Should I invest in production or reserves?
Understanding the correlation between market value and product volume and reserve levels
Mazen Matar, CFA, MBA, CRA, Pinnacle Wealth, Calgary, Alberta
| EDITOR'S NOTE:Oil and gas executives often face the difficult choice as to whether to invest in production or in reserves in order to increase the market value of their company. Mazen Matar's article looks at the factors that impact market value. More precisely, it examines the correlation between market value and the production volume and levels of reserves at a number of Canadian energy companies during the period of the financial crisis (2008-2009) and the following years. |
Oil and Gas is a global industry that integrates vertically and horizontally with many other industries and thus represents an important engine for global economic growth. The International Energy Agency expects that oil and gas will provide 50% of the world's energy in 2035. Canada is widely recognized as a country that has an advanced upstream sector supported with advanced extraction technologies that contributed about CAD$ 65 billion to the GDP in 2006.
Valuation of oil and gas companies has been a controversial issue, with market value being considered traditionally a proxy for fair value, especially for those believing in efficient market theory. Fundamental factors (such as a company's performance and profitability) come out on top of factors considered for evaluating fair value. For extractive-resource companies, commodity prices, production and reserves level, and interest rates are traditionally among the top fundamental factors that investors and analysts look at when evaluating companies operating in this sector.
The correlation between market return and changes in production and reserves has been researched and presented in many papers such as the one by Boyer and Filion (2007) who examined this correlation among Canadian oil and gas companies over the period from 1995 to 2002. However, the disturbance in the marketplace after the financial crisis (2008-2009) motivates one to reexamine this relationship with more focus on the relationship between market value and production and reserves level rather than market return and percentage change in production volume and reserves level.
The decision to invest in a particular company depends heavily on the price of the company and the ability to justify that price. This research helps investors to explain and justify the pricing of a company in light of its production and reserves level.
Scope of the research
The scope of the research includes a sample of nine companies that were taken out of a population of 108 oil and gas companies listed on the Toronto Stock Exchange (TSX). In terms of market capitalization, the sample represents the largest nine upstream and non-integrated public companies in the oil and gas sector as of Sept. 30 2012, in Canada.
Although the sample size represents only 8.3% of the population when measured in numerical terms (the number of companies in the sample as compared to the number of companies in the population), it represents more than 30% of the market value of the oil and gas sector on the TSX. The research uses data compliant with regulatory requirements for all companies which isolates the effect of discrepancies in reserves and production valuation methods.
Only two independent factors are covered in this research, production volume and reserves level. Production volume is usually disclosed quarterly and annually in interim and annual reports as a figure that represents the average daily production during that quarter or year in thousand/million barrels per day for oil and thousands/million cubic feet per day (cf/d) for natural gas. Both numbers are consolidated in the total production figures and reported in thousands/million barrels of oil equivalents per day, which is used for this research. Reserve figures are disclosed annually as a regulatory requirement in most jurisdictions in different forms.
The form used here is the annual proved plus probable reserves in million barrels of oil equivalents (MMboe), which can be found in the National Instrument 51-101 (Disclosure of Oil and Gas Activities, form NI 51-101), as a Canadian regulatory requirement, or in annual reports and Annual Information Forms of each company. Market prices are available in both frequencies, annually and quarterly and obtained from the TSX.
The research covers the period from the first quarter of 2007 until the fourth quarter of 2011, which represents 20 data points for each company for quarterly production volume (180 data points, in total) and five (5) data points for each company for reserves level and annual production volume (45 data point for each variable, in total).
Price and market value data were lagged one quarter in order to allow ample room for independent variables to be reflected into market price. Prices were obtained from the TSX and Yahoo Finance in the form of fully adjusted prices for splits and dividends. To calculate market value, fully adjusted prices have been multiplied by outstanding shares as reported in the most recent annual or interim financial report (fully adjusted prices correspond to market values).
Theoretical framework
Despite the large number of oil and gas research papers, production and reserves level have rarely been introduced separately as major variables that affect the valuation of oil and gas companies. In the Canadian context, a few research papers have addressed the definition and dynamics of real options, but without addressing their impact on stock prices.
In our literature review, we divided those research papers into two sections, where the first handles literature that addressed the norms of production and reserves figures, while the second section illustrates how valuation and correlation modules have been introduced by scholars interested in the oil and gas industry. Findings show that ample room for research is still available for interested researchers to explain the relevance of performance measurement and operational data to companies' valuation in the industry's context.
Understanding reserves and production
Reserves and production disclosure is an essential part of any oil and gas reporting procedure, whether it is provided explicitly in separate format or implicitly as part of financial statements. Reserves are balance sheet items and usually represent the largest asset any upstream company could have, while production appears in income statements as gross sales, after completing the sales process. It is important to note, however, that both items are correlated inversely, in quantity figures, all else being equal. Unless new discoveries exceed production, reserves will diminish as more crude oil and natural gas are produced.
Reserves can be classified into proven and probable reserves. Proven reserves are usually divided into proved developed and proved undeveloped, where the latter refers to reserves that can be developed under current economic conditions and by current available technologies. Different regulatory bodies usually require different reporting methodologies. However, they all tend to require proved reserves to be included. The Canadian Securities Administrators (CSA) classifies reserves into three levels: proved, probable, and possible reserves, with a probability of 90%, 50%, and 10%, for each of them, respectively, to be recovered at the same reported quantity.
