The shift to shale

My interest in the industry was initially due to the dynamic shift that came about around the time of the financial crisis.  Although the shift had been underway for some years at that time, especially in gas, I had not been aware of it.  The companies that led the way into shale gas, like Southwestern, Chesapeake, Devon, XTO, were not familiar names to me. The shift into unconventional oil and gas production has been almost entirely driven by smaller independent companies, with the larger companies like Exxon, Shell, and Statoil buying their way in later on through acquisitions.  Today, the vast majority of E&P capital spent in the USA is on tight oil and shale gas (though much less on gas at the moment).  Only $30b of an incredible $300b of capital spent on US E&P will be spent by the major oil companies (now considered to be Shell, Exxon, Chevron, BP, ConocoPhillips).  Note that E&P spending globally, ex US and Canada, is projected to be $524b.





Oil and Gas Journal- http://www.ogj.com/articles/print/volume-112/issue-3/special-report-capital-spending-outlook/e-amp-p-capital-spending-to-rebound-in-north-america.html

The shift to unconventional is of momentous consequence that can hardly be overstated.  The ability to find hydrocarbons, once the key for a good E&P company, is no longer of paramount importance.  The Eagleford formation is about 25,000 square miles.  Everyone can find the resource, the key is to be able to extract it at a profit.  Finding the resource does indeed still have some advantages- EOG did terrifically well with their first mover advantage in the Eagleford, as did Southwestern in the Fayetteville shale.  The company that finds the resource can often have a huge advantage in securing the leases, but in many cases the followers do just as well.  EOG was the first to drill successful unconventional Bakken wells, and Chesapeake the first to drill Marcellus wells (I think) but there are other companies that were able to do just as well, or better, in these regions from a financial standpoint.

Going into this project, my prejudiced view is that the companies that have thrived, have generally been those with a keen focus on financial returns on a per-well basis.  Southwestern and EOG had long published IRRs on a per well basis, and this seemed to be a major focus, judging by their conference calls and investor presentations.  EOG has done better than Southwestern, but this is more due to their strategic move of focusing purely on unconventional oil whereas Southwestern has continued to focus on dry-gas production despite the low prices.  Other companies have focused on land acquisition or production growth with more marginal economics.

The question of the day is: how can we value the E&P companies?  The most common metric for the stock market in general, the PE ratio, is generally inappropriate for a number of reasons.  The most obvious reason for this is that accounting earnings are largely divorced from the true economics of an E&P company because of the huge amounts of capitalized expense and depreciation.  In the past there were several common metrics such as a multiple of cash flow, a value per barrel of reserves, or a value based on daily production.  These were always a very approximate way of valuing a company, but they have become even more problematic with the shift into shale.   The buy-side analysts have used the NAV (net asset value) methodology, which may be an interesting exercise, but at the end of the day it is extremely subjective, because of the discount factors and uncertainties applied throughout.  I suspect that in many cases the NAVs are adjusted to the market capitalization, whether consciously or unconsciously.  In other words, if the enterprise value (net debt plus market capitalization) is $10b, you can be sure that the analysts NAV won't come out to be $4b or $25b.