The dawn of unconventional shale plays in the U.S. over the past decade has had a significant impact on the business valuations of onshore North American exploration and production companies. The rise in commodity prices during those years and the advancement of horizontal drilling and hydraulic fracturing, among other factors, enabled E&P companies to develop assets that were previously uneconomic and thus create substantial value.

It’s a different story today. The collapse in commodity prices has depressed the industry and the valuations of its market participants.

Appraisers have historically measured E&P valuations using two approaches: market and asset. Because the energy industry is capital intensive, and very active with transactions in both the public and private markets, these approaches have traditionally provided supportable measurements.

The market approach involves identifying recent transactional data from the sale of E&Ps and/or their acreage holdings, and benchmarking E&Ps against publicly traded peer groups. The asset approach takes into account the net present value of future cash flows derived from production to measure the worth of assets. These appraisal methods continue to be appropriate valuation techniques for measuring net assets, even in today’s climate.

Although the evaluation process has not changed, the situational analysis involved in ascertaining circumstances unique to a subject company has been accentuated by pressures firms are facing from the contemporary pricing applicable for current production. The characteristics integral to an E&P’s success have been magnified. These characteristics signal an E&P company’s ability to withstand the current downcycle without being forced into decisions that curtail or eliminate its opportunities when oil and gas prices improve.

This article highlights company-specific elements that are critical factors to consider in evaluating E&Ps in the current commodity price environment, and how these elements should be factored into the valuation analysis.

Reserve valuations

One of the most significant valuation elements to emerge in recent years is the value weighting assigned to probable and possible reserves. The process an E&P undertakes to enhance ultimate recovery from probable and possible reserves is referred to as de-risking.

During the past decade market forces, including high oil and gas prices, advanced horizontal drilling and completion techniques and downspacing of the number of acres between wells, have enabled companies to de-risk their acreage, converting possible reserves into probable reserves and probables into proved reserves. Both the public and private markets have given significant credit to E&P companies for these enhancements, which have been value drivers for the entire industry.

The stalwart factor in realizing value from probable and possible reserves, however, is the economic viability underlying their prove-up. Oil prices higher than $80 per barrel over recent years enabled the exploration necessary to prove up acreage, because drilling could be strategically and economically executed. Under current commodity pricing, it is no longer economic to develop these reserves unless their de-risking can be accomplished at market prices. This has resulted in a significant shift in the overall value of an E&P.

Another extenuating circumstance in valuations today is the significant decline in well profitability and the potential economic impairment to proved developed and proved undeveloped reserves. The erosion of value from proved reserves often puts operators and leaseholders at odds based on the factors motivating each: the need for cash flow versus maintaining high internal rate of return (IRR) hurdles.

Before the recent collapse in oil prices, the potential from probable and possible reserves accounted for a significant portion of an E&P company’s total value. In the current state of the industry, the value of probable and possible reserves has significantly diminished. Valuations today stem from proved developed producing reserves and undeveloped reserves that remain economically feasible to produce. Some value for probable and possible reserves may still be given for certain factors (see “Probables And Possibles.”)

The considerable decline in the valuation credit given for probable and possible reserves can be illustrated by analyzing publicly traded companies under a “then versus now” pricing perspective from 2014 to 2015. The graphic compares the gross property plant and equipment (PP&E) carrying values (including proved developed producing and proved undeveloped reserves) reported on the balance sheets of 10 publicly traded E&Ps to the market value of invested capital (MVIC) for each company as of June 30, 2014, and June 30, 2015.

In mid-2014, when the de-risking of probable and possible reserves was not limited by commodity prices, the public market widely recognized the upside in value to be realized from unbooked reserves. But as commodity prices have fallen, the carrying values of booked properties are now a much greater percentage of MVIC, often exceeding 100%.

Valuations have shifted away from pricing significant credit to probable and possible reserves in 2015 because of current pricing levels. As a result, the value of proved reserves and a firm’s specific attributes are increasingly important.

Outlined below are a few of the more significant company-specific characteristics to assess in resolving a contemporary E&P appraisal.

Quality of proved reserves. The location of proved reserves is significant. Not all crude oil is created equal; analysis of breakeven pricing by play and sub-play is critical to understanding an individual company’s economics. Certain areas may not be economic at $50 oil, while others may generate a healthy rate of return. Appraisers must request and analyze a company’s most recent authority for expenditures (AFEs) related to drilling programs and review internal management reports comparing budgets to actuals in order to assess a firm’s ability to bring its wells on line within its own cost constraints.

Current reserve reports for proved reserves prepared by petroleum engineers should be adjusted to reflect the contemporary market perspective with regard to forward commodity pricing, as well as realistic authorized funding expenditures and updated operating costs that reflect drilling and completion pricing in the recovery period. In addition, companies having proved producing reserves with a relatively low decline base will be better-positioned in the near term.