Sample construction
To reach the required sample, we used a list published by TMX that includes all oil and gas companies listed in the TSX (the full list is not published here). Next, we sorted the companies in a descending order according to market capitalization from largest to smallest and examined each firm's operation, starting from the top of the list, for downstream activities over the past five years. The primary sources used to examine the operation of each firm were its website and annual reports for the past five years. Table 1 lists the companies that have been examined in order to reach the final sample.
Three types of data treatments have been applied to each variable, where the first one illustrates the individual correlation between each company's market value and the independent variable, the second illustrates the relationship between company size and its individual correlation (as revealed in the previous treatment) and the third illustrates the correlation between aggregate market value of the sample and aggregate value of the independent variable over the period of the study horizon.
Reserves and market value
The aggregate levels of reserves of the sample were moderately correlated (0.54) with aggregate market value of companies over the study period. As may be noted in Table 2, individual correlation figures varied for each company and recorded a mean of 0.20 and a standard deviation of 0.63.
There is no clear trend-line for the relationship between the size of the company (in terms of market value as of Nov. 30, 2012) and its correlation figure. When running a regression analysis between market value and correlation coefficients of each company (see Figure 1), R-squared was significantly low (0.044), indicating low explanatory power of a company's size in explaining the correlation coefficient between its market value and its reserves levels.
The regression analysis in Figure 2 provides decision makers and investors with a tool to predict the correlation coefficient of the company based on its market size, which allows them to incorporate the independent variable (in this case, reserves level) in valuation modules. Although this type of analysis has not been used in any of the literature reviewed for this paper, we believe that it is valuable for investors as a technical analysis tool and can be used to predict the market value of oil and gas firms over the short term. For this particular variable, the chart illustrates that the relationship between the firm's size and the firm's correlation coefficient is low enough, which may lead investors to ignore the size of the firm at a certain point of time (i.e. today) when developing their valuation modules based on the correlation between market value and reserves level.
The trend-line shows that the increase in reserves level was accompanied by an increase in market value for the period between 2008 to 2010, while a deviation happened in 2007 and 2011. In 2007, reserves were relatively low but market value was relatively high (compared to 2008, for instance), which could be attributed to the optimism that prevailed in that year with the high commodity prices. In 2011, the ensuing pessimism may explain why market value didn't correspond to the increase in reserves level. In either case, further research and analysis should be carried out to explain this anomaly.
Annual production volume and market value
Correlation between aggregate production and aggregate market values was 0.74, while the mean of individual correlation measures of each company was 0.40 with a standard deviation of 0.53. Table 3 illustrates individual correlation coefficients for each company.
Relationship between correlation coefficient and market value of each company recorded R-square of 0.18, but again, the trend-line was not indicative of any significant relationship, as can be seen in Figure 3.
It can be noticed that market size has more explanatory power to the correlation between market value and annual production volume than to the correlation between market value and reserves level. This may lead analysts and investors to incorporate current firm's size into their modules to predict correlation between market value and production volume.
Both correlation and explanatory power of this model are higher. Aggregate market value for the year 2009 was added to anomalies noticed earlier for year 2007 and 2011. Again, the optimistic sentiment in the market place after the financial crisis of 2008 might be the explanation of this situation. However, further research should take place before drawing a conclusion.
Quarterly production volume and market value
Examining quarterly production figures revealed that the mean and standard deviation of correlation coefficients for individual companies were 0.36 and 0.46, respectively, which are slightly lower than the mean and standard deviation of correlation coefficients of annual production data (0.40 and 0.53, respectively). Table 4 illustrates the individual correlation coefficient between quarterly production volumes and their corresponding market value for each company.
The relationship between a firm's size and the correlation coefficient of its quarterly production volume and market value had a low R-squared as well (0.05), as shown in Figure 4.
Figure 5 leads one to conclude that a firm's size is not significant in predicting the correlation coefficient between quarterly production volume and market value, because of its low explanatory power.
Although the explanatory power of this analysis is relatively low, a trend-line can be drawn to show that a relationship exists in the long term. Other types of data analysis should be examined to flesh out any causality relationship.
Summary
Annual production volume had the highest correlation with the aggregate market value of the firms in the sample (0.74), which leads us to believe that annual production volume is a good predictor for future market value. Reserves level comes second in importance as a prediction tool with a correlation coefficient of 0.54 with aggregate market value. Surprisingly, quarterly production volume had a low correlation coefficient with aggregate market value (0.05). These results lead one to conclude that investors perceive annual production volume as the primary tool to evaluate oil and gas firms as compared to referring to reserves level or quarterly production volume.
About the author
Mazen Matar has worked for over ten years in the finance and investment arenas with special focus on oil and gas upstream and downstream sectors. Mazen's experience revolves around developing advance valuation models for various industries and investment opportunities. Currently, he is a member of the Corporate Finance team at Pinnacle Wealth, the largest exempt market dealer in Canada. Mazen is a Chartered Financial Analyst (CFA Charterholder), Certified Risk Analyst, and holds an MBA degree from Cape Breton University in Canada.