If there’s one coverage group that’s even more desirable than metals and mining, it just might be oil & gas investment banking.
Not only do you see some of the biggest deals with the world’s largest companies, but you also learn new accounting techniques, valuation methodologies, and maybe even something about petroleum engineering.
Everything within the natural resources group – metals/mining, oil & gas, and power and utilities – is like a cross between industrials and commodities, and you see that most of all with oil & gas – where some sectors (upstream) are commodity plays and others (oilfield services) are much closer to “normal” companies.
We have a sector specialist onboard today who’s going to break it down and explain everything to you.
Here’s a quick geological survey of the land ahead, before we dig in and start drilling wells:
- Who gets into oil & gas investment banking and how to maximize your chances of breaking in
- Sector drivers and what to look for when analyzing an oil & gas company
- Valuation, from NAV to EBITDAX and everything in between
- The top boutiques and other banks in oil and gas coverage
- Where you go after the sun sets and you decide to look for “more lucrative oil fields”
From Petroleum Engineering to Financial Engineering
Q: A lot of analysts and associates get placed into their respective groups by happenstance, luck, or just good ol’ networking. How is your story different?
A: I actually studied petroleum engineering in college, which focuses on calculating the availability of resources.
Nowadays, students tackle broader “energy allocation studies,” including utilities / power generation and alternative energy. A lot of people here in New York work in finance, but as you’ve said before, if we were all in Texas, we would all talk about how we’re in oil and gas. :-)
[N.B.: A friend of mine did time in consumer investment banking, worked at a retail company, and then moved into oil and gas.]
I started off wanting to be a petroleum engineer, and had a couple of internships working in laboratories and then in offices.
Working at a “normal” company in this industry is very different from working at a bank – for instance, if you were doing finance at a place such as ChevronTexaco, your work would be more focused on a narrow line of activity at that firm, though you’d still need solid attention to detail.
Q: And so you wanted to move into banking to get a broader view of the sector?
A: Exactly. At an investment bank, your work is much broader, macro-oriented, and you might even say you have a bird’s eye view of things.
This is one reason why you see [petroleum] engineers trying to get into investment banking following their internships in industry. Another reason (drum roll) is the gold-plated exit opportunity.
Even with only a 3-month internship, people look at you differently and expect a little more from you.
When it came time to apply for investment banks, I contacted alumni, cold emailed boutiques, and reached out via LinkedIn to anyone I had something in common with. The bankers saw I already had an energy background, so the conversation was pretty easy from there.
Unlike other sectors, where you can get in without much industry knowledge, sector expertise is highly valued in oil & gas. There’s so much jargon and so much to know that you really need some type of exposure beforehand.
If you didn’t study natural resources in your major, at least take a class. I know some people get placed randomly, but you definitely want to do the “pre-season training” ahead of time if you can.
Back in 2003, there was a booklet called “Economics of the Natural World,” by the US Academic Decathlon. Reading something like this would be a quick starting point – here’s a chapter on natural resources microeconomics.
Surveying the Landscape: Successful Exploration Expenses & Intangible Drilling Costs
Q: So how is your group divided? What are the different segments?
A: Much like other groups, the oil and gas sector can be viewed in different ways.
The two most common methods are by stage and company size. The latter is easier to explain, so we’ll start there:
Super Majors: These are the largest oil firms in the world. At the time of this article, the list includes BP, Chevron, ExxonMobil, Royal Dutch Shell, and Total SA (and sometimes ConocoPhillips). These companies do everything, from finding oil and gas to transporting it to refining it.
Before you get really impressed, keep in mind this list excludes state owned companies.
If you were to include those players as well, the number one contender would be Saudi Aramco, with over $1 billion per day in revenue and sometimes estimated as being worth $10 trillion USD (not a typo). Several other state-owned Russian / Chinese / Middle Eastern companies are on that list as well.
Master Limited Partnerships (MLP): These companies are similar to Real Estate Investment Trusts (REITs), in that they are tax-efficient entities that derive their income from one source: in the case of an MLP, that source is pipeline revenue earned by transporting oil and gas rather than exploring or refining it.
Companies include: Magellan Midstream Partners LP, Energy Transfer Equity LP, and Plains All American Pipeline LP.
For more information on MLPs, please see this primer by Wachovia.
Companies smaller than super majors and companies which are not MLPs tend to fall into one or more of the categories below:
Integrated Companies: Not quite the largest, but still sizable firms. These companies operate across multiple stages, which is a little more complicated than dividing the world by company size (Companies include: Petrobras, China Petroleum & Chemical, and Statoil).
Upstream (Exploration & Production, or E&P): These companies explore sites to find oil and gas, and then develop and produce what they find (Companies include: Chesapeake Energy, EOG Resources, and Occidental Petroleum – some operate across multiple segments).
Midstream: Storage and transportation – these companies often do take the form of the MLPs discussed above, but tend to be smaller and more focused on only these activities.
