?Arguably, the upstream oil and gas business is one of the “purest” cash-flow businesses around. What is interesting, however, is how widely opinions vary as to what value should be attributed to oil and gas reserves at any point in time.


Whether the investor is an oil and gas company buying a property from a competitor in a sealed-bid auction process or a retail or institutional investor buying the stock of a publicly traded producer, each is buying at least a share of an expected future cash-flow stream. The question: Will the buyer receive an adequate return on his investment?


Historically, it is rare for an industry buyer to pay another industry seller at or above total proved PV-10 for an oil and gas property with significant proved undeveloped potential. Depending on the asset, nonproved upside has gotten minimal, if any, value from industry buyers.


Going in, most sophisticated industry buyers want greater than 10% internal rate of return (IRR) to compensate for the systematic risk they are assuming when buying a deal with significant undeveloped-reserve potential. However, in the public market today, it is rare for a company’s implied-reserve value to not be a multiple of total proved PV-10.


Is there a fundamental disconnect between the public and private valuation of oil and gas reserves?


To illustrate how the reserves of certain producers are valued in the public marketplace, Energy Spectrum Advisors (ESA) developed a chart showing reserves value as implied by public-market valuation versus other measures of value.


To easily compare the reserves value of different-sized companies, ESA “normalized” the plot by showing a ratio of “indicated reserves value” (IRV) to the “private asset value” (PAV) on one axis and the ratio of IRV to the industry standard measure of discounted cash-flow value, or the SEC (total proved) PV-10 value on the other axis.


Companies that plot in the upper right of the graph have higher-valued reserves, and companies in the lower left have lower-valued reserves as implied by the public-equity market.


For example, SandRidge Energy Inc. had a recent IRV/PAV ratio of 2.2 and an IRV/SEC PV-10 ratio of 2.2. This means that the company’s recent common-share price implied the reserves were worth up to 2.2 times what another “average industry buyer” would pay for the same reserves in a competitive auction and approximately 2.2 times the company’s year-end SEC PV-10 value.


Another producer, Ultra Petroleum Corp., currently sells for an IRV/PAV ratio of 1.9 and an IRV/SEC PV-10 ratio of 2.2. Some would argue that, even at its current share price, Ultra is undervalued given its vast, low-cost reserves potential in the Pinedale and Jonah fields.


A company that stands out in being higher-valued is Southwestern Energy Co., which has a sizable position in the Fayetteville shale play. Southwestern’s recent share price implied a value of the company’s reserves that is an eye-popping 6.0 times its SEC PV-10 value and about 3.5 times the reserves value, as would be expected to be ascribed by an average industry buyer.


The company undoubtedly has large reported proved, probable and possible (3P) reserves potential but 6.0 times SEC PV-10 value seems a stretch as compared with other producers with sizable 3P undeveloped reserves potential.


Are your favorite oil and gas company’s reserves over- or under-valued or priced just right in the public marketplace?


In some situations, only time will tell if current share prices are appropriate. In other instances, from a fundamental cash-flow analysis standpoint, an investor has to wonder about the value, both high and low, being attributed to the reserves of some publicly traded producers.

—Charles M. Lapeyre, Energy Spectrum Advisors Inc.
(energyspectrum.com/advisors)

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