Analyzing oil and gas exploration and production (E&P) stocks can be overwhelming for those without an oil and gas industry background. But, with just a basic understanding of exploration, production and reserves, investors can get a better grasp of E&P stock evaluation and make profits from this lucrative, albeit cyclical, industry group. (For related reading, see Oil And Gas Industry Primer.)

Exploration
Oil and gas wells can generally be classified into two different types - exploratory wells and development wells. Sometimes known as a wildcat well, exploratory wells are those drilled to find new reservoirs (places where hydrocarbons haven't been found in the past). Wells drilled into the known extent of a producing reservoir are known as development wells. (For related reading, see Drilling For Big Tax Breaks.)

Exploratory wells are much riskier endeavors than development wells. However, similar to the world of equity investing, the extra risk often correlates to extra potential reward. Drilling an exploratory well can sometimes result in the discovery of a large new reservoir or oil and gas field. Most E&P companies will drill a combination of exploratory wells and development wells in the course of any given exploration program. The approach is similar to building a diversified portfolio of stocks.

Drilling
Because all hydrocarbon production declines over time, E&P companies must drill new wells in order to grow revenue and earnings. Therefore, a key analytical consideration is the company's drilling program. Investors should read about what the E&P has been doing and what it plans to do in its drilling program to understand where revenue and earnings growth could come from.

There are a lot of factors to consider - the oil vs. gas mix, the drilling cost of each well, the company's working interest (essentially the ownership percentage of the well) and the mix of development and exploratory wells to name a few. The better the E&P is at increasing production in a cost effective way, the greater the potential return on equity for shareholders. (To learn more about ROE, check out Keep Your Eyes On The ROE.)

Analysts usually consider the company's overall drilling success rate, or the percentage of all wells drilled that resulted in economic production. If the company plans to drill the same type of wells (and in similar geographic locations) in the future as it has in the past, the past drilling success rate can be somewhat of an indicator of future success. If the analyst is confident that the drilling program will be successful, he or she will have confidence in the company's ability to increase production and cash flows in the future.

Production
Investors are wise to carefully consider an E&P's production trend before investing in its stock. E&Ps usually report several production figures, such as average daily production rate, total production for the period, and the exit production rate in every earnings press release and every financial filing. Like the analysis of any company, investors want to see production (and therefore profit potential) increasing over time without corresponding material increases in new debt and equity securities. The combination of those factors, with all other things being equal, is what drives earnings per share growth for an E&P.

Profitability
Analysts use an E&P's financial statements in conjunction with production figures to examine revenue and costs on a per-unit-of-production basis. Revenue per barrel of oil equivalent (BOE) of production is tied closely to the prevailing market price for oil and gas. Revenue per unit can differ substantially from market prices if the E&P hedges production using futures contracts. (To learn more, read Fueling Futures In the Energy Market.)

Costs
E&Ps generally incur period costs in three categories: cash operating costs, general and administrative expenses, and depletion and depreciation expenses (which are non-cash costs). It is useful to look at each cost category on a unit of production basis to assess trends and to compare the E&P to other companies in the sector. E&Ps are always price takers because of the nature of the commodity they produce and sell, so managing for profitability always relates closely to effective cost management.

Accounting
E&P companies may use the successful efforts method or the full cost method to account for exploration activity. Under the full cost method, all exploration costs are capitalized on the balance sheet and charged against revenue over time in the form of depletion expense. Under the successfully efforts method, certain exploration costs are expensed as incurred and costs associated with unsuccessful wells ("dry holes") are expensed in the period in which they are incurred.

The two methods can generate significant differences in the E&P company's income statement. Other things being equal, the depletion, depreciation and amortization cost using the full cost method will be higher compared to the successful efforts method. Regardless of the accounting method used, to get a sense of drilling costs the analyst must look closely at both the income statement and the cash flow statement. Exploration costs are classified as capital expenditures on the cash flow statement. (Learn how to read financials properly in Introduction To Fundamental Analysis.)

It is partially because of the differences in accounting treatment for exploration costs that analysts often look at operating cash flow per share when assessing E&Ps. Another reason is that exploration costs are generally tax deductible in the period in which they are incurred and, as a result, much of the tax expense of an E&P is of the deferred variety. Many oil and gas investors consider E&Ps to trade on price-cash flow basis and not on a price-earnings basis. Therefore, analysts often project cash flow per share to arrive at target prices for E&P stocks.

