Investing Strategies: Mulling metrics

Oil and gas investors, public and private, corporate and personal, use a range of metrics to evaluate the projected performance of the investments they consider. These metrics include both intuitive and analytical methods.

Two easy-to-use and popular analytical financial evaluation methods are net present value (NPV) and internal rate of return (IRR).

The underlying basis for calculating NPV is that a dollar today is worth more than a dollar tomorrow. Present dollars in hand are worth more than future dollars that are both uncertain and yet-to-be-realized. The NPV calculation is easy and straightforward, whether done by hand or in a spreadsheet program such as Excel. The NPV equation is:

Once an investor has flow streams for both expenditures and revenues, it’s quick and easy to calculate net present value.

A metric that commonly accompanies NPV is the IRR calculation. The underlying basis for calculating IRR is to determine the equivalent interest rate, or return, the investor is getting on money invested. The IRR equation is:

Similarly to NPV, it’s quick and easy to calculate the IRR once the investor has the projected financial flow streams.

Although both NPV and IRR are easy to use and commonly accepted, looking “under the hood” illuminates serious flaws in each metric. The objective of this article isn’t to completely discredit NPV and IRR; however, by understanding the weaknesses as well as the strengths of these valuation metrics, oil and gas investors can be better positioned to make optimal investment choices. Don’t hang every decision solely on NPV and IRR.

The IRR equation can have multiple solutions, all equally “correct.”

IRR problems

Multiple rates of return. In considering IRR, one must first realize that it’s a mathematical equation being applied to an economic question. As such, the answer to the equation is the “solution.” This poses a problem, because the IRR equation can have multiple solutions, or answers, with all of them being “correct.”

How does this happen? It’s simple. Every time the cash flow changes from negative to positive or vice versa, the IRR equation has an additional answer. For example, if an oil and gas investment first has a negative cash flow (the money invested), then a series of positive cash flows (the income), and then a negative cash flow (the cost to plug and abandon), the project has two legitimate “rates of return,” both being mathematically correct. (See Table 1, “Discounted Cash Flow,” and Figure 1, “Sum Of Discounted Cash Flows vs. Discount Rate.”)

From the table and the graph it’s easy to see what’s happening mathematically. Which answer will a common spreadsheet return? When inserting the calculation, one has to make an initial “guess” at the answer, as the spreadsheet will then solve the equation with an iterative al- gorithm. The answer it returns depends on the initial guess.

More specifically, applying Excel to this example will result in the 3.50% IRR answer if the investor’s initial guess is 0.01, or 1%, and 19.54% if one’s initial guess is 15%. Hence, the answer can depend on the initial guess.

Does the investor want the “solution” to the investment question to depend on an initial guess of the “right” answer? Again, one must keep in mind that this process applies a mathematical solution to an economic question. The practitioner is transferring the answer from one discipline over to another and incurring a problem along the way, often without realizing the weakness of such a transfer.

Another problem with IRR is it doesn’t distinguish between lending and borrowing money. Both these examples involve 50% IRRs.

Lending or borrowing? Another problem with IRR is that it doesn’t distinguish between lending money and borrowing money. For example, imagine having to decide between the following projects:

Case 1: The investor invests $1,000 at time zero for a one-period investment that delivers $1,500 at the end of period 1 (see Table 2a). This yields an IRR of 50%.

Case 2: Due to the anticipated plugging liability, a producer gives the investor an asset that is expected to yield $1,000 at time zero and then cost $1,500 to plug and abandon at the end of period 1 (see Table 2b). Again, this yields an IRR of 50%.

If the period length is one year, is Case 2, which has an IRR of 50%, a good investment? Probably not. This may be an oversimplified example, but it clearly demonstrates the situation: i.e., one is using a mathematical equation to answer an economic question.

Interestingly, if one plugs Case 2 into a recent or semi-recent version of Excel, the answer is -33%. How does this happen? Evidently, Excel contains an internal check that changes equations, without warning the user, under certain conditions. Clearly, if one inserts -.33 into the true IRR equation, the sum of the discounted cash flows will not equal zero.

Additional problems. The IRR metric has a number of other problems, including the necessity of assuming an oil or gas price (unless one hedges), discounting potentially valuable out-year cash flows to the point they’re insignificant, or using the same discount rate for all years. Simple math calculations do fail to address strategic options, such as if one good well proves up several additional wells or drillsites, or holds a lease by production, or finds new pay intervals.

