Understanding the Energy Sector and Oil & Gas Investments

Understanding the Energy Sector and Oil & Gas Investments

Let me tell you about the energy sector—it's made up of oil and gas, utilities, nuclear, coal, and alternative energy companies. But for most investors like you, the real draw is the exploration, production, drilling, and refining of oil and gas reserves. If you're looking to invest—whether in shares of an oil and gas company, an ETF, or a mutual fund—to turn a profit, you'll need to do your research, just like the pros do.

The Role of Valuation Multiples in Oil and Gas Analysis

In the oil and gas sector, analysts rely on five specific multiples to gauge how companies stack up against their competition. These multiples tend to rise during periods of low commodity prices and fall when prices are high. Getting a handle on these widely used multiples gives you a solid foundation in the fundamentals of the oil and gas industry.

Enterprise Value/EBITDA Explained

Let's start with EV/EBITDA, which is enterprise value compared to earnings before interest, taxes, depreciation, and amortization—often called the enterprise multiple. A low ratio suggests the company might be undervalued, and it's great for cross-border comparisons since it bypasses tax differences. Generally, the lower the multiple compared to peers, the more undervalued it appears.

This ratio looks at the oil and gas business without debt, pitting it against EBITDA, which measures profits before interest. Oil and gas companies carry a lot of debt, so EV includes the cost of that debt. It's a key metric for valuing these firms and spotting takeover targets, which happen often in this sector. You'll find exploration costs in financial statements as exploration, abandonment, and dry hole costs. Add back non-cash items like impairments, accretion of asset retirement obligations, and deferred taxes.

One big advantage of EV/EBITDA over P/E or P/CF is that it's not swayed by capital structure. If a company issues more shares, it dilutes EPS and hikes the P/E, making it seem pricier, but EV/EBITDA stays the same. For highly leveraged firms, P/CF might look low, while EV/EBITDA could show it as average or expensive.

Enterprise Value/Barrels of Oil Equivalent Per Day

Next up is EV/BOE/D, or enterprise value compared to daily production—also known as price per flowing barrel. This is a go-to metric for oil and gas analysts. You calculate it by taking enterprise value (market cap plus debt minus cash) and dividing by barrels of oil equivalent per day. Companies report production in BOE, so if this multiple is high relative to peers, it's trading at a premium; if low, at a discount.

While useful, this metric ignores potential from undeveloped fields. That's why you need to consider the costs of developing new fields to truly understand an oil company's financial health.

Enterprise Value/Proven and Probable Reserves

Then there's EV/2P, which is enterprise value compared to proven and probable reserves. This one's straightforward—no estimates or assumptions needed—and it helps you see how well a company's resources will back its operations. Reserves break down into proven (1P or P90, with 90% production probability), probable (P50, 50% certainty), and when combined, 2P.

Don't use EV/2P alone because not all reserves are equal, but it's still valuable if cash flow details are scarce. A high multiple means a premium for the oil in the ground; a low one points to potential undervaluation. You could use EV/3P, including possible reserves (10% chance), but it's less common. Remember, reserves vary, so this multiple isn't a standalone valuation tool.

Price/Cash Flow Per Share

Analysts in oil and gas often turn to P/CF, or price compared to cash flow per share. Cash flow is tougher to fudge than book value or P/E. Just divide the share price by cash flow per share—use a 30- or 60-day average price to smooth volatility. Here, cash flow means operating cash flow, excluding exploration expenses but including non-cash items like depreciation, amortization, deferred taxes, and depletion.

This approach allows for solid comparisons across the sector. For accuracy, use fully diluted shares. One downside: it can mislead if leverage is unusually high or low.

Enterprise Value/Debt-Adjusted Cash Flow

Finally, EV/DACF compares enterprise value to debt-adjusted cash flow. Oil and gas firms have wildly different capital structures, and high-debt ones look better on P/CF, so many analysts prefer this. Calculate it by dividing enterprise value by cash flow from operations plus financial charges like interest, current taxes, and preferred shares.