Downstream: Refining, logistics, and marketing. By “marketing,” I mean the retail operation (at the gas station) or even in the store (other petroleum products) (Companies include: Phillips 66, Marathon Oil, and Hess Corp.).
Other: Outside of these categories, there are companies in sectors such as oilfield services (think: Halliburton) that fall under the “oil & gas” classification but which really provide infrastructure or services to energy companies.
If you want to know more about how the sector works, please see this primer by Investopedia.
Q: Great, so what moves the market for oil and gas?
A: On a macro level, economic conditions, and in particular, geopolitical events (national, regional, and local) make an impact on the market.
These (broad) factors influence both demand and supply.
On the demand side, you see economic growth, debt grade improvements or declines, population growth, civil unrest, and political instability as factors.
Suppose you observe massive growth in emerging markets such as China and India; this economic growth would be the biggest demand driver – when your GDP increases almost 20x in real terms, inevitably you will use more energy.
You can add seasonality as a driver as well: when things get cold, you tend to use more energy…
Supply side, you have OPEC (Organization of Petroleum Exporting Countries) decisions, access to financing, and discoveries of new deposits or even updated findings.
From a government standpoint, the factors include access limitations (where can we go dig?), the type of drilling a company can undertake, and government sponsorship of alternative energy.
You can add wars, sanctions (Iran), production/refining capacity, natural disasters, and technological advancements (fracking and horizontal drilling) to this list as well.
Upstream: On a micro level, the factors include the outcome of individual drilling projects (how lucrative they are), operational outages, strikes, asset sales, regulatory changes (tax breaks anyone?), and prices under sharing agreements.
Sometimes you’ll see an oil company split the costs of a dig with another firm or do a joint venture. You frequently see this with government-owned companies – a private firm will be brought in to share its expertise (think: Russia and Exxon Mobil with their arctic shelf drilling plan).
Downstream: Margins are determined by what the company pays for in terms of raw materials and the price of the output (set by the market).
This latter point is established by a number of factors. According to ExxonMobil, these factors include: “global and regional supply/demand balances, inventory levels, refinery operations, import/export balances, currency fluctuations, seasonal demand, weather and political climate.”
Q: And what are some of the indicators that oil & gas professionals look at?
A: For starters, you’ve got the OPEC basket price that is looked at globally.
Finding and Discovering the Technical Depths
Q: Since oil & gas is such a specialized sector, would you mind sharing a few pitch books before we move into the technical details?
I think it’s easier to understand if you can see some of these metrics and methodologies.
A: Not at all, please take a look at these:
- Pinnacle Gas Resources by FBR Capital Markets [fka: Friedman, Billings, Ramsey & Co.]
- Hiland Holdings by Barclays Capital
- Exxon Mobil / XTO Energy by Barclays Capital
- Chevron / Texaco by Credit Suisse (search for the text “conducted three valuation analyses”)
Q: Great. So with those examples in mind, what are the more common valuation methodologies and multiples?
A: This gets complicated because it depends on the specific area that you are working in (ex: integrated, upstream, midstream, and downstream), but let me summarize it:
You tend to use Production and Reserves-based multiples here, such as Enterprise Value / Proved Reserves and Enterprise Value / Daily Production, because when analyzing energy companies you’re always asking, “How much am I paying for each unit of energy in the ground and/or production capacity?”
EBITDAX is a variation on the traditional EBITDA metric, and it exists because some oil & gas companies expense unsuccessful exploration and others capitalize it – so it normalizes and makes it possible to compare companies that follow different standards, similar to what EBITDAR does for companies that own vs. rent buildings (or airplanes).
You’ll see lots of Reserve and Production-related metrics such as the Reserve Life Ratio (Reserves / Production), % Oil vs. % Gas, and even Key Geographies shown along with these multiples.
The Net Asset Value (NAV) methodology is also very important and is a twist on the traditional DCF; unlike a DCF, where you assume infinite growth into the future, with a NAV model you assume that a company’s reserves get depleted far into the future and that revenue and profit go to $0, perhaps after a few years of growth initially.
So you project cash flows (production * commodity prices – expenses) until the reserves run out, discount and add them up, and then factor in the value of other business segments, undeveloped acreage, and so on.
This can get infinitely complicated – you can separate a company’s reserves by geography and by Proven vs. Probable vs. Possible (which refer to the probability of finding and producing energy), and assign different risk-weightings to each of them so that you discount cash flows by different percentages in each segment.
I’ve even seen models where people analyze each individual well separately, but that is so time-consuming that it’s not too common.
For a simple example of the output from a NAV analysis, see this page.
Also check out this excellent interview with a reader who moved from oil & gas investment banking to an energy hedge fund to see how he set up his NAV models in case studies.
You can also use a DCF analysis even for upstream companies, but the NAV tends to be prevalent; public comps and precedent transactions are still used, but with the different multiples I mentioned.
