to own the stock of a bigger company. But an investor with the opinion that the smaller stock is more likely to move will favor it over an equivalent larger company issue, all other things being equal. This preference is likely reinforced by coverage.

“Analysts would likely tell you that, at the margin, a stock is more interesting if one or two things could happen to move the price,” says Holt, pointing out that most any research report will contain “what value-changing event could happen” during the next period of time. A big company will have greater difficulty experiencing one of those events.

The attractiveness of the big, diversified model has everything to do with risk mitigation and portfolio benefits, which are not realized in a quarter, but rather over years. Big company ownership is in some sense a long-term proposition that is not easily measured.

“But I think what companies would share with us is that the pressure for money managers to show returns, measured on how they did this year, is immense. There are lots of good reasons that if I were investing for five years, I would embrace the logic of the big company, but I’ll own a little one for a month or two, and swoop into another small one for a month or two,” says Holt.

For many people, the investment timeline is not getting longer. And as that thinking predominates, the bias between large- and small-company valuation will swing toward the latter.

Big companies will struggle to be as nimble and fast-moving as small companies, and the value created by small companies recently has been at the front end of the E&P chain, as lease positions are built at $250 to $1,000 per acre and sold six months later for $10,000 per acre.

“There are few things like that, and in that instance, the front-end return is huge and premiums around nimbleness are well-justified. But once you move out of that specialized area and into the nuts and bolts, it’s different,” Holt says. Then, one reverts to choosing investments, to a large extent, around management. Assets always matter, but processes and operational excellence weigh almost as heavily. Holt says a strong sports franchise is a good analogy.

“Players come and go, but there’s no substitute for a good owner, a good system, a good alumni network. A good program might have a few down years but will always compete.”

Strategy implementation is almost more important than the strategy itself. Whether the plan is a focus on the Lower 48, North America including deepwater, or all things unconventional, the people making the decisions and the speed at which they make them are critical.

An organization that can make a decision and write a check faster outperforms the others today, Holt says. Yet, the industry is moving more and more into unconventional development, which many will agree is a project for big companies. Thus, it seems counterintuitive that smaller companies would receive better valuations, even if they have speed on their side. The concern of companies of all sizes is increasingly on operational excellence. That means giving priority to bringing down service costs, achieving more efficient logistics, and all that comes with project operations that larger entities are, to a point, better at managing.

“The more we move towards unconventional, as we talk about executing on assets, the more attractive the big company looks,” says Holt. But the valuation discrepancy remains. And the divergence seems to be growing, even as the underlying business logic for big company operations is increasing.

Welcome back

Although there is valuation inequality, on the whole Holt likes the investment picture that the U.S, with its unconventional development, paints for investors. Few opportunities provide such attractive returns in a politically stable environment.

“There is a Venn diagram of investor sentiment with two categories. One side is, ‘I think the world is going to hell,’ and the other is, ‘I think the world is good.’ Those two areas are intersecting with the same investment conclusion: ‘I think I will put money into oil, or physical natural resources,’” he says. The implication for his corporate clients is a “staggering” opportunity set.

“The list of opportunities is perhaps as long as it has ever been, in terms of liquids-oriented, oily U.S. investments.”

Holt marvels over the industry’s resurgence in a region widely considered an afterthought for the better part of three decades.

“Here we had an industry that from peak U.S. production forward—30-some years ago—we were in a period of decline. This was a declining oil and gas province. But here we are in the seventh inning, we are a growth industry, and all of the money is pouring in.”

It’s one thing, Holt comments, to have a production spike coming on a multiyear rise. But in the U.S., after years of decline, the industry suddenly took off.

“We have taken an old art and we have added new tricks, but I don’t know when there’s been another example of a turnaround like that,” says Holt. “It’s like if the U.S. steelmaking industry became the world leader again.”

Cheap natural gas and natural gas liquids are driving investment and job growth in the U.S. to a level not seen in years.

“And that’s the dirty little secret: the reindustrialization of America. The stories are happening every day, but no one pauses and asks, ‘Did labor costs go down? It wasn’t legal costs or real estate. What cost did go down?’”

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