Despite some late-2013 profit-taking and rotation, the North American E&P public market (as measured by the EPX) is enjoying its best extended performance in years, outpacing the WTI benchmark over the past three years. The initial public offering market in 2013 was likewise strong, with three deals for a volume of about $2.5 billion, while the follow-on market included 26 deals for almost $9 billion of volume.

Get ready for more growth in 2014, as companies continue to come to market and public investors value companies based on net asset value, even in cases of sustained cash-flow outspending. More than a dozen companies could go public this year, raising more than $6 billion.

Value creation has clearly been driven by public E & Ps building attractive drilling portfolios. The question is, what differentiates valuations in the prevailing market? Why do some companies trade many multiples of EBITDAX (earnings before interest, taxes, depreciation, amortization and exploration expense) higher than other companies in the same or similar plays? Is it commodity mix? Is it basin focus? What role does growth play? How about inventory as a factor? Where do returns come in? And how focused is the market on balance sheet and liquidity?

To address these questions, BMO Capital Markets' energy investment banking team analyzed the current operational metrics and public market valuations of approximately 50 independent E & P companies (see Select Companies' Valuations sidebar), creating a quantitative framework to isolate the most important drivers. BMO considered a variety of measures (see Methodology sidebar): core play; inventory life; core-play internal rates of return; balance-sheet liquidity; growth rates of production and EBITDAX; oil and gas production mix; and the ratio of enterprise value to EBITDAX.

Ultimately, we tested for relationships in the data. We plotted each of the measures versus the companies' EV/2014 EBITDAX and looked for correlations. BMO's framework confirmed some of the conventional wisdom about unconventional plays and revealed some interesting implications.

In the 2003-2008 period, production and EBITDAX growth were typically the strongest indicators of valuation, and companies focused on exploration success rates, finding and development (F&D) optimization and reserve replacement. Post the credit crisis, when capital was scarce, there was a strong relationship between balance-sheet strength and valuation. Companies were rewarded by investors for spending within cash flow and maintaining low leverage levels.

Today, these relationships have shifted. In plotting the companies in Figure 1, stand alone growth has a very weak correlation to valuation, not much better than 0.04. Certain specific cases notwithstanding, the data did not signal that growth was a singular influencer across the broad market. Since the credit crisis, investors seem to have focused on more returns-driven growth and not just growth for growth's sake.

During the post-crisis period, spending within cash flow was a priority with investors. Today, balance-sheet strength appears to be less of a factor in influencing valuation. In Figure 2, we compared valuation multiples versus balance-sheet liquidity and noted a weak relationship of 0.0232. Investors still need to see a path to funding the inventory drillout program, yet by itself, deficit spending on the high-return wells hasn't materially impacted valuation. There are high-deficit companies that trade at meaningful premiums to lower-spending companies, but there are low-deficit companies that also trade at meaningful premiums.

With no apparent standalone relationship between pure growth or balance sheet and broad market valuations, BMO analyzed a variety of elements in combination across the universe of companies. In Figure 3, some patterns began to emerge when we simultaneously plotted four parameters of each company: core-play IRR, inventory life, balance-sheet liquidity and valuation. As indicated by the standalone balance-sheet analysis, financial capacity to execute a drilling plan is still a consideration. Nevertheless, there are several examples of well-funded companies that don't garner a premium valuation, because they have a portfolio in transition or less attractive relative well returns.

There are several data points demonstrating that higher-growth, deficit-spending companies are being rewarded with attractive relative valuations in anticipation that they will execute their announced programs. Readily available debt and equity capital has also lessened market sensitivity to balance-sheet considerations. The data ultimately suggests that the highest public market valuations are marked by long inventory life and high core-play IRRs.

BMO next isolated inventory life and core-play IRRs, combining the two metrics into a single factor we call “resource quality factor,” or RQF. In Figure 4, for the companies studied, we plotted relative valuation versus RQF. The 0.54 correlation is one of the strongest relationships seen by the BMO team in a decade of constructing these kinds of analyses. The data suggests that the market has rewarded those companies with premium valuations when they have disclosed and proven up high-quality inventory in repeatable plays. The farther to the right on the RQF scale (ie, when either the wells' returns or the play's inventory life is high, or both), the better the valuation will likely be.

In Figure 5, we also classified single-play companies and plotted valuation versus RQF; a similar relationship emerged. It was not surprising to observe that the highest-return plays were rewarded with premium valuations, but a lack of resource life or scale in an attractive play resulted in lower relative valuation.

To finish testing the statistical soundness of the framework, BMO constructed a multi-variable regression analysis on all of the measures listed above to substantiate the conclusions. Not unexpectedly, RQF, inventory life and core-play-IRRs had the most significant impact on valuation, with core-play IRRs individually having a more pronounced impact than inventory life.

This framework expresses what has been swirling around the industry since the shale boom: Repeatable, high-return asset bases are driving value.

But, isn't it intuitive to any observer of upstream public markets that high inventory and attractive returns drive higher valuations? Why do all this work? Albert Einstein once said, “I believe in intuitions and inspirations … I sometimes feel that I am right. I do not know that I am.” We weren't satisfied with gut instinct and conventional wisdom; we wanted to know that inventory life and core-play IRRs drive valuation in today's market.

BMO believes the RQF framework highlights five implications.

First, public-equity markets are currently rewarding high RQF companies with premium valuations, and many investors are utilizing net asset valuation (NAV) to fundamentally value companies and their drilling programs from the ground up. While markets do change, today high RQF companies are continuing to look to the public-equity markets as a means of funding drilling programs, and private-equity-backed companies are migrating to the public markets as a vehicle for exits.

With public market valuations of high RQF companies outpacing valuations in the A&D market, accessing the public-equity markets can be the most efficient means of equitizing the balance sheet, especially given the slowdown in the joint-venture market.

Second, for the A & D market, we would expect to see companies continue to divest non-core, lower-returning assets to accelerate the capital recycle into the high RQF part of the company's asset portfolio.

Third, in very specific circumstances (when valuation and accretion/dilution can be appropriately managed), corporate M & A could reposition portfolios in transition into high RQF companies and would transform market perception of an asset portfolio. This is especially relevant for larger companies looking to fill in portfolio gaps.

Fourth, current debt cost of capital is still the most efficient funding source for accelerating high RQF programs. Reasonable use of debt capital could help companies to realize premium valuations. Reasonably outspending cash flow is currently acceptable to debt investors.

And finally, for all companies, investors have become much more focused on the geologic quality of assets and the technical prowess of the operator. Investors now differentiate based on targeted zones, drilling techniques (such as shorter-length laterals and slickwater usage), three-stream production, drilling-cycle time, returns and inventory life. This increased technical disclosure will likely not be reversed any time soon.

Perhaps the most interesting question is regarding the sustainability of RQF-driven valuation. In a global investing market where alpha is challenging to achieve, technology usage has generally been the differentiator and value generator when investing across industry sectors. In E&P companies, shale technology has created the holy grail for the public markets—investors now have a means of achieving foreseeable, cost-of-capital-beating returns and growth in E&Ps.

Jason Martinez is a managing director with Bank of Montreal Capital Markets, focusing on energy investment banking. He has more than 16 years of experience in finance and accounting within the energy industry with 12 years as an investment banker. Andrew Baker, Taylor Galloway, Sean O'Donnell and Ani Sen also contributed analysis to this article.

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