Potency of probable and possible reserves. The past successes revealed by a company’s drilling record in the years leading up to 2014 are important to an understanding of the likelihood of its retaining and proving up acreage positions during the recovery period. Identifying improvements achieved in a specific area with respect to de-risking, downspacing, EURs, pad drilling and other factors that impact the IRR on well economics is critical when measuring the economic potential associated with a company’s geologic potential. A company’s ability to maintain momentum within its particular play will influence the buoyancy of its probable and possible acreage.

Assessing the likelihood of an E&P retaining and proving up its acreage requires an overall synopsis of company-specific risk. Some of the more significant factors include, but are not limited to, the management team’s tenure and experience, relationships with operators and other working interest owners, ownership of drilling and completion equipment and pipelines, price sensitivity for AFEs, size of the net revenue interests held, and retention of engineering and production talent. To a large degree this is a judgment call that correlates to the specific purpose of the appraisal and the standard of value used for the evaluation, such as fair market value, intrinsic value or liquidation value. However, the ultimate conclusion of value must be reconciled with the realities of the circumstances.

Operational capabilities and flexibility. Understanding the nature and extent of an E&P company’s infrastructure and in-house capabilities can assist in gauging whether drilling programs downsized during the recovery period will continue. Operating provides a level of control, discretion and predictable performance that companies relying on outside operators lack. E&Ps having internal drilling and completion operations are tasked with preserving workforce and equipment as cash flows permit.

Access to drilling rigs and service personnel is likewise important to the junior weights and other nonoperators relying on contract drillers. E&Ps must be flexible and, when necessary, defer well completions until commodity pricing improves. Currrently, they are reallocating capex to development drilling instead of exploratory drilling and to resource plays with the highest returns.

Cost structure. Financial prudence has quickly become the new normal for E&Ps. Companies must continue to find ways to cut costs across the board, from lease operating costs to G&A expenses. Further decreases in costs per barrel will be critical to maintaining cash flows and funding reduced capex budgets.

The relationships E&Ps have with oilfield service companies may be strained as oversupply continues to drive costs down. Closer collaboration with service providers is required to reduce costs and raise value. However, cheaper is not always better, and operational inefficiencies and safety concerns must be considered. Furthermore, companies—especially medium-sized and large E&Ps—need to retain critical infrastructure and workforce so as to quickly take advantage of opportunities when commodity prices improve.

A significant aspect of managing cost structure in lean times is to keep ahead of breakeven points. Because oil and gas properties are, by their nature, wasting assets, companies must operate above a breakeven basis to avoid subsidizing operating losses in downturns from existing cash flow and impairing their ability to replace acreage inventory. Successful companies typically do a good job estimating well costs and managing marketing and takeaway expenses. Overall budgeting for acquisitions, G&A costs, repairs and maintenance and capex is equally important, however, to ensure the ability to survive from existing revenue generated from producing assets.

When valuing an E&P, appraisers should include inquiries that enable a clear identification of the total cost structure of the business. This may mean the valuator prepares a revised and/or updated operating budget with financial cost and expense data provided by the subject company. The process also entails identifying viable options and alternatives that are realistically available for an E&P should near-term budget constraints jeopardize its ability to remain a going concern.

Balance sheet strength and financial flexibility. The elephant in the room in analyzing a company’s ability to survive an industry downturn is its capital structure and amount of leverage. Obviously, companies with strong balance sheets and ample liquidity to cover near-term obligations as they come due are better positioned. Having the flexibility to draw down additional capital and restructure debt is another distinguishing factor in the valuation process.

A company’s hedging position is a vital related consideration. The degree to which 2015 production and beyond is hedged and at what price is a major influence on near-term liquidity. The strength of a company’s hedging position will be reflected on its balance sheet in the fair market value of hedges.

IRR. E&P companies have enjoyed robust rates of return for individual wells in recent years, ranging from 20% to more than 50% depending on single well economics. In the aggregate, these returns have enabled companies to far exceed their cost of capital, allowing them to self-fund drilling programs and acquisitions. Valuation analysts should peel back the layers of current drilling programs to understand company-specific influences on well economics and how the company views its IRR in the current environment (see “Economics And IRRs”.)

In summary, there are many common threads among market participants in the upstream segment. Yet each is driven by its own, unique brand of success stemming from what it is able to accomplish with its assets. Valuations of E&P companies must continue to factor in circumstances that influence all market participants, but company-specific risk factors have a heightened importance in the current pricing environment. Appraisers tasked with valuing a closely held E&P company must scrutinize these factors now more than ever.

Thomas J. Stewart is a partner and Aaron Ballard is a manager in Whitley Penn’s Forensic, Valuation and Litigation Support department.