(Important) The Hitchhiker's Guide To E&P Valuation + Commentary On Baytex
In today's article, I will be talking about exploration and production or E&P stock valuation. I will not be talking about offshore, oilfield servicing, pipeline, integrated majors, or refineries, just E&Ps. Hopefully, through this write-up, you will also gain a better understanding of how to evaluate E&Ps.
What is intrinsic value?
Investing is hard because it is both science and art. While some academics have attempted to put intrinsic value in a simple-to-understand formula, any real business owner understands that the real intrinsic value of a business is much harder to calculate.
The basics, as everyone knows, is that an investment should be valued at the net present value of all future free cash flows. The trick is, of course, 1) figuring out what those free cash flows are, 2) what discount rates to use, and 3) whether or not you are even remotely correct on 1 and 2.
But alas, we all venture on to tackle these two seemingly impossible tasks regardless, because after all, what else would we do with our time?
E&P 101
One very simple way to think about E&P valuation is to think of it as buying underground hydrocarbon inventory. Whether it's oil, natural gas liquids, or natural gas, an investor is, in essence, buying inventory.
Now with each passing second, the E&P is bringing that hydrocarbon inventory to the surface, and the investor is occurring both the associated cost to extract that inventory and the revenue associated with it.
And it's every E&P's job to try and increase this "inventory" every year with its capital spending. Whether it's doing it by enhanced oil recovery methods (polymer, waterfloods), buying land, buying competitors (proved reserves), or whatever is the case, it's important to expand the inventory. Because without expansion, this company is a "melting ice cube."