IRR summary. To be sure, an investment’s IRR is not a metric devoid of value. Its strengths include being easy to use, commonly known and offering a calculation of how fast one’s money is growing. However, in using it, the oil and gas investor may want to remember its flaws and realize it applies a mathematical solution to an economic question.

Analytical and intuitive information indicates risk and return are related.

Problems with NPV

Discount rate and risk. Central to calculating an investment’s NPV is deciding on a value for the discount rate. Surprisingly, most organizations use the same discount rate for all prospective investments. Using an equal discount rate for all investments implies that all of the projects have equal risk—but they don’t.

An overwhelming amount of information, both analytical and intuitive, indicates risk and return are related (see Table 3). To further clarify this point, consider the following:

Investments don’t have equal risk and so should be discounted differently; here, a stable well production history, and an erratic history.

Assume that the same engineer approaches his chief financial officer with two different projects, C and D, which are for remedial work on existing wells. For simplicity, assume each well has the same problem, the same remedial expense, the same resulting production, the same resulting decline curve and the same projected IRR. However, the two wells have significantly different production histories (see figures 2 and 3).

Based on the historical production, do the projects have equal risk or uncertainty? Would one expect the chief financial officer to “loan” each project corporate funds at the same discount rate?

If a company took each project to a bank for financing (neglecting the fact that banks don’t loan money for a single-well remedial project), should one expect the bank to loan each project money at the same interest rate? Clearly, forecasting resulting production from Well D has a higher risk/uncertainty than forecasting the resulting production from Well C. Because the projects carry different risks, shouldn’t they be evaluated with different discount rates?

One could argue that a discount rate is simply a corporation’s composite “cost of capital.” However, to assume that a corporation’s cost of capital, whether from equity or debt sources, is independent of corporate risk, is erroneous and naïve. Therefore, shouldn’t a corporation or private investor adjust the discount rate with risk?

Determining the appropriate discount rate is a subject that is beyond the scope of this article. The point here is that risk and return are related, and one needs to consider different risks when setting a discount rate for different projects.

Discounting future cash flows to oblivion. As with IRR, discounting can quickly render future cash flows to the point of being insignificant. For example, using a discount rate of 15% will discount year six cash flows by 57%.

It is difficult to forecast cash flows six years out, due to product-price uncertainty, production uncertainty, operational risk, the regulatory environment and other factors. Future cash flows need to be discounted.

However, how many of the world’s oil and gas assets are more than six years old? Similarly, how many oil and gas companies, and professional careers, are more than six years old? Moreover, it often takes a number of years to develop and exploit a strategic situation. One must be careful about discounting. Reducing a business decision to a simple mathematical calculation is a gross oversimplification that carries its own risks.

NPV summary. Regardless of these considerations, the NPV metric does have strengths. These include its ease of calculation, widespread use and the fact that its calculated result is in currency, as opposed to being a dimensionless number. Nevertheless, the metric has significant shortcomings, especially if one applies the same discount rate to all projects.

A significant downfall of both NPV and IRR metrics is that each requires a product-price forecast. This poses a problem, because oil and gas prices are volatile (the monthly standard deviation of the oil price is 9%) and tend to follow a random walk.

Alternative metrics. It would be disingenuous to critique NPV and IRR without offering suggestions. As mentioned, the metrics do have value. However, when considering an oil and gas investment, one may want to consider additional metrics, including:

• cost per barrel or Mcf (thousand cubic feet) to acquire or develop;

• post-five-year reserves (estimated decline curve);

• immediate/year-one cash flow;

• operating margin and how low one can take operating costs;

• administrative and technical overhead required;

• point at which the project self-finances additional development through cash flow;

• options created (such as establishing a beachhead);

• other metrics.

In summary, evaluating oil and gas investments is an inexact science in a technically and financially dominated industry. This makes the process prone to overweighting of NPV and IRR calculations in investment decisions. Knowing the shortcomings of these simple mathematical calculations and considering other factors can improve investment decisions and business performance.

Rodney Schulz teaches “Oil & Gas Economics & Uncertainty,” a two-day seminar, for the Society of Petroleum Engineers (SPE). He is the principal and founder of Schulz Financial, a retail financial advisory firm based in Houston, as well as Schulz Oil & Gas, an independent with interests in South Texas.