Valuing Upstream Energy in 2017

Steve Sprenger, principal, valuation services at RSM US LLP, discusses the complexities of valuing upstream energy companies, and what price stability means for profitability

Privcap: What are the main differences between valuing an upstream energy company and a valuing a typical PE investment?

Steve Sprenger, RSM US LLP:A general theme with most energy companies is that you are commodity-price-driven. But, specifically on the oil and gas side, there are a number of inputs that are different from other types of companies and other types of assets. So if we talk about upstream companies, for example, certainly you’re anticipating oil and gas prices are paramount. But the other

important questions are, where are your reserves located? What is the certainty associated with those? Are we talking about valuing proven reserves? Are we talking about valuing expiration property? 

The certainty of the proved reserve—even within that category you have proven developed producing, you have proven developed nonproducing and you have proven undeveloped. And so there are various classifications that, of course, affect not only the cash flow projection, but also what rate you should be considering in discounting those projected cash flows. Other factors from an upstream side are your cost. And that can be significantly different depending on the quality of the reserves. 

One of the things that has really affected the profitability in break-even pricing for the upstream assets is the cost. So what we’re seeing a lot of these days is pretty substantial drops in lease operating expense. We’ve seen extensions of EURs [estimated ultimate recovery] and IP [initial production] rates. So basically what we’re seeing is longer lives associated with wells and greater production. And that has a lot to do with the technology … While it may not have brought overall costs down, it’s brought costs down on a dollar-per-barrel of oil equivalent recovered.  

The transportation cost associated with getting the product to [end] demand is highly important. So if you’ve got something that’s very isolated, the cost to transport that to a refiner—ultimately, to get it to end demand—matters. And it affects the value of a barrel of oil equivalent, depending on where you are. So those are all factors that are relatively unique to an oil and gas upstream company. 

What are the main considerations for midstream oil and gas? 

Sprenger: From a midstream company, there are different inputs. You’ve got a little bit more stability. Your assets are generally earning a return and a tariff for the transportation or a storage of that commodity. So it really just depends on what type of oil and gas company we’re talking about. And then from an oil field services perspective, they’re very much dependent upon the E&P, the upstream spending. And as that spending changes for those companies, then it changes the revenue and profitability for an oilfield service company.  

Do you expect to see increased investment in the oil and gas space? 

Sprenger:What we will see—or should see—is some greater investments made by E&P companies, and we are seeing that already. I think the Baker Hughes rig count dropped to its lowest point last May. We’ve seen a substantial recovery in the rig count. 

And even that can be a little bit misleading because the technology over the years has changed. We’re able to better utilize rigs with pad drilling and different things like that, [so] that the number of rigs out there doesn’t need to be what they once needed to be in order to get the same type of production. So that’s one of those issues. The recovery—something could happen tomorrow, some geopolitical shock could affect the price of oil. But the reality is, is most folks are feeling like we’ve reached a stabilization point with $50 oil.  

A lot of those break-evens for U.S. plays at this point are ranging between $40 and $60, and I’ve seen a lot more weight towards the lower end of that in recent months. If we’re saying stabilized prices are in the $50 to $60 ranges, that makes a lot of plays that much more profitable now.