This article discusses the
primary value drivers in oil and gas—including factors like oil and gas prices,
market conditions and the impact of geographic location on price differentials.
It also highlights the industry’s shift towards capital efficiency over
production volume and the value that third-party valuation firms can bring by
considering these critical drivers in their analyses.
The energy industry is a
dynamic sector that is constantly influenced by a multitude of internal and
external factors, including gas prices, technological advancement and asset
diversification. Understanding the key value drivers within the energy industry
can position businesses to capitalize on emerging opportunities, adapt to
market fluctuations and make informed strategic decisions.
OIL AND GAS PRICES, MARKET
CONDITIONS, AND OPEC ACTIONS
The energy industry is highly
sensitive to market conditions, especially oil and gas prices. These prices are
notoriously volatile, due primarily to their dependence on supply and demand
dynamics. Several external factors contribute to this volatility, including
political events and conflicts, as well as the actions of organizations like
OPEC (Organization of the Petroleum Exporting Countries).
Understanding these market
conditions is crucial for valuation, as they directly affect the financial
performance of energy assets and companies. When oil prices are high and demand
is robust, valuations tend to be more favorable. Conversely, during periods of
low prices, due to oversupply or economic downturns, valuations may suffer.
Recent events showcase the
complexity and fragility of oil and gas prices. The Russia-Ukraine conflict,
for instance, triggered a significant upheaval in these prices. Between
February and May 2022, oil prices surged by approximately 25%, while natural
gas prices witnessed an astonishing 88% spike, from February to August of the
same year. Russia—as one of the world’s leading crude oil producers—cast a
shadow of uncertainty over global supply and demand dynamics. To counter
recession fears and declining oil values, OPEC+ took the proactive step of
announcing production cuts in October 2022, with the aim of shoring up oil
prices.
Yet these efforts were
further complicated by regulatory changes initiated in 2021, which imposed
stringent restrictions on oil and gas projects within the United States. These
measures included the cancellation of the Keystone XL pipeline and the
suspension of oil and gas leases on federal lands.
UNDERSTANDING PRICE
DIFFERENTIALS
Geographical location is a
pivotal factor that affects both price differentials, or premiums, and
operational efficiencies in the energy industry. Proximity to key
infrastructure—such as pipelines, LNG terminals, refineries and saltwater
disposal facilities—can significantly impact the economics of energy projects.
Certain regions, like the
Eagle Ford shale, the Permian Basin, or the Haynesville shale, are
strategically positioned for exporting and refining operations. These areas
often experience lower transportation costs, and in many cases benefit from
established infrastructure networks and have differentials or premiums that
affect the oil and gas prices in our valuations.
Additionally, seasonality
impacts the value of assets, especially in particular regions (e.g., the
Rockies). Premiums are reaped during the winter when natural gas is in high
demand in the West, giving the Rockies a competitive edge over other
gas-producing areas. However, differentials come into play during the summer,
as premiums take a dip tied to shifts in supply and demand.
REDUCTION OF COSTS THROUGH
CONSISTENCY IN UNCONVENTIONAL RESOURCES
In recent years,
unconventional resources—in contrast to their conventional counterparts—have
risen to prominence as a dominant source of oil and gas production. While
conventional resources are typically found in porous, easily accessible
reservoirs, unconventional resources reside in dense, rock-like formations that
are more challenging to access.
Consistency in results from
unconventional wells is a critical driver of value, as past well performance
can reasonably inform future projections. The ability to extract predictable,
consistent results also becomes extremely valuable.
Consider the Permian basin
and Marcellus shale, two prolific regions for unconventional resource
extraction. The key to reducing capital expenditures and enhancing operational
processes lies in the ability to learn from past experiences. Companies
operating in these areas have leveraged their data to fine-tune well designs,
optimize horizontal drilling practices, and refine fracing techniques. These
measures not only cut operational costs but also contribute to the development
of best practices for future endeavors.
For instance, instead of
drilling numerous individual vertical wells, operators in the Marcellus have
shifted towards drilling fewer—but longer—horizontal wells that extend deep
into the formation. This strategic shift significantly enhances
cost-effectiveness and improves the break-even economics of the project, Fig.
1.
In the realm of
unconventional resources, where the production rate is highest in the initial
years, continuous innovation and the ability to replicate successful outcomes
are essential. Companies that achieve highly productive unconventional wells
with reliable and consistent results are the ones positioned for superior
financial performance and, ultimately, higher asset valuations.
