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How Can Oil Stocks Be Cheap AND Expensive

Is it time for investors to load up on oil shares–or time to sell?  The answer is–it depends what metric you’re looking at.  On a cash flow basis, they’re expensive.  But based on Net Asset Valuations (NAV), they’re cheap.  How can oil stocks be both expensive and cheap?  I’ll tell you.

First–where are we at today? The upticks in the oil price have got energy investors excited the last few weeks. A 30% move in WTI since mid-March—to as high as $57—has triggered a nearly 20% appreciation in producer indexes like S&P Oil and Gas E&P (NYSE: XOP).

By some metrics, the scale of optimism around oil-weighted E&Ps has become way overdone.

Alarms were sounded in an April 7 report from Canada’s RBC Capital Markets, which noted that large cap integrated and independent oil stocks are now pricing in WTI at $89 in the long-term.

That’s right, these stocks need oil at $89 in order to justify their valuations. When in fact WTI is still trading at just $55.

That’s a big discrepancy. One that should give investors pause for thought.

But digging into the numbers it becomes clear there’s something else going on when it comes to valuations for oil stocks.

Namely—it’s critical to decide what analytical metrics you’re looking at when it comes to valuing producers.

One go-to method of valuation for many analysts is the price-to-cash flow ratio, which simply shows a firm’s enterprise value as a multiple to the underlying cash being generated by current production.

Using the price-to-cash flow numbers, oil stocks do indeed look expensive today. Just look at a few recent figures from BMO Capital Markets.

BMO’s research shows that price-to-cash flow multiples for senior producers—companies like Marathon, Murphy, and Whiting—have rocketed upward so far in 2015. Today, the average senior E&P is trading at 8.8x cash flow. Just a few months ago, at the end of 2014, the multiple was as low as 5x.

In fact, average cash flow multiples across the senior space are currently near the highest levels we’ve seen over the past 10 years–much higher than the average multiple of 6x that’s prevailed since 2000.

To find a period of higher multiples investors have to go back to the salad days for the E&P sector in late 2007 and early 2008—when soaring oil prices created one of the most optimistic periods on record for energy investors.

The fact that we’re once again nearing the heady valuations of that time is concerning.

But cash flow multiples are just part of the story. When we look at the E&P sector using different valuation metrics, we get a completely different story—one that shows producers may be a good buy right now.

Look at a metric like price to net asset value (NAV), which measures a company’s trading worth relative not just to the profits it’s producing, but to the total assessed value of its in-ground oil and gas holdings.

BMO’s research shows that E&Ps are relatively cheap today compared to NAV. Remember that I said that cash flow multiples are going for an above-average 8.8x (as compared to an average of just 6x for the sector since 2000)? Well, when it comes to NAV the story is the opposite—E&Ps are selling for below average prices.

Valuations based on NAVs from 2014 reserves reports are right now averaging 0.9x for senior producers. And when we factor in current forward pricing for oil and gas, the multiple drops to 0.7x, according to BMO.

The really interesting thing is that the average price-to-NAV ratio since 2003 has been 0.85x for the senior sector. Meaning that at today’s pricing strip, producers are valued well below historic levels–almost 20%.

But wait… how is it possible that the E&P sector is trading at all-time high multiples to cash flow—and at the same time selling for record-low levels in relation to net asset value? Is it time to sell, or time to load up?

It turns out—it could be both. The short explanation being that, in today’s oil and gas sector, it’s critical to look at a range of data beyond just any one simple metric.

That’s because resource drilling plays have critically changed production and reserves profiles for North American E&Ps. Because shale gas and oil plays generally come with much longer—and often more predictable—reserve life than conventional reservoirs.

That means a shale well will usually provide cash flow for longer than a conventional well. And yet, this long life isn’t apparent if you simply look at a multiple to cash flow—which is basically a snapshot of just one moment in the life of a well (or a group of wells, in the case of a large company).

In order to detect the financial benefits that long-life reserves bring, it’s necessary to look at overall net asset value—where engineers predict the total life of a well, and then assess the value of that cash flow. If the well life is longer, the NAV is going to be higher.

This fact is already starting to percolate into the consciousness of energy analysts. AltaCorp Capital, for example, recently stated in a research report that “traditional ‘point -in-time’ multiples such as EV/DACF [enterprise value to discounted cash flow] do not capture decline profiles and underlying value” when it comes to today’s oil and gas fields.

The firm instead advocates looking at net asset value as a better way to assess E&Ps. And their findings jive with the numbers above—showing that 70% of the stocks in their coverage universe saw a contraction in trading multiples to NAV during 2014.

The firm pointed out that some stocks—such as Painted Pony (TSX: PPY), Rock Energy (TSX: RE) and Bonterra (TSX: BNE) have seen their multiples to NAV contract by over 20% during the past year. A fact that shows these stocks are getting cheaper relative to the value they hold.

Those sorts of numbers may be much more useful for investors today, as more-traditional metrics like cash flow multiples only giving an idea of relative valuations between stocks—but less of a picture of the general buy or sell signals for the sector as a whole.



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