Fundamental financial analysis techniques, including the application of discounted cash flow processes, can be used to make investment and valuation decisions in all commercial environments. However, successful application in a particular business sector requires an understanding of the commercial drivers and the sources of competitive advantage in that industry.
This is particularly true in the petroleum business where the sources of competitive advantage, and consequently value, differ between the upstream and downstream sectors of the industry.
Upstream petroleum businesses, whether stand alone or part of a vertically integrated company, are commodity producers. Their products (e.g. crude oil, natural gas) are produced to an industry standard and consequently there is limited scope for product differentiation between companies.
There may be scope to differentiate on the basis of factors such as reliability of supply, or the physical characteristics of the hydrocarbon, but the ability to create value through marketing strategies is far more limited in the upstream petroleum industry than in, for example, manufacturing or services.
Consequently, competitive advantage in the upstream petroleum industry is driven largely by the cost of production and the ability to sustain production rates. To make well considered valuation decisions, we need to ensure these factors are incorporated into the valuation process.
A hydrocarbon resource only has value to the extent that it can be commercialised and sold into a market. Therefore the cost of gaining access to the market must be included when making valuation decisions. In the case of natural gas this might include consideration of the relative merits of pipeline gas versus LNG commercialisation options.
Proximity to existing transportation and processing infrastructure will be a major factor in assessing value. A hydrocarbon resource that has no prospect for near term commercialisation is often referred to as ‘stranded’ and it only has value to the extent that that situation might change over time. These factors need to be incorporated when making both exploration decisions and development decisions. In exploration they can drive the difference between a ‘technical success’ and a ‘commercial success’.
Besides the cost of commercialisation, the other main driver of value for a hydrocarbon resource is its size or reserve life. Reserve life will of course vary with production rates. But the size of the reserve and its quality will have implications for the unit cost of production and the sustainability of the cash flows required to justify the up front capital investment.
From a corporate perspective, the life of the company is a function of its reserves, its production rates, and its ability to replace its reserves. This is another key difference between natural resource producers and other business sectors. In many other industries, the industrial process can be assumed to continue without constraint and analysts therefore focus on appropriate ‘terminal values’ to reflect undefined future prospects. In the upstream petroleum business the finite nature of our reserves means that we must be much more circumspect about making judgments of future life.
A petroleum producer may endeavour to replace its reserves by either of two methods. They can undertake exploration and discover new reserves, or they can acquire reserves that have been discovered by another party. How effectively a petroleum company pursues either of these two options will be a key factor when accessing its fundamental value.
Reserve replacement ratios and the unit cost of reserve additions are key indicators that analysts use when judging the relative performance and investment attractiveness of upstream petroleum companies
In the downstream petroleum business, the sources of value are entirely different. In the downstream industry, whether it be refining or petrochemicals, the hydrocarbon input is just another operating cost. Value is created by the efficiency of the industrial process that is used to convert the hydrocarbon input into marketable products.
In the downstream, as opposed to the upstream, there is a far greater scope for product differentiation and product innovation, and therefore the marketing function is comparatively a far more important source of value creation. Performance is measured by the value that has been added to the hydrocarbon input and hence we calculate key performance indicators such as ‘refining margin’ to make judgements about the relative efficiency and, hence, value of downstream operators.
The beauty of modern financial valuation theory, such as the capital asset pricing model and discounted cash flow techniques is its ability to be applied to all business environments be it a service industry, a manufacturing environment or a natural resource company.
However, successful application and therefore good decision making, requires a good understanding of the sources of competitive advantage and the key value drivers of a particular industry. The distinct difference in the value drivers between the upstream and downstream of the petroleum industry are an effective illustration of this point.
James Hay leads the Ethan Hathaway course Petroleum Economics and Risk Analysis. James has a degree in Geology and Applied Mathematics, an MBA from Cornell University with a concentration in finance, and is currently undertaking a PhD in energy policy. He has worked as a financial analyst in the energy industry for over twenty years and has presented over 200 training courses and workshops focussing on valuation and financial reporting.
