Kistos Investment Case Updates

Is Oil & Gas Investable?

Oil rig in the field
18 June 2023

I. Who am I to talk about Oil

Before I proceed, let me address one obvious question. Who on earth am I, and am I qualified to talk about such a complex sector?

Let me tell you that I have been dealing with oil since 2003. That year, as a fresh member of the Ernst & Young Valuation team, I was sent to Siberia to evaluate the gasoline stations of Russia’s second-largest oil producer, Yukos. The following year I was building my first DCF model of an independent oil company and discussed with engineers their assumptions for the hydrodynamic models of the field development.

Later, as a buy-side analyst in a London-based hedge fund, I was responsible for a position in Imperial Energy, acquired by ONGC in late 2008.

The following year, I took my oil & gas experience to the next level, joining one of the leading oil & gas research teams on the sell side. The opportunity gave me a chance to make about 30 site visits to places like North Caspian, Niger Delta, Yamal, West Siberia, Texas, Turkey, Serbia and Germany (I was part of a small group of analysts who visited Nord Stream facilities in 2018).

I have a lot of stories to tell.

II. Oil & gas is not a great business

If you are familiar with Buffett’s definition of a great business, then oil & gas, or commodities in general, would be the last place to look for potential opportunities.

Indeed, Buffett prefers companies with the following characteristics:

  1. Durable competitive advantages (‘moat’) in the form of a strong brand or unique market position.
  2. High returns on capital and low reinvestment needs.
  3. Strong management with integrity and a proven track record.

In fact, he never stops praising his long-term partner, Charlie Munger, for the influence he had on his investment style.
“From my perspective … Charlie’s most important architectural feat was the design of today’s Berkshire. The blueprint he gave me was simple: Forget what you know about buying fair businesses at wonderful prices; instead, buy wonderful businesses at fair prices.”

- Warren Buffett, 2014 Letter to Berkshire Shareholders
The oil & gas business is a complete opposite of a “great business”. It requires substantial upfront investments to produce stuff that is not differentiated in any way. The price of this product is highly volatile and driven by factors beyond management’s control. The sector is heavily taxed and has historically generated low-to-moderate returns on invested capital because of its high capital intensity. And I haven’t even mentioned the ESG aspect yet.
To give you an idea of how “unattractive” the oil business is, imagine two bottles of liquids. One bottle has some premium mineral water (e.g. Perrier or Evian), and another has crude oil. Guess which of the bottles will have more expensive content. Yes, you are right - premium mineral water. Amazon sells a pack of Perrier for £3.97 per litre, which comes at about $5/litre ($23/gallon). Maybe Perrier is “too premium”, but even more affordable brands would cost more than a bottle with crude oil.

With Brent oil price at $76 this Friday (16 June), a bottle of crude oil should cost less than 50 US cents ($0.46/litre).

Now imagine all the efforts to extract that oil and bring it to a consumer. It starts with high-risk exploration and computer programmes, includes high-cost drilling rigs, qualified engineers, and vast transportation infrastructure, including giant tankers and thousands of kilometres of pipelines. There is a fair doze of political risks as well. And I have not even discussed the refining side.

III. But investing is also about prices and odds

However, if successful investing could be boiled down into a single formula, the markets would not exist. Firstly, we do not have all the information in advance. Secondly, businesses and sectors change. And most importantly, other participants are trying to figure out which company is the best and that gets reflected in the price you pay for it.

It is not hard to figure out a strong business by looking at its historical sales growth rate, margins, returns on capital and other key ratios. But if everyone agrees with you, then the price you have to pay will be quite high.

The same Charlie Munger likes to compare a stock market to a horse racing competition. Here is a good quote from his lecture at USC in 1994.
To be clear, I would prefer to own a great business at a reasonable price, not least because it is more tax-efficient. The profits from this business are re-invested back into the operations. This increases the intrinsic value without any personal income taxes. If you buy a company with limited reinvestment opportunities and its share price appreciates, you have to sell it and pay capital gains tax.

However, with many great companies trading at high multiples, I am ready to look for opportunities elsewhere.

In fact, Warren Buffett has been doing somewhat similar recently. One stock he has been consistently buying for the past six quarters is Occidental Petroleum. It is now his third largest position in Berkshire’s stock portfolio.

I quite liked the slide from the presentation of David Iben, the founder of Kopernik Global Investors. He spoke at last year’s London Value Investor Conference, which I also attended.

IV. When odds are high

Munger is not the only one to refer to the odds rather than simply the fundamentals of the business that you are buying.

Seth Klarman, a co-founder of Baupost fund, has written one of the most expensive books on investing, The Margin of Safety. One of the ideas of the book was that you could find really attractive investment opportunities in situations when there is a forced seller who is not sensitive to the price at which he liquidates his position.

Howard Marks, a co-founder of Oaktree Capital Management, talked about a similar idea in both of his books, including the latest one, Mastering the Market Cycle. He contrasts two market conditions: the one with lots of excitement and high expectations and the other one when sentiment is low. One of the main conclusions is that potential returns are higher if you invest in the second situation. Low valuation also reduces potential risks. What the real economy does is often less critical for your investment success than in what type of conditions you make an investment.