Reserves
Analyzing petroleum reserves - the estimated quantity of hydrocarbons owned by the E&P that are still in the ground - is important because these are the source for all future revenue and cash flow streams. There are several common classifications for reserves. Proved reserves are those that engineers have the most confidence calculating because the field has been proved by appraisal wells or producing wells. In other words, we know the hydrocarbons are there because production has been generated from the reservoir. Proved producing reserves are reserves that are proved and expected to be recovered from existing wells, existing equipment and current operating methods. Proved undeveloped reserves (commonly called "PUDs") are reserves that are expected to be recovered from new wells on undrilled acreage or from geologic zones untapped by existing wells.

The Importance of NAV
Investors generally want to see reserve growth over time, although in an economic way that will benefit the shareholders. Therefore, if the company has been acquiring reserves, analysts will want to ensure the price paid for them was reasonable. Reserves are also important in the calculation of net asset value (NAV) and net asset value per share (NAVPS) for the company.

Similar to book value, NAV considers the present value of after-tax cash flows from reserves (usually at a 10% discount rate) as well as the present value of cash flows from future exploration activity. NAVPS is frequently used to value E&P companies in the same way that one would use a discounted cash flow valuation for an industrial or consumer products company. The formula for NAVPS could be given as follows:

Copyright © 2007 Investopedia.com

Note that the NAV calculation is usually best performed by those with an oil and gas engineering background because a highly important factor is the present value added from future exploration. That number is difficult to calculate and is dependent on the company's undeveloped acreage and drilling prospects in that acreage.

Conclusion
All oil and gas reservoirs shrink over time. In order to maintain and grow profits, E&Ps must drill new wells and find new reservoirs or fields. Profiting from E&P equity investments means finding companies that can do this well - or at least better - than the masses of investors think they can.

Related Articles
  1. Mutual Funds & ETFs

    ETF Analysis: SPDR S&P Oil & Gas

    Discover the investment strategy behind SPDR S&P Oil & Gas Exploration and Production ETF, and learn what type of investor may find it suitable.
  2. Credit & Loans

    What's a Nonperforming Loan?

    A nonperforming loan is any borrowed sum where the borrower has failed to pay scheduled payments for at least 90 days.
  3. Economics

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  4. Economics

    Understanding Cash and Cash Equivalents

    Cash and cash equivalents are items that are either physical currency or liquid investments that can be immediately converted into cash.
  5. Economics

    Explaining Carrying Cost of Inventory

    The carrying cost of inventory is the cost a business pays for holding goods in stock.
  6. Investing

    Can a Venezuela Revolt Impact Oil Prices?

    How a social crisis in Venezuela could affect West Texas Intermediate crude oil and Brent crude oil prices.
  7. Mutual Funds & ETFs

    ETF Analysis: PowerShares S&P 500 Downside Hedged

    Find out about the PowerShares S&P 500 Downside Hedged ETF, and learn detailed information about characteristics, suitability and recommendations of it.
  8. Mutual Funds & ETFs

    ETF Analysis: iShares US Oil&Gas Explor&Prodtn

    Learn about the iShares U.S. Oil & Gas Exploration & Production ETF, which provides an efficient way to invest in the exploration and production sector.
  9. Investing

    How To Calculate Minority Interest

    Minority interest calculations require the use of minority shareholders’ percentage ownership of a subsidiary, after controlling interest is acquired.
  10. Stock Analysis

    The 4 Worst Oil and Gas Stocks of 2015

    Learn about the energy sector and the type of companies that operate within the sector. Find out about the four worst performing oil and gas stocks of 2015.
RELATED TERMS
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the ...
  2. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  3. International Financial Reporting ...

    A set of international accounting standards stating how particular ...
  4. Revenue

    The amount of money that a company actually receives during a ...
  5. Balance Sheet

    A financial statement that summarizes a company's assets, liabilities ...
  6. Equity

    The value of an asset less the value of all liabilities on that ...
RELATED FAQS
  1. What emerging markets are best suited for investing in the oil & gas drilling sector?

    Over the past decade, emerging markets have driven the demand and production for oil and natural gas to new heights. Rising ... Read Full Answer >>
  2. Is the oil & gas drilling sector a good choice for value investing?

    Companies that look for oil and gas to extract, tend to have more volatile life cycles than most value investors are comfortable ... Read Full Answer >>
  3. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  4. How do futures contracts roll over?

    Traders roll over futures contracts to switch from the front month contract that is close to expiration to another contract ... Read Full Answer >>
  5. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  6. Why do companies enter into futures contracts?

    Different types of companies may enter into futures contracts for different purposes. The most common reason is to hedge ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!