One difference in the DCF here is that you may separate CapEx into Drilling & Completion (D&C) CapEx vs. Leasehold and Infrastructure CapEx, with the former being sort of like “growth CapEx” (the cost of drilling new wells) and the latter more like “maintenance CapEx” for normal companies.
And then you have actual spending in categories like acquisitions, exploration, and development, which can be considered another form of CapEx.
You have to be careful with the assumptions you’re making, because you don’t want to inadvertently imply that a company will grow cash flows at 5% indefinitely without spending anything on drilling new wells.
For MLPs, the most common valuation methodologies are price to distributable cash flow multiples and the dividend discount model – just like with REITs, MLPs must issue a certain percentage of their earnings in the form of dividends, so the DDM works quite well for valuation purposes.
Yields, though not technically a valuation multiple, are also very important since many investors view MLPs as income-oriented investments (and they really are income investments if you look at the dividend yield numbers).
Distributable Cash Flow is basically cash available to Limited unit holders (as opposed to the General Partners, or GPs) after paying for CapEx, other cash expenses, and distributions to the GPs.
Technically, it’s defined as Net Income + D&A – Maintenance CapEx – Cash Flows to General Partners.
You can create all sorts of metrics and multiples once you’ve calculated Distributable Cash Flow, such as Distribution Yield (Distributed Cash / Price) and DCF Yield (Distributable Cash Flow / Price).
Credit statistics (covered in your corporate banking article) are also important – for example, investors look at both coverage ratios (EBITDA / Interest Expense) and leverage ratios (Total Debt / EBITDA) to assess which MLPs might be riskier than others.
Downstream (Refining & Marketing)
There are not too many differences in this sector because the companies are very similar to “normal” companies in other industries.
So you still see EV / EBITDA, P / E, and traditional DCF analyses.
Q: Wow. I’m amazed at how long you’ve been talking about this now.
Anything else to add?
A: Oh, I’m not done yet.
You still see methodologies like the relative contribution analysis (compare how much the buyer and seller are contributing in terms of net income, cash flows, reserves, production, etc. and base the ownership percentages and implied purchase price in a deal on that) and historical equity price comparisons (e.g. average closing price for both participants over certain time frames).
Sum of the Parts can be common with the super majors and any company that has a big presence in multiple sectors – you might use the NAV model for the E&P segment, DCF for refining/marketing, and a DDM for midstream (for example).
Q: Now you’re done, right?
A: Haha, OK, two more and then I’ll be done:
Ratio of Premium Paid to Capitalized Synergies in Precedent Transactions: This analysis can employ either average daily closing prices or the closing prices themselves on particular dates.
Return on Gross Invested Capital Comparison: Used for a single time frame (ex: ten year) and looks at the entire company or particular segment (ex: Exploration & Production or Refining & Marketing).
The standard definition for this calculation is “(Earnings – Dividends) / Total Capital.” Here, “Total Capital” is the sum of the debt and equity in a company.
Energy Banks: Super Majors and Integrated Firms?
Q: OK, enough with the technical tips, my head is spinning… great overview, though.
What are the top banks in your space?
A: The top bulge bracket banks in the space are a familiar set, and most of the big firms all have strong oil & gas teams as well.
The top boutiques are more spread out. Here are a few examples:
KLR Group focuses on the broad “natural resources” sector.
Rivington Capital Advisors, Simmons & Co., Energy Spectrum Advisors, Mitchell Energy Advisors, and RBC Richardson Barr, RBC Rundle, Tudor Pickering Holt, and Raymond James Albrecht also cover the sector.
Geographically, as you’d expect, there are a ton of boutique energy banks in Texas, but you also see them in hubs like New York and London as well.
Q: I noticed not all of your boutiques are really boutiques, what’s the deal?
A: Depending on what year it is, you’ll see banks consolidate or move entire teams to a “less rocky” platform… so that’s why I’m including banks and groups like “RBC Rundle” on this list as well.
Off Into the Sunset… Or Back for More
Q: What do you like to read to keep on top of the sector?
Notice I’m not giving you the whole thing to read, just one section. :-)
For more acquisition and divestiture (A&D) reading, you can check out A&D Watch.
Q: So where do you go after you’ve done your time digging for black gold?
A: There are a lot of commodity [hedge] funds out there that really appreciate the skill set you gain in covering oil & gas.
As previous interviewees have mentioned, there aren’t a ton of PE firms focused on energy because of the volatility in the sector, but they do exist and you’d be well-positioned for them after working here.
I’ve also seen people move to oil & gas companies big and small, and sometimes even move into different industry groups in banking.
You definitely develop a more and more specialized skill set in oil & gas as you continue in the field, so it’s easier to move into something different early on if you find it’s not for you.
The good news is that it’s easier to move from oil & gas into something else than to do the reverse.
Q: Great. Thanks for your time!
A: My pleasure.