Analyzing oil and gas companies is no easy task. One of the main challenges is assessing a company’s future viability because production is sourced from depleting resources. Mining companies operate with finite reserves. This is starkly different from traditional industrial manufacturing companies that source raw materials to produce value-added goods. Oil companies constantly need to replace what is produced. There are two key areas analysts examine when deciding how companies are performing: profitability ratios and sustainability ratios.
Looking at twelve U.S. oil and gas production companies, we can get a sense of how the sector is performing overall. We are examining data covering the years 2014 to 2016 in order to smooth out annual volatility. This period is also a time of declining oil prices, so relative performance indicators are especially relevant. Companies outperforming peers in these years could be better positioned to deliver outsized returns in an upward trending oil market.
One of the key indicators analysts examine is profitability. For our sample of oil companies, however, it is important to measure not only how profitable a company is, but also how much it costs to generate that profit. The chart below shows companies profit per barrel of equivalent oil produced (i.e. both oil and gas displayed in barrels -- boe), measured as earnings before interest, tax and exploration expenses (EBITDAX), versus the cost of producing an equivalent barrel.
Using this metric in the chart below, we see that companies such as Pioneer Natural Resources (PXD) are outperforming Occidental Petroleum (OXY) and Hess Corporation (HES) because EBITDAX per barrel is around $30 per barrel, but PXD’s production cost of $8 per barrel is roughly half that of HES.
Another important metric is how much it costs to replace the oil and gas reserves (called FD&A costs) that are being produced against the profit being made from selling these reserves. Analysts call this the capital cycle ratio. Looking at our group of companies in the chart below, Chevron (CVX) is the clear winner with profitability per barrel around $40 against roughly $30 to replace that barrel. At the other end of the spectrum is Chesapeake (CHK) with similar FD&A costs but much weaker profitability per barrel.
Mining companies need to continually replace reserves, so analysts spend a lot of time making sure companies have a sustainable business model. One way to do that is to take a look at how much companies are spending on capital expenditure (capex) compared to their production growth. This is one way to measure investment efficiency, or which companies are getting the most from their investments,.
Looking at the companies below we see PXD and Newfield Exploration (NFX) are doing quite well with three-year production growth in excess of 20% and capital spending that is less than peers. On the other hand, companies like Apache Corporation (APA) are spending around $5 billion annually on average over the last three years, with production that has collapsed by 30% over the same period.
Not only is it important to see how companies are growing production, but it is equally important to measure how effectively companies replace what is produced. Analysts often use the basic replacement ratio, which is a percentage measure of how much production was replaced. This is often compared to the cost of replacement.
Looking at our companies, Marathon Oil (MRO) and CVX seem to be doing quite well, replacing nearly 100% of annual average production over the last three years. MRO is able to do this at lower costs than CVX. CHK, Anadarko Petroleum (APC) and Devon Energy (DVN) are the clear losers here, spending money on FD&A while their reserve base actually shrinks. A negative basic replacement ratio shows that not only was annual production not replaced, but the reserve base actually shrank.
Disclaimer: Gary Ashton is an oil and gas financial consultant who writes for EvaluationDomains. The observations he makes are his own and are not intended as investment advice. Chart data sourced from SEC 10-K filings.