The oil & gas sector appears to be in a state which many legendary investors considered attractive for making long-term investments.

1. “Sentiment is low”

Except for a brief period in 2022 when some market pundits called for a $200 oil price, the sentiment towards the sector has been quite low. Many investors have started calling the oil industry uninvestable after years of disappointing shareholder returns and poor capital allocation.

The sector lags behind more glamorous parts of the economy in terms of IPO activity.
Its weight in the S&P 500 index is still only about 5% compared to 16% at the peak in 2008 and a 8% average weight since 1996.
Source: Reuters

2. Access to capital is limited

Companies find it harder to raise capital to start a new oil & gas project. Following the growing pressure from shareholders, executives commit to higher dividends rather than new investments. Below is a chart showing how oil companies have allocated cash flows from operations between capital expenditure and dividends.
Source: IEA

3. Industry behaviour has become more rational

Importantly, many industry players are committed to a strong spending discipline rather than market share gains. This applies not just to US shale producers but also to OPEC nations (e.g. Saudi Arabia). Such behaviour is an important change from the previous market cycles.
Source: Statista

4. ESG creates forced sellers and stops others from investing

ESG adds further pressure on the sector. Oil & gas companies are more concerned about reducing their carbon intensity than finding new reserves. Exxon is a good example. Following the pressure from shareholders, the company has decided to reduce its planned spending on the upstream segment and prioritise climate change projects.

5. While the sector is cyclical, it is producing real products that meet the essential demand of society

Finally, as a cyclical sector, oil & gas is prone to Boom & Bust cycles. From “Peak Oil” to “Peak Demand” - sentiment can change fast. But unlike many of the recent hypes, this industry has a real product that is critical to the functioning of the modern economy. This limits some downside risk while still providing some additional speculative upside if sentiment becomes too optimistic.

V. Be careful with valuation

While the energy sector has favourable conditions to search for attractive opportunities, you have to be careful with valuation. Quite often, investors get seduced by the low valuation multiples or high growth potential of a junior oil explorer and then get disappointed by poor investment results.

There is a fundamental difference between a traditional business and an oil company. The latter operate with a finite amount of reserves. To carry on producing oil over the long term, companies have to keep making new discoveries, improve recovery rates at existing fields or just buy competitors. But this act is often omitted from valuation analysis.

From my experience, high growth could actually be bad for an oil company, while old age can be very attractive.

Let me explain this with a specific example.

If you open any book on oil field development, one of the first charts you will see will be this chart below.
Every field has four stages: growth, plateau, decline and tail. Their duration and change in production (growth or decline rates) can vary, but broadly it takes about 3-5 years for the field to reach its peak output which can last 3-5 years, followed by 5-10 years of a decline phase. Finally, the field enters the “Tail” phase when production stabilises.

What is the most attractive phase, in your view? The answer, of course, depends on who you are. An engineer or contractor is most excited about the “Growth” phase. Societies until recently were also excited about it. But if you are an owner of this field, you will be much happier after the “Plateau” phase is over.

The focus of Stage I is all about not blowing up the budget and delaying the launch by too much. Both issues happen more often than not. This is normally a heavy-capex phase. During the “Growth” phase, a company spends about 50-70% of total capex, while it is able to produce just about 20% of the total reserves of the field.

Stage II is all about maximising the peak output and delaying the decline phase. Usually, you can only achieve one goal - the higher the peak output, the faster the decline. The risk is that peak production comes at a lower rate and/or decline starts earlier.

Management shifts its focus to efficiency and cost optimisation during Stage III. It is often the time when companies start looking for new opportunities to replace falling production.

Stage IV, on the other hand, can be very exciting. Heavy capex is behind; sharp production declines have passed. You operate with extensive infrastructure. By this time, you are quite familiar with the field’s geology, so various operational risks are pretty low. Time to enjoy the flow of dividends!

I have also prepared charts showing a typical cash flow profile for an oil field. Total FCF follows the production profile and peaks around the growth phase, often 1-3 years later. However, what is more interesting is that cumulative FCF during Phase I accounts for just about 10-15% of total FCF. During Phase IV, companies can collect about 30-40% of all FCF generated by the field over its lifetime. This also assumes constant prices. The contribution of Phase IV to the total FCF could be higher if oil prices rise over time.
Even more exciting is the change in the field’s NPV and implied valuation metrics. I have plotted NPV assuming you own 100% of the field from each year onwards. In other words, you are entitled to receive 100% of FCF from Year 1. If you own the field from Year 2, you receive FCF for a 19-year period (from Year 2 until Year 20) and so on.
The main conclusion is that the value of the field in Year 12 (c. $1bn, in my example) is twice as high as in the first year ($500mn). In other words, when you inherit a brand new oil field with untouched discovered reserves, the value of that field is only half compared to Year 12 after about 60% of reserves have been produced.