INCREASE IN RESERVES THROUGH
TECHNOLOGICAL ADVANCEMENTS
One of the core value
drivers in the energy industry is the ability to increase proven reserves.
Enhanced recovery techniques and advancements in technology play a crucial role
in achieving this goal.
The recovery factor, or the
percentage of oil and gas that can be extracted from a reservoir, can be
significantly improved through technological innovations. Whether in
conventional or unconventional assets, implementing new methods, such as CO2
injection or waterflooding, can boost recovery rates from an initial estimate
of 60% to as high as 80% in conventional assets. For unconventional assets, we
are seeing optimal proppant types and amounts, fluid types and amounts and
completion practices.
Valuations must account for
these technological advancements when assessing the value of energy assets.
Companies that invest in innovative recovery methods can unlock substantial
value by increasing their proven reserves.
INTEGRATION INTO RELATED
INDUSTRIES
To maximize value and
mitigate risks, many energy companies are embracing integration and
diversification into related industries. Rather than focusing solely on
upstream exploration and production, companies are expanding into midstream
operations, LNG (liquefied natural gas) ventures, saltwater disposal and even
water treatment facilities.
This integrated approach
allows companies to reduce reliance on third-party contractors, enhance
operational efficiency, and capture additional revenue streams. For example,
owning midstream assets enables better control over transportation and
distribution, reducing costs and improving supply chain management.
Large energy corporations,
such as bp and Chevron, have successfully integrated their portfolios to
include various segments of the energy value chain, from extraction to
delivery. These strategic moves enable them to adapt to changing market
conditions and deliver sustained value to their stakeholders.
ASSET DIVERSIFICATION AND
HEDGING STRATEGY
Companies are increasingly
recognizing the importance of spreading their assets across various regions, to
mitigate risks associated with localized fluctuations in supply and demand.
This diversification strategy offers a buffer against unforeseen disruptions,
such as geopolitical conflicts or environmental regulations, which can severely
impact energy markets. Companies are increasingly moving away from pure play
strategies, building portfolios of oil and gas assets in different basins.
They are also actively
incorporating hedging into their strategy, in weathering storms of price
volatility, shielding them from potential losses when prices drop. Hedges are
more than mere risk mitigators but hold the promise of long-term financial
returns. Additionally, hedging allows companies to reduce uncertainty in prices
and forecast them more reliably, allowing for more informed decisions on debt
payment, development of current assets, and growth.
CAPITAL DISCIPLINE DUE TO
CASH FLOWS VS. FOCUSING ON PRODUCTION
Companies are also driving
value through capital discipline. Traditionally, energy companies adhered to a production-centric
approach, especially during periods of low prices. When faced with unfavorable
market conditions, such as plummeting oil prices, their strategy often involved
holding back on capital investments and refraining from expanding drilling operations,
Fig. 2. Instead, the emphasis was on optimizing production, particularly
through the development of Proved Developed Producing reserves (PDPs).
However, a paradigm shift
has emerged in the past four years, catalyzed by external factors like the Covid-19
pandemic and stricter government regulations. This shift revolves around a
concept known as capital efficiency: prioritizing cash flow over sheer
production volume.
Capital efficiency
represents a strategic pivot, wherein a significant portion of company cash
flows is directed toward shareholders, rather than being channeled into rapid
drilling expansion. The primary objective is to maintain a consistent stream of
cash flows, irrespective of market fluctuations. This not only minimizes risk
exposure but also enhances the industry’s appeal to private equity investors
seeking stability and steady returns.
THE
VALUE OF THIRD-PARTY VALUATIONS
Valuation firms specializing
in the energy industry must navigate a complex landscape shaped by market conditions,
technological advancements, geographic considerations and strategic
diversification. By understanding and effectively incorporating these key value
drivers, they can provide accurate and valuable insights to clients in this
ever-evolving sector. When searching for a firm, a valuation partner should bring
extensive experience within the oil and gas industry and present expertise in
the relevant business dynamics. WO
Juliette B. Pearson MBA, P Eng. is a senior vice president at Stout Valuation Advisory. She has over 20 years of experience providing valuation services to both public and private-sector clients. She has
extensive expertise across a broad range of industries, including upstream,
midstream, and downstream oil and gas, as well as oil field services, power and
utilities, renewables, healthcare, and financial services.