Examination of E&P Companies

Subsequent to the release and endorsement of the new upstream contract framework – Iran petroleum contract (IPC) – several companies with experience in different sectors of the Oil and Gas Industry took part in the appraisal process run by the Ministry of Petroleum. The purpose of this appraisal was the identification and shortlisting of qualified candidates to establish exploration and production (E&P) companies and eventually the relevant committee within the ministry approved 11 candidate entities. These 11 are the potential JV partners who will work alongside the International Oil Companies (IOC) under the IPC framework and in light of this vision are in the process of forming their E&P units. Since the E&P business model is relatedly new in Iran (except for NIOC), I attempt to demonstrate the key pillars of a typical E&P organizations active throughout the E&P value funnel (from exploration, appraisal, development, production through abandonment) from an outsiders view and in doing so shall briefly explain the importance of each with aid of relevant examples. In order to do this, I shall use five critical pillars including: production, investment, financial status, value creation and reserves. It should be noted that these elements are not independent of each other and changes in one will impact some or all of the others. Let’s start from production. The production volume of an upstream company is often considered as the key measure for the size of the entity. This is why production volume is one of the key scoring criteria that will impact companies’ access to huge resources in host nations. For example, during the recent Iranian pre-qualification IOCs, the average production volume over the last three years was one of the key scoring elements demonstrating the companies’ ability to undertake huge projects. On the other hand, having substantial production volumes and the corresponding income, usually benefits the E&P company through providing a funding source for its investment activities and reduces the need for external financing. For a more comprehensive review however, it is not enough to look at total production volume and one should pay attention to factors such as production breakdown by field or country and the related outlook, production theme such as offshore, conventional, unconventional or deepwater, oil and gas production split and also the production trend over time. For example, by comparing the composition of production theme over the past recent years, we observe that most of the National oil companies (NOC) have a single theme focus of production, such as Russia’s Gazprom which has about 90% of its production from conventional resources whereas for IOCs such as Shell, more than 50% of production comes from unconventional resources including LNG or deepwater. Also NOCs such as Sinopec or CNOOC of China will suffer from production decline over the near future whereas international giants are likely to benefit from an average production increase of of about 3% over the same period. The second pillar which can be a key indication of the growth outlook of the upstream company in the long term, is its investments. Capital expenditures in E&P companies is often split into three categories of exploration, development and business development where each of these could have a material value creating or eroding impact in the short or long term. In recent years for example, with the sustain low oil prices E&P companies suffered from a huge drop in their incomes and consequently slash their exploration budgets – which tend to have a longer payback period compared to other forms of investments – and prioritized development, improved recovery and BD programs. In the context of investments, one of the most important aspects – particularly for those companies without substantial existing operating cash flow generation capacity – is access to external funding sources in the form of raising debt from capital markets or project specific financing. To get better insight analyzing the breakdown of fields or countries from/to which an E&P entity exists/enters provides valuable understanding into the firms’ outlook. As an example, with a change in strategic direction to exit high cost areas, Austria’s OMV has recently existed its UK operations by selling its business and also swapping assets from its Norway portfolio with Gazprom in western Siberia.

To bring the two elements mentioned so far together, an E&P company which is experiencing a production decline over the next few years is likely to face serious existential issues if it is not having suitable investment plans. The third aspect of appraising E&P companies, involves the evaluation of their financial status including critically their free cash flow generation capability. Understandably, during the Investment phase the cash flow of the entity is likely to be negative, the important point however, is that in the first place such negative cash flow related to investment projects should ideally be funded by the positive cash flow from producing assets and where such offsetting is not feasible and the firm requires external financing, in the long term the cumulative free cash flow of the company must be substantially positive to make up for the shortfalls. The other point relevant to financial health check is the company’s cash flow breakeven oil/ gas price. We can see that the cash flow generated by the entity’s operations has three primary uses: development investment, exploration investment and dividend pay back to investors. The breakeven hydrocarbon price is the price required for the firm to be able to successfully pursue its plans and in case that this price is above the realized market prices for most of the time, The E&P entity has no choice but to alter its cash consumption plans. The other sub category of financial status checks relates to the financial leverage of the entity, demonstrating the extent of its fixed financial commitments and is an indicator for the Balance Street strength and borrowing capacity of the firm. A highly leveraged company (in comparison to industry benchmarks) will often have a higher debt servicing cost and hence will have limited borrowing power to take advantage of any emerging investment opportunities. As an example, based on 2016 figures, the American giant Exxon Mobil with financial leverage below 20% benefits from a strong balance sheet with ample capacity to borrow should a valuable investment or acquisition opportunity come up whilst Anadarko, with more than 50% of leverage doesn’t share this advantage and is pursuing an asset sales program to strengthen its financial status and reduce leverage.

The fourth pillar to look at when appraising an E&P company, is its value creation capability shown by its net present value (NPV) which is an aggregation of the company’s individual assets NPV. In perfect market conditions and equilibrium, the NPV of an entity equals its market value (for listed companies). However, in real world various market expectations and assumptions lead to a diversion in NPV vs market value which provides an investment opportunity for capital market participants. The NPV of an individual asset is impacted by various factors including its production profile, cost profile, fiscal regime, currency expectation assumptions, hydrocarbon price assumptions and cost of capital and subsequently these impact the NPV of the firm as a whole. In the context of value creation and profitability analysis another measure is the internal rate of return (IRR) which is a percentage rate indicating the maximum cost of capital above which the project will be value-eroding. Looking at the third and fourth pillars discuss whilst the focus of financial health checks is on the short-term (most notably financially year), the value measures look at the long term, often the lifecycle of an asset and the firm which is usually few decades. As an example for the importance of the rate of return on projects, we can look at the significant reduction of exploration projects’ IRR to under 10% in recent years. This reduction which has mainly been due to factors including fall in prices , technical complexities, water or reservoir depth and the remoteness of the prospects from existing infrastructure prevented these projects from securing funding for the respective drilling activities. In response to these challenges, E&P firms incorporated strategies including reducing and standardizing wells, targeting reservoir sweet spots, focusing on nearby and tie back prospects and increasing efficiencies and Innovations in field development to reduce costs and improve project returns.

Last and by no means least, the fifth pillar to look at is the reserve base booked and accessible by the entity. Reserves focus is important as it is this access that will provide production and subsequent cash flows in the near and distant future and if we consider production to be the veins of an E&P company, reserve represent the blood flowing within them. In this framework, one of the key metrics is the reserve replacement ratio (RRR) which shows how much of the depleted reserves through production has been replaced through discoveries or reserve acquisitions. An RRR below 100% means that overall the reserve base of the company has declined over the period and may be a sign of concern is prolonged over many years. One of the other important KPIs related to the reserves and production is the R/P ratio which indicates the remaining life of reserves in years should current production trends continue and no reserves are added or sold. In looking at reserves of an E&P company, understanding the breakdown by geographical region, oil and gas split and also the classification of 1P (proved) 2P (proved and probable) and 3P (proved and probable and possible) is important in forming an outlook for the entity. To obtain a better feel for the Importance and materiality of reserves to an E&P company, we can look at the Shell example in 2004. In that year Shell announced due to calculation errors over several years its proved reserve base had been overstated by about four billion barrels and a correction had to be made. This adjustment resulted in a dramatic capital market response and subsequently Shell’s share price fell in value by about 8% wiping out about 15 billion dollars from its market value. These Five pillars are not all the detail there is into an E&P company but are the fundamental pillars of the E&P temple that Iranian companies are in the process of building.

Author: Hadi Alviri