Note: This was originally posted for CVI members in September 2021.
Disclaimer: One of us owns this.
For those not following oil and gas closely, energy prices have gone a bit wild like a lot of other commodities. Of course, it could be wilder, as we are still not at $100 a barrel for oil... yet(?).
Here’s strip oil and gas prices from a year ago and today. As a quick Oil and Gas Trading 101 - buyers and sellers of commodities trade futures contracts via swaps, puts, and calls, to lock in prices and remove commodity price risk in the future. Trading desks at banks/other firms provide quotes of the future strip. As you can see, things have gone up (Note: strip updated from Sept to Oct):
Interestingly though, we have actually gone well beyond 2018 price levels, natural gas in particular.
Now, this is not as crazy as what’s happening in some other places. Across the pond in England natural gas prices have truly spiked. https://www.bloomberg.com/news/articles/2021-10-05/u-k-gas-surges-to-record-300-pence-a-therm-on-supply-concerns To give some context (for Canadian readers), if you take your natural gas bill from last winter and multiply it by 10-15x you will get to current English prices.
The macro environment is frothy, so what do producers look like?
The micro case study – Advantage Energy
Advantage Energy is a company we have followed for a long time and a good one to use for a case study. They have steadily built up their asset base over the last twenty years and now produce about 50,000 boe/d, 90% weighted towards gas and the rest being condensate/NGLs. They own and operate their assets, have being doing the same sort of thing for a long time, and have a long development runway on their existing assets. That makes the way we analyze energy companies work better. In contrast, companies that constantly buy and sell assets are terribly hard to really understand what’s happening in the reserves from an outsider perspective without access to the actual engineering reports, and so we avoids those.
First let’s look at how much Advantage spends to find an mcf of gas (really mcfe – or thousand cubic feet equivalent – as about 10% of production is liquids/NGLs). This information can be found in the Annual Information Form of public Canadian oil and gas companies. If you are not familiar with oil and gas, we recommend you take a look at our Oil and Gas 101 page here - https://www.canadianvalueinvestors.com/oil-and-gas-investing-101 )
The cost to find reserves has dropped over time, due to an industry-wide improvements in efficiency and Advantage also spent significant amounts of money on infrastructure like gas processing plants, which initially increases finding and development costs (as capex is spent on plants instead of drilling) but decreases operating costs (compared to processing through a third party at higher cost, assuming owned assets are constructed appropriately and operated well).
By putting together a few assumptions on how much is costs to find a barrel, how much it costs to produce that barrel, and at what price that barrel might be sold at, you can build up a free cash flow model to think through the question of what is Advantage worth. We put a simple example together as shown below.
Advantage also has a Carbon Capture and Storage project/business unit they are getting off the ground, and that could or could not add value to your analysis. https://www.advantageog.com/investors/newsreleases/article?id=122695
Of course, the caveat with oil and gas is..
Where will prices be next year? We here at CVI don’t know. We want investments to work in a wide range of scenarios, and for energy companies that means a wide range of prices.
That said, it is curious what is happening. We fully support being more green here at CVI, it’s just that we are not sure everyone has thought through to secondary effects of government action. Maybe if you continuously add new regulations and restrictions, block new infrastructure, and scare away capital and people, you will ultimately end up with higher commodity prices. It’s a green revolution and people might get what they want; a greener, and more expensive, life.
Of course, the cure for low prices is low prices. And the cure for high prices is high prices... Caveat emptor.