But imagine we looked at a traditional company instead. When would its fair value be higher: just when it is about to embark on a high-growth trajectory or past that phase? In most cases, faster growth would lead to a higher valuation. (Technically speaking, this is true as long as incremental returns on new projects are above the company’s cost of capital).

In Year 12, our hypothetical oil company is facing a steep decline in production (20% per year), yet it is worth more than at the beginning (Year 1, when all the growth is ahead of it).

If you estimate the value of barrels that remain underground for each year, you will be amazed to discover that by Year 20, when the field has produced 90% of its original reserves, it is still more valuable on a per-barrel basis than at the beginning.
The reason for this is, of course, capex and the time factor (the same amount of money today is worth more than in the future). Phase I is about drilling enough wells to reach peak output and having sufficient transportation infrastructure to sell the crude to the market. Phase II is about cash flows.

Different stages of field development also lead to stark changes in traditional valuation metrics such as EV/EBITDA and FCF yield.

The point I want to make is that in a later phase, oil companies can look very cheap, and that is fine if they have no new reserves to bring into production. However, do not be seduced by the cheap valuation multiples of a mature oil company unless you are willing to bet on its exploration potential.

If you think about what it takes to ramp up production at the beginning (huge upfront capex, uncertain geology, risks of delays and cost overruns) and compare it to valuation multiples, then investing in oil companies at later stages may be a better alternative. At a late stage, geological risks are low, and funding needs do not exist.

In general, however, financial multiples like EV/EBITDA or FCF yield are much less relevant for a single project oil business.

A better valuation metric is the value of barrels that remain underground relative to market price. So if NPV/boe is $6 and the company is valued at $3/boe - it is probably a good bet.

Lastly, before I move to the final part of my post, I would like to point your attention to the change in NPV from its peak ($1.7bn) to a more moderate level in Year 13 ($0.8bn). Why did the NPV drop more than 50% in just four years? The simple and correct answer is that the field has produced about 22mn boe of oil, and the remaining reserves are lower.

But have you considered what happened to the profits? This is the crux of the matter, based on my experience.

What oil companies do once their projects enter the “Cash Cow” phase differentiates the winners from everyone else. Most companies are actively looking to replace reserves. They plough money into new capex. The new capex often generates lower returns and eventually destroys shareholder value.

The full value of a particular field is realised only if the net proceeds are distributed to the shareholders.

VI. So what matters?

Management track record. Perhaps surprisingly, but I prefer to start looking at the management running an oil company rather than a company’s assets. In particular, I pay attention to what management has said and delivered operationally and in allocating capital. How is management incentivised? What are the ultimate goal and the KPIs for management?

Strong balance sheet. Since oil & gas operations are capital-intensive and the end price of oil is highly cyclical, only well-capitalised companies with low financial leverage can succeed in the long run.

Low costs (no need for oil prices to rise to make money). For the same reason, the company’s assets should be low-cost (under $30/boe all-in costs, including lifting, transportation and other opex and admin costs). Too many companies look attractive in a high oil price environment, but with high fixed costs (e.g. running a large offshore platform and having long-term fixed transportation tariffs), they are incredibly vulnerable. The moment the oil price drops, they turn from high dividend payers into capital seekers.

Stage of development. The earlier the stage, the more uncertainty. This uncertainty includes not just funding needs and the macro environment but also geology. The less the oil field has produced, the more uncertain its total reserves and peak output are. As the field produces more oil, the performance of its wells over time provides valuable information about the geological characteristics of the field. Accumulated knowledge allows the application of better technologies which can increase recovery rates. At a later stage of development, the overall costs to run a field are often lower. Lifting costs will likely be higher, but with much less need to drill wells and build-out infrastructure, the FCF per barrel of production usually is higher.

Exploration is worth little. Historically, only about one out of six exploration wells has been successful. Others were dry. The chances that an oil company finds oil are about 16%, based on historical results. A lot depends on the area and previous work that has been done. Still, I would not pay much (if anything) for the exploration potential of a company. Apart from a low base rate, it is making a potential discovery commercial success that is often problematic. If the discovery is small, building the necessary infrastructure may not be profitable. Many other factors prevent a discovered field from becoming commercially viable. (e.g. high gas content, low permeability, local regulation, limited funding).

Existing infrastructure. If a company operates in an area with developed transportation infrastructure, including available pipelines or terminals to ship the oil, then its total costs would be manageable.

Low geological risks. This is the most complex issue since no region is particularly good at keeping its fiscal regime stable over many years, but the overall level of legal rights protection, judicial and even political system matter for creating shareholder value of an oil company.


Traditional metrics to evaluate business (e.g. growth rates, ROIC) are not helpful in the oil industry. To evaluate an oil company, you should look at its assets and understand the stage of its development. The earlier, the riskier. Management’s integrity, communication and track record in allocating capital plays a disproportionately high role in the overall success. Be aware of high dividend payers who have a bloated cost base and short reserves life.

Next week, I will publish a detailed case of a small oil producer I recently invested in. It has many characteristics of a good oil business at an attractive price. But, of course, I could be wrong and would appreciate your feedback and suggestions.

Thank you for reading this post.

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