RockRose bought the reserves for about $5.3/boe, well below historical finding & development (F&D) costs in the industry of $10-15/boe. So you may wonder, "How did they acquire assets so cheaply?". I think there were at least four reasons for that:
- There were many forced sellers in 2016-2020. The deals were counter-cyclical.
- The focus was on small assets, which are not strategic for large players who often lack management resources to focus on marginal fields.
- Dedicated teams at small companies like RockRose can extract much more value from those assets.
- Value arbitrage. Mature assets dilute the value of large integrated oil & gas companies, and this is why they assign lower prices to them. Investors value integrateds at traditional metrics like price-to-earnings and dividend yields. If earnings are on a downward trajectory due to falling production (short reserves life), investors assign a low P/E multiple. To improve their valuation, companies seek "growth" assets and try to get rid of declining ones.
With the increased pressure from the ESG, the availability of small assets generating cash should still be high today.
I want to spend a moment explaining how significant the uplift in asset valuation could be.
Every operator of an oil field faces abandonment costs at the end of operations. The oil wells have to be plugged in and certain parts of infrastructure removed to minimise environmental impact. Four key drivers of such costs determine the reported value on the balance sheet: engineering solutions, inflation, discount rate and the date when the field ceases to operate.
If the initial assumption was for the field to operate for five more years, but its actual life was extended to ten years, then at a 10% discount rate, the initial provision should have been 40% lower. The life of the field can be extended not just due to a higher recovery factor (increased reserves) but also due to discoveries in the region, which would extend the operations of critical infrastructure (e.g. gas processing plant or Floating Production Storage and Offloading vessel (FPSO)). Besides, over time a more efficient solution can be found to abandon the wells, resulting in additional cost savings.
Let's look at a theoretical example. Suppose an oil company found a field that it wants to purchase. It estimates 10mn boe of remaining reserves with an NPV of $10/boe ($100mn fair value of remaining reserves). Additional $50mn abandonment costs reduce the purchase price to $50mn. Both parties agree on the price and set the effective economic date on 1 January.
However, the actual deal closes once the regulatory approvals are received, which may be about six months. The actual purchase price is then reduced by the value of oil extracted from the effective date until completion. Let us assume the field produced 1mn boe and generated $25/boe after-tax profit. So the actual purchase price is reduced by $25mn.
Now, as the new team steps over, they focus on improving field operations and extending its life by five more years. They also choose a better abandonment option that saves 20% of the original cost budget. Ultimately, the abandonment provision drops from $50mn to just $25mn. The NAV of the field (value of oil reserves less abandonment costs) is boosted from $50mn to $75mn. The actual purchase price, in the meantime, was reduced from $50mn to $25mn.
The net effect on the IRR could be enormous. At a $50mn purchase price and with only five years of operations, the field should have generated a 10% internal rate of return. In a scenario of a $25mn purchase price and abandonment costs delayed until Year 10, the IRR exceeds 100%.
This calculation does not consider the potential uplift in reserves quantities as the field operates longer.