Valuation gaps between intrinsic and market values for Canadian E&P's

Some surprises, but not many.

Valuation of commodity based companies is as much an art as a science, since value is determined primarily by world commodity prices outside of the capabilities of management or government to manage. A key issue is what rate of return investor should and implicitly do expect from their holdings.

I suggest that given the risks in commodity based companies, wise investors will seek a long term return of about 15% after taxes, but the stock market seems content with less in many cases. This is perhaps why energy investments have been a bust for retail investors for decades. Using the energy sector of the S&P 500 as a proxy, the return on this sector since 2004 (twenty years) has averaged approximately 5.5 percent continuously compounded. That has left a lot of investors disappointed. A contributing factor is the volatility of oil & gas prices and the response of the industry in raising or curtailing capital outlays, as illustrated by this chart from the Canadian Energy Regulator. It is an area not for the faint of heart.

I have been an energy sector investor since the mid-1980’s and have navigated my way through this morass of risk quite successfully with long term returns well into double digits, but not uniformly profitable every year. Since taking the Advanced Valuation graduate course at New York University’s Stern School, a course taught by market expert Aswatch Damodaran, I have moderated the swings in outcomes in my oil & gas investments by using a modified Black Scholes approach to valuation of the reserves of companies that interest me, buying large positions in those that seem under valued and avoiding those that from time to time seem highly overvalued.

I maintain current models of each company I follow both using conventional valuation metrics such as multiples of cash flow and discounted cash flow, but I have found Black Scholes produces more reliable results since it does not rely on a commodity price forecast but recognizes that such prices are volatile.

I thought readers might like to compare the results of Black Scholes valuations of popular Canadian exploration and production (E&P) companies operating in the Westrn Canadian Sedimentary Basin with the market valuation of those companies on a per share basis. Here is a spreadsheet of the outcomes.

Many will find these results perverse. For one thing, they result from requiring a 15% after tax return on capital for each company, and markedly higher valuations result if that hurdle rate is lowered to (say) 10%. For example, at a 10% hurdle rate Canadian Natural Resources rises to over $90 a share. For another, some companies have extensive land holdings they have yet to drill and the value of these (if any) is not yet reflected in reserves. Headwater, Tamarack Valley and Peyto fall into this category.

But the input is valuable to me. I hold major positions in Saturn, Peyto, Bonterra, Whitecap, Birchcliff and Spartan Delta and have no holdings whatsoever is the companies below Spartan Delta on the spreadsheet list. My choices reflect not only relative valuation but also confidence in management and a judgment about the nature of the basins in which they operate.

I think all the companies listed are good long term investments and generally well-managed and well-positioned to benefit from firm commodity prices. But I don’t like to hold share in companies that prefer “buybacks” to dividends or who carry more debt than I am comfortable with. I acquired my major positions when they were out of favor and at very attractive prices relative to current market prices and see no reason to sell now or ever for that matter. They provide me with a large and growing stream of dividends. My one large holding not listed is Rubellite Energy which reports results March 14, 2024 and I await their updated reserve report to make any judgment about whether to add to my holding or just wait for the company to keep developing its Clearwater acreage.

I have posted most of the Black Scholes analyses on Twitter and am happy to share any of them with any reader who expresses interest by posting the requested valuation on X.