Back At It - Wrong Framework Again!

My commitment to publish my Biggest Mistake of the Day (BMD) has fallen under the weight of a volatile month.  Whether or not the Chinese said it, it certainly might be a curse to "live in interesting times"  - at least in terms of keeping a blogging promise.

I have been reviewing my analysis of British Petroleum (BP).  BP is a major vertically integrated oil and gas company.  Several different functions of the oil and gas business, such as "upstream" exploration and production, "midstream" transportation and "downstream" refining and marketing are consolidated under one roof. Each of these functions has characteristics that are so different that many companies, such as ConocoPhillips (COP), have split them into separate businesses.

Typically the most valuable part of a vertically integrated oil and gas company are the reserves.  The nature of reserves is to discover them, develop them and extract them.  The end result is no asset.  This is an unusual structure.  Most of the time, companies have non-depleting assets that are designed to generate recurring revenues.  Here is where the challenge is to use the correct framework.

It is tempting, in the case of an exploration and production (E&P) business, to study its revenues, its expense structure and its cash flows and attempt some type of valuation based on those metrics.  Many Wall Street analysts resort to this - or even just use the dividend yield to value it.  Value Line, an investment service, uses a multiple of "cash flow" by which it means net profits (stated variously) added to depreciation. This is certainly an easy way to come to a conclusion, but it is hardly "fundamental" analysis. 

Even the accounting profession struggles with an approach. Accounting has to use a framework which is designed for a conventional business - one whose assets generate recurring revenues. As a result, the balance sheet and income statement presentation provides little insight into the understanding and valuation of an E&P business.

However, over time, accounting has created supplemental reports that provide useful information.  The critical starting point is to gain a sense of the value of the "proved developed reserves."  These are the reserves which are basically ready to produce oil and gas because all of the "get ready" expenses have been spent.  By studying the "proved developed reserves" and the changes in them from year to year, an analysis can arrive at the value of the reserves and gain insight into the value-adding or value-destroying nature of the activities that create them.