Simple valuation methods for EP projects We cover

Simple valuation methods for E&P projects

We covered a number of operational topics in my petroleum fundamentals course, but one aspect that is of immediate use to TECO investors is the valuation methodology.

All oil companies, whether they are majors like Exxon and Chevron, or tiny independents like TECO, have the same standard approach for decision support modeling before taking on a project. As an upstream independent, Treaty is pretty much a collection of exploration projects whose cashflow stream will be aggregated into the company's bottom line.

Since that is the case, it is important to understand their likely approach for financial modeling. Doing so will align your expectations with that of the firm, and prepare you for positive or negative variance to budget. Once again they are a collection of exploration and production projects right now, and hence you have to look at their projects as a diversified portfolio with holdings in East Texas, West Texas, Belize, and Louisiana.

I've done a lot of financial modeling over the years and although the formula is pretty much revenue less costs equals net income, there are a bunch of industry specific intricacies ranging from revenue modeling to all the different costs and even what you add back in for different net income figures. The oil industry is different from the computer industry. When Apple sells a bunch of ipods, it depletes its inventory but all it has to do is hit the button and order some more out of the factory. The oil industry, however, does not have that luxury. It takes millions of years to produce hydrocarbons, and every time a company pumps it's product out of the ground and brings it to market, it is depleting it's assets. Hence, the government gives a tax credit for depletion so that oil companies can continue to explore, however it still means that the asset base continues to shrink if no discoveries are brought online.

The lecturer for this segment was the PM for an energy holdings company here in Houston, and I had the opportunity to talk to him at great length in between sessions as I was the only trader in the room. His return objective on each well, which has a life of generally 8 years, is 100%. He emphasized to me that the pay back period and return on investment needs to be measured in years. In fact pay back period for the wells he invests in tends to be 4 years, which is why it is important to have multiple wells so that not only is risk diversified but also production is staggered.

If you look below I have included the simplified oil well financial model we used in class, and the assumptions are in there. There is another module that we used to model and project revenue but I'll leave that out for now. What I'm trying to illustrate though is the decision support process used by big money.

There is too much emphasis by the typical retail investor on GETTING BIG NEWS TODAY!!!!!  This sets people up for disappointment and gives the idiotic bashers ammunition to antagonize longs. Don't get me wrong, as a trader I want to see a pop on news but for the really big move in this stock up to dollar land we need big money and big money isn't playing news. Notice how in the model below that the time frame is in years and it is set up to conform to the production life of the well. Big money is looking to make 100% over a 7-8 year period over each well. Candidly my lecturer told me that they have to plan that way because sometimes they come in under expectations, sometimes they come in over expectations, and sometimes they miss. But ultimately, their investment time frame is 5 years or more and they shoot for total return on total investment to run at 100%.

Once again, the numbers below are all just samples but the percentages and such are industry standard. All I am trying to illustrate for the TECO bulls is the thought process used by the firm, and more importantly what the big money investors will be looking at ahead of allocating to Treaty. They are not looking to play press releases  for a pop like a penny stock flipper, they are looking to lock up money for a period of at least 5 years for a 100% plus return.

Now, I'm about 3 beers deep and watching some of this Bama vs Aggie game so sorry if I don't get to people's questions until later tomorrow or Monday.

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