?In fewer than three months, sentiment in the energy market went from “higher than a kite” to “lower than a snake’s belly” in dramatic fashion.


For more than a year and a half prior to commodity prices peaking in July, the market obsessed with shrinking world oil supplies and producers’ inability to satisfy increasingly insatiable worldwide demand. “Peak oil” was touted as a fundamental supply-side issue by experts. Peak-oil theorists argued that, in an already tight worldwide supply/demand situation, the supply arrow was pointing down while the demand arrow was pointing up for the foreseeable future, largely due to China and India’s exploding energy demand.


Today, peak oil is no longer a topic of conversation. Now, falling oil and natural gas demand is the focus with the advent of the credit crisis, rising unemployment, defaults and bankruptcies, and a threat of worldwide recession. It took more than a year and a half for oil to go from $65 a barrel to $145, and only about 90 days to make the round trip back to $65.


The drastic swings not only in oil prices but also in natural gas prices have had a significant negative effect on energy-sector stock prices. In addition, the normally robust oil and gas asset-sale market has almost come to a standstill because commodity prices haven’t yet found a “bottom,” or at least stabilized. Sellers haven’t yet recalibrated value expectations, and buyers don’t have the appetite to “pay up” for upside or have ready access to outside capital to grow their reserve bases.


Even more dramatically, high price-per-acre deals, especially in the unconventional-resource plays, have dried up almost overnight because the Tier 1 buyer has decided to sit on the sidelines and not play anymore until commodity prices recover and the profitability outlook improves.


The recent decline in oil and gas prices and other economic factors have affected investors’ perception of oil and gas reserves’ value during the past six months. To illustrate, the implied reserve value (IRV) of five publicly traded, independent oil and gas companies in late October was compared with the companies’ IRV in April.


The IRV is the “mark to market” value of a company’s oil and gas reserves implied by the value of its outstanding equity and debt securities (after certain balance-sheet adjustments) on a given day. To normalize the findings, each company’s IRV was divided by its current daily equivalent natural gas production. The result was plotted against each company’s pseudo reserve life of its proved reserves as the independent variable.


As a reference, a trend line—the asset-value line—illustrates how gas reserves were valued by sophisticated market participants (i.e. oil and gas companies) when they buy and sell reserves via competitive auction or other negotiated transactions. The asset-value line represents reserves value reflecting oil and gas prices, market sentiment and general economic conditions over a longer period of time. Publicly disclosed asset sales data for a recent 12-month period was used to develop the line.


In April, the IRV of all five companies plotted above the long-term asset-value line. The public market valued the reserves of Southwestern Energy Co. and SandRidge Energy Inc. significantly above the line. Six months later, the IRV of each company fell between 25% and 65%. Also, the IRV of four of the five companies now plot below the asset-value line. SandRidge’s IRV fell the most (65%) in this small group to below the asset-value line.


In some cases, share prices have fallen so much recently that the implied value for nonproducing reserves has been discounted to very low levels. Corporate merger activity in recent years has been relatively quiet, but now it is likely that, if current equity valuations persist, cash-rich companies will be looking to “buy reserves on Wall Street” because it may be cheaper and less risky than adding reserves via the drillbit or private auction purchase.


Did energy investors and the oil and gas industry as a whole misprice risk, particularly in the first half of 2008, after drinking too much of the peak oil Kool-Aid? Has the market now over-reacted and driven commodity prices and share prices too low? The answer to both questions is probably “yes.” However, while demand “visibility” is somewhat cloudy at the moment, a stronger case for peak oil can more arguably be made today than in early 2007.


Industry participants with a contrarian attitude and ability to see past the doom and gloom undoubtedly realize that the current bearish sentiment presents unique opportunities where risks are appropriately—and in some cases attractively—priced.
—Charles M. Lapeyre,
Energy Spectrum Advisors Inc.
(energyspectrum.com/advisors)

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