Outdated Convention Distorts Oil and Gas Firms' Bottom Lines: Valuing Barrels Better
by Jim Smith|
The conventional method used by the oil and gas industry to report on upstream operations and results distorts profitability and valuations. Industry practice is to use "barrels of oil equivalent" or BOE— a measure that combines oil and gas volumes based on thermal parity, or the energy content of the source. Research by Finance Professor James Smith, the Maguire Chair of Oil and Gas Management, shows why and how the BOE convention has overstated the cost of adding reserves, the principal asset held by these firms. This comes at a time when the industry can scarcely afford miscalculations to their detriment.
Since 2008, when natural gas prices declined precipitously — from a spot price of $14 per mcf (thousand cubic foot) to under $3 today —distortions due to reliance on the BOE convention have increased. Performance and valuation differences between firms when measured on the basis of by thermal parity, rather than the relative prices of oil and gas distort shareholder perception of operational efficiency. Smith and the likes of British Petroleum's CEO John Browne acknowledge this industry problem —that in actuality 'barrels of oil equivalent' is a fiction. A new approach by Smith offers "a workable alternative." Smith proposes that the value of oil and gas reserves be calculated based on the market-based equivalence of these two resources, thus capturing the specific, real economic values and costs of oil and gas.
Elusive barrels
According to Smith, "Thermal parity implicitly assumes the Btu (British thermal unit) of gas commands the same market price as oil, which is not true. For example, people are willing to pay more for gasoline because it is easily used in a car versus natural gas. "From the producer side, the cost of finding oil needs to be measured relative to price of oil," says Smith. "If [oil] is more valuable than the resources expended to find and develop it, that's what companies and their investors care about," he notes.
In upstream investment, the value of the resources found this year, or over a three-year snapshot, it is important to not use thermal equivalence measures [like BOE] that artificially combines oil with gas because gas does not have the same value. "By separating out oil and gas, and comparing apples to apples, we see the industry has not been overspending to find oil because oil is more valuable than the mixture of oil and gas -- a mixture that no one sells in the marketplace for a 6-to-1 price, which is what thermal parity implies," says Smith.
Currently, with U.S. oil prices around $52 per barrel and natural gas below $3 per mcf, the price ratio is approximately 17 to 1. Earlier research noted that "aggregation by thermal equivalence tended to overstate the cost of reserve additions by roughly 10% for the period 1982-2002." Smith suggests the problem is now much larger.
Benchmarking in practice
The research shows that the barrel of oil equivalent (BOE) measure currently used to benchmark firm performance should instead be based on economic equivalence rather than thermal equivalence. Smith's research decomposes how the current high oil-to-gas price ratio (which was even higher at 25:1 when oil was $100 in 2014) has misled firm valuations that are based on BOE. "From 2010 to 2014, when natural gas prices were low, the economic value of a BOE was declining—pulled down by gas—whereas the value of oil was stable," Smith observes. "The same is true for the value of companies, in which an upstream producer is valued by oil and gas reserves on the balance sheet. Gassy firms' market value has declined as gas prices are much lower than in years past, but reliance on BOE masks that." Market value should be in line with the relative prices of oil and gas reserves —not lumped together in an aggregated measure like BOE (thermal parity).
The research sheds a 'different light' on industry performance, Smith offers. "In a competitive industry, you would expect the price of a product to correspond to the cost of supplying it; that implies zero profit," he explains. "A firm typically recovers its costs plus a reasonable return on capital." Analysts suggest the industry has had trouble replacing reserves; they say, for example, that frontier exploration, Arctic exploration, and other types of higher-cost exploration indicate a 19% loss of capital spent, based on the years 2011-2013. Smith says, "That's a big number. If one were comparing apples-to-apples, measured by economic equivalence, the loss is 3%. In a highly unpredictable industry, a 3% loss is not seriously off a competitive rate of return."
By using Smith's economic equivalence method, industry benchmarking among competitors reveals some surprising results. For example, National Fuel Gas, whose performance is ranked highly by traditional BOE calculations, descends sharply in the industry ranking under Smith’s calculations. Based on Smith’s measure of finding and development costs, the firm actually fell below the breakeven level, meaning the cost to find oil and gas reserves exceeded the value of the reserves booked as assets. Similarly, the shale oil-oriented firm EOG moved up the ranks based on its reserve replacement costs; that is, it moved from below to above the breakeven boundary where reserve values exceed finding costs. Smith cautions that such rankings do not tell the whole story since some firms may spend more than others to extract deposits of higher value, but basing comparisons on economic equivalents is a much better benchmark than the conventional BOE approach.
In conclusion
The industry practice of combining oil and gas streams in terms of equivalent barrels has the advantage of being objective and simple. But it "imparts a significant bias to estimates of value, cost, and profitability if ‘equivalence’ is not defined in terms that are economically meaningful," notes Smith in his research. This new approach offers a better solution that levels the playing field, given that all oil and gas firms have differing proportions of oil and gas reserves. In an operating environment where every percent of margin matters, there may be no better time for a truer measure.
The paper "Valuing Barrels of Oil Equivalent" by James Smith, Cary Maguire Chair in Oil and Gas Management, Cox School of Business, Southern Methodist University, is forthcoming in The Energy Journal.