There are three variables that dominate the valuation of oil companies. In no particular order, they are:
1. Production and Reserve Replacement
2. Finding costs
3. The price of oil

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Control What Can be Controlled
Production levels determine the revenues, and without revenues, not much else matters. Next to production is reserve replacement. If a company sells a million barrels of oil a year but only adds 750,000 barrels in new reserves a year, over time reserves begin to deplete and that reduces the value of the company's principal asset.

The third variable, the price of oil, is, to a large extent, beyond the control of oil companies. Oil companies, unless they have hedged production, must accept the market price for oil or simply refuse to sell it. Obviously refusal to sell is not the ideal option. Thus, in periods of low oil prices, companies that can explore and produce a barrel of oil for less have a competitive advantage.

The (Simple) Economics of Oil
What determines a low price of oil? Years ago, when oil was trading at $10, folks would have loved to sell the black gold at $60. Today, oil is at $70 but that doesn't look as nice as $130 a year ago.

What matters is this: economics tells us that the price of any commodity will equal the marginal cost of production of the last quantity demanded. If the world demands 80 million barrels of oil a day and the cost to produce that 80 millionth barrel is $75, then the price of oil should be approximately $75. Thus when demand declines - all else equal - prices decline and vice versa.

However, all else is not equal. The supply of oil is not infinite, so over time it becomes more expensive to keep supply stable. Thus in the long term, you should expect oil prices to generally increase. This means that companies that increase production and reserves and maintain lower costs will outperform over the long run despite the price of oil.

A True Gem
Berry Petroleum (NYSE:BRY) is a sizable oil and gas company that might not jump out at you at 17-times earnings, especially when it stands behind large stable giants like Chevron (NYSE:CVX) - with a P/E of 8.50 - and ConocoPhillips (NYSE:COP), both of which yield nearly 4% alone in dividend payouts, compared to 1.3% for Berry. Even XTO (NYSE: XTO), widely considered an excellent oil outfit with excellent management isn't as efficient as Berry.

But Berry is a $1.1 billion company that could easily be worth multiples of that in the next few years. Since 2004, reserves have grown at an annual compound rate of 22%. Production has grown by 12% a year over the same time. Berry is currently selling about 12 million barrels of oil equivalent a day; reserves total 246 million barrels, of which 224 is proved. Three year finding and development costs are under $14 a barrel. Add in about $15 per barrel in operating costs, plus money for interest expenses, and you get around $40 in total cost per barrel of oil. At $50 oil, the company still makes good money.

The Bottom Line
The company has come a long way. It had a few problems over the past year, namely the bankruptcy of one its refiners and a debt-heavy balance sheet. But the company continues to improve upon its reserves, enabling to sell off some assets and head in the right direction. If oil prices remain where they are, Berry should continue to profit handsomely from its efficient operating structure. (For a primer on the oil industry, refer to our Oil and Gas Industry Primer.)

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