1. Key Ratios For Analyzing Oil And Gas Stocks: Introduction
  2. Key Ratios For Analyzing Oil And Gas Stocks: Measuring Performance
  3. Key Ratios For Analyzing Oil And Gas Stocks: Conclusion
The number one measure of performance in oil and gas producers is core cash flow. This allows for increased certainty in meeting debt obligations (the oil industry generally carries larger levels of debt). Future cash flows also help to value a company on a monthly or yearly basis. Companies such as Kodiak Oil and Gas (NYSE:KOG) have high levels of debt, but large increases in future production make this debt serviceable. Without future cash flows an oil and gas producer could have financial flexibility problems. Net income could remain consistent, but if cash flow does not increase, financial issues could occur without the ability to cover its debt. This is why focusing on free cash flow, cash flow from operations and core cash flow are the most important metrics for the oil and gas industry. Oil and gas reports a very high level of costs associated as non-cash items. Depreciation, depletion and amortization coupled with a large amount of deferred taxes are good reasons to use cash flow as the dominant measure for success and not net income. Commodity prices can move up or down significantly in a short period of time. Weather, inventories, and supply and demand can all affect pricing. This can be mitigated by hedges, providing a more stable cash flow. Cash flow along with bank credit lines and cash balances provide liquidity for current and future obligations. The adequacy of cash flow is used to identify a company's ability to finance capital needs internally versus externally. This effect on capital spending indirectly affects a company's ability to alter the timing of projects without impairing operations.

SEE: Free Cash Flow Yield: The Best Fundamental Indicator

The reasons above detail why the price-to-cash-flow ratio (P/CF) is an important tool for analyzing oil and gas E&P companies. It evaluates the price of a company's stock relative to how much cash flow it is generating on a per share basis. The higher this multiple, the riskier the stock is. It is wise to use several ratios for proper analysis, as all have strengths and weaknesses. Due to the complexity of the oil and gas industry, a price to cash flow multiple should be used. This removes the effects of non-cash metrics such as depreciation. This ratio does not take leverage into account, so it can be misleading when used by itself. P/CF is not a value that should be used alone. To understand its value, other such as stocks must be figured and compared to the company being analyzed. It could be compared to other metrics such as the price to earnings , price to sales or price to book ratios. All of these ratios would have a different expected number based on the industry and size of the company.

Price to Cash Flow = Stock Price Per Share

SEE: Analyzing The Price-To-Cash-Flow Ratio

Cash flow can be figured differently from one analyst to another. The easiest way to compute cash flow is through the cash flow statement. By adding operating, financing and investing cash flows a value can be establish to use as a comparison. This equation can be used to figure cash flow:

Cash Flow = Net Income + DD&A + Exploration Expenses + Deferred Taxes

When comparing companies using Price to Cash Flow, it is important to be consistent. For an adequate comparison, these companies must be alike and comparable. This multiple is advantageous, because it is difficult to change or manipulate the amount of cash flowing in and out of a company. Earnings, book value and sales are all easily changed using aggressive accounting. A negative associated with P/CF is that it neglects the use of some non-cash items such as deferred income.

Like Price to Cash Flow, the P/E Ratio provides a valuation metric. It is the most widely-used ratio because of its simplicity. The P/E Ratio reflects what an investor is willing to pay for a dollar of earnings. It may give an idea on valuation for larger integrated oil and gas names, but it does little for smaller companies focused on short-term growth. In general the P/E Ratio is a barometer of investor mood or optimism, but does little for non-integrated names.

Companies that have larger debt loads, or that are leveraged will show better Price to Cash Flows. Because of this, the enterprise value over debt adjusted cash flow was developed. This places oil and gas companies on an equal footing with respect to debt. Enterprise value is a measure of the theoretical takeover cost, which includes the debt acquired along with any company cash.

Enterprise Value = Market Cap + Debt + Minority Interest + Preferred Shares – Total Cash and Equivalents
Debt-Adjusted Cash Flow = Cash Flow from Operations + Financing Costs (after tax) + Exploration Expenses (Before Taxes) +/- Working Capital Adjustment

The EV/DACF multiple is specifically used in the oil and gas in place of the EBITDA/EV valuation ratio. This calculation is after tax and independent of financing. Given the high resource taxes and above average debt carried by the oil and gas industry, EV/DACF is well suited for these companies.

Cash flow is important when evaluating an oil and gas producer but there is no cash flow without resource. Oil, natural gas liquids and natural gas all have their own independent supply and demand. Because of this, prices can vary significantly from year to year. This dynamic has been apparent over the past few years, with oil prices increasing and natural gas decreasing in the United States. In other countries, natural gas pricing is significantly higher. Horizontal drilling has increased natural gas production, which has flooded the U.S. market. Natural gas is exposed to regional pricing as it has difficulties in transport. Oil can be transported globally and benefits from global pricing. Types of crude oil are Brent Blend, West Texas Intermediate, and Bakken Light, just to name a few. Each type varies in composition and price, and is labeled by locale. The large increase in United States' oil and natural gas production has had unforeseen and large changes. As stated earlier, natural gas pricing has dropped and now only the lowest-cost producers are able to continue drilling programs. Due to the lack of oil pipeline capacity and increased production in the U.S., West Texas Intermediate sells at a discount to Brent. The same reasons have caused Bakken crude to have a wide differential with WTI. As pipeline capacity expands, these differentials should tighten closer to historical averages.

SEE: 5 Biggest Risks Faced By Oil And Gas Companies

Energy ratios are the best way to calculate the current value of a company's reserves and production. It takes multiple energy ratios to analyze the value of an oil and gas company. Reserves are the amount of resource still in the ground. Production is the average amount of resource being pulled from the ground. Both of these metrics are very important in oil and gas. As oil and gas is produced, reserves are depleted. Production creates cash flow which can be used to replace reserves. It is also important to consider how reserves are replaced, either by the drill bit or acquisitions. There are three types of reserves: proved, probable, and possible. Oil and gas exploration involves some guesswork with respect to the certainty of resources being produced. Proved reserves have a very good chance of being produced. This designation is important as acreage is de-risked. Probable reserves have a 50% chance of being produced, while possible reserves are the least likely. The production-to-reserves ratio is used to determine if a company is replacing the reserves depleted through production. To perform this calculation the amount of natural gas and oil are divided by the amount of reserves. Since natural gas is usually quantified by billions of cubic feet (Bcf), and oil by MMBbls (one million barrels), another calculation needs to be done to convert Bcf to MMBoe (Barrels of oil equivalent). To accomplish this, divide the Bcf by 6 Mcf /BBl. This number can be added to MMBbls to get MMBoe. Once both are converted, divide the production by company reserves.

Production to Reserves = Production/Reserves

The second energy ratio is the Reserve Life Index. The RLI is the reciprocal of the Production to Reserves Ratio. As it sounds, it shows how long reserves will last at the current production rate with no additions to reserves. To achieve the RLI (measured in years), divide 1 by the Production to Reserves Ratio. This ratio can vary in meaning. It would seem a long RLI in years, would be better as resource would be produced over a long period of time. If a company is lacking the ability to develop this resource, it would have a long RLI, so be sure to see if the company has the means to produce this particular resource.

RLI (years) = 1/Production to Reserves Ratio

The Reserve-Replacement Ratio is used to see if a company is replacing production. Basically, it shows whether a company is increasing reserves or depleting them.

Reserve-Replacement Ratio (%) = Increase in Reserves + Production/Production

SEE: 6 Basic Financial Ratios And What They Reveal

Key Ratios For Analyzing Oil And Gas Stocks: Conclusion
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