3 Key Metrics Oil & Gas Investors Need to Know

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The P/E ratio is a popular go-to investing metric, but it's far from perfect -- it's way too easy for accountants to shift around.

In this week's episode of Industry Focus: Energy, Motley Fool analysts Sean O'Reilly and Taylor Muckerman share three more specific metrics for potential investors in upstream oil. Listen in to find out the three most important numbers to look for on an oil company's balance sheet, and how to interpret them.

Also, the hosts talk about why companies have had to decrease their reserves, how oil producers have been able to cut their production costs by such incredible margins, why so many companies are hyping the Permian right now, and more.

A transcript follows the video.

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This podcast was recorded on July 28, 2016.

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, July 28, 2016, so we're talking about energy, materials, and industrials. I'm joined in the studio by Motley Fool premium analyst Taylor Muckerman. How's it going, man?

Taylor Muckerman: I've never been called a premium analyst before. I appreciate that.

O'Reilly: You're on the premium side. You work for the newsletter. What is your fancy title, co-GM of ...

Muckerman: Yeah, general manager/analyst.

O'Reilly: Insert eye roll.

Muckerman: Two hats. Yeah, I'm doing it with you.

O'Reilly: Yeah. Anyway ...

Muckerman: At a company where you can kind of make up your title, I don't know if that really makes any sense.

O'Reilly: Yeah, I'm actually an executive chef here, even though I have no ...

Muckerman: Cooking up some financial results.

O'Reilly: We're going to do a little bit ... we're going to take our listeners to school today, I guess, and it's going to be an oil and gas show. We haven't done one of those in a while. Last week we talked about Elon Musk's master plan for Tesla.

Muckerman: The week before that was a Tesla-themed show as well.

O'Reilly: They keep doing things and I have to cover them.

Muckerman: Yeah, that's why.

O'Reilly: Anyway, we sat down and we came up with a couple of industry-specific terms that investors in the oil and gas space need to know to really get to know the companies that ... fine carbon fossil fuels.

Muckerman: Yeah, this is for the exploration of production companies.

O'Reilly: For start, when you're looking at a company, Taylor, for Fool Canada or personal, whatever, what is the first term that you look for that might be useful for our listeners?

Muckerman: Well, since we're talking about upstream companies, I'll look at them generally just for services, for the Motley Fool services, or just research in general. Personally, I don't invest in upstream producers, my own personal habit.

O'Reilly: You and [Tyler] Crowe, man.

Muckerman: Yeah, yeah, we like the services companies in the pipeline, but to really understand what's happening in the market, you need to understand upstream producers. When you're looking at these, you're generally not really going to look at price to earnings because in a cyclical industry; that can be a little bit deceiving. You can see low P/E when earnings are through the roof, so they're at the top of the cycle. Then you can see high P/Es scaring investors away when earnings are in a trough, as they have been over the last couple of years.

O'Reilly: The market does attempt to discount the future. They do take the cyclical nature of the commodity cycle into account.

Muckerman: Right, so that simple ratio there that a lot of people, it's like the first thing some investors look for is the P/E ratio to see how it's valued compared to earnings. That might not be the best place. Enterprise value, so you can look at enterprise value for reserves so you could see what it's valued at per barrel of oil that they believe they can extract, or you can do, and we'll talk about it a little later, is enterprise value per PV10, which is the present value of the reserves discounted at 10%.

There's a few different metrics that you're going to look at for these. You want to look at cash flow because a lot of these upstream producers are dividend payers, for better or for worse, so that's a little bit more typical. Enterprise value is a very important metric.

O'Reilly: Got it, OK. The first metric that I really want to talk about when we hop over into the income statement, you're talking about GAAP earnings, that income and P/Es and everything. I always tell people that are getting started in investing, P/E and net income, that's an accountant's game. You can make that look however you want.

Muckerman: Executive chef, tell us how it is.

O'Reilly: No, that's my job. One thing that cannot be really fudge for an oil producer, and oil and gas producer, is exploration and development costs. Walk me through what that entails and maybe some companies that investors looking to get invested in this space might look at that are doing really well based upon this metric.

Muckerman: Yeah, so they generally break out costs in two different brackets. Exploration and development is usually sometimes termed as finding and development or exploration and development. The second half is production and completion.

O'Reilly: The former, the exploration development cost, that's the thing that's been cut a lot?

Muckerman: A lot, yeah, yeah. You look at a company like Marathon Oil (NYSE: MRO), to take their exploration budget for conventional oil over the last couple of years, in 2014 it was $500 million a year. 2015, cut it in half to $250 million a year. 2016, $30 million a year.

O'Reilly: Where is that $30 million going?

Muckerman: There's a few longer-tail projects that they just have to put money into.

O'Reilly: What do you even get for $30 million?

Muckerman: Not much, and that's one of the big worries in the industry is these are the projects that are going to deliver oil production years down the road, and that is why companies have decided to cut back on that in the last year or two, because they need cash flow now to pay for those dividends I had mentioned a little earlier and to just keep the lights on. They've been pulling back on these long-term investments. ConocoPhillips as well, pulling back a lot in the Gulf of Mexico. They plan to completely exit exploration drilling in the Gulf of Mexico by 2017.

Offshore is definitely a little bit more of a coin flip, and it's definitely more expensive from top to bottom, exploration, drilling, and completion. That being said, there's a lot of reserves supposedly out there. They could be missing a big heap of oil reserves, but onshore they've got a pretty decent portfolio.

O'Reilly: Yeah. Obviously, with exploration and development costs on planet Earth, you've got a pretty wide range because you go over to Saudi Arabia's Ghawar Field and you stick a straw in the sand and you've got oil.

Muckerman: Yeah, that's what we call a conventional oil. Easier to find, easier to drill for, versus unconventional, which is offshore and shale.

O'Reilly: Obviously, at the other end of the spectrum is deep-sea offshore stuff, Antarctica, all that stuff. What kind of cost per barrel -- just give me ranges, I mean, you don't have to be exact -- what's good for conventional? What's normal for offshore? I mean, just anecdotally spitball. I did want to get an idea.

Muckerman: When you're looking at capital spending, which generally includes this exploration, the one-time costs, you're looking at some of these areas around the world, you look at Norway, it could be 65% of the cost of a barrel. It could be 51% in the U.K. Then you get into, like we talked about, Saudi Arabia and their fields, you're looking at some of these costs are below $5 and $10 a barrel.

O'Reilly: Yeah, I saw this one number, it was like $7 or $8 a barrel.

Muckerman: Yeah, so it's very regional. The U.K. is dealing with the North Sea, turbulent water. They've kind of removed from a lot of the transportation options. You've got some exploration and development costs there, which as I mentioned, is a little over 50% and you're looking at maybe $20 to $25 a barrel.

O'Reilly: Got it, which is ironically enough where crude bottomed out earlier this year.

Muckerman: Yeah, exactly, and that's why exploration was one of the first things to go for a lot of companies.

O'Reilly: I cannot believe Marathon cut to $30 million.

Muckerman: Yeah, basically from $500 million to $30 million in two years.

O'Reilly: I'm going to go to their latest earnings to find out where this $30 million went.

Muckerman: It's going very slowly is where it's going.

O'Reilly: Can you even get a rig for that?

Muckerman: Onshore, but if these are ... I can't remember which projects this $30 million is going toward, but if it's offshore, that's not really going to cut it for very long.

O'Reilly: Got it. OK, so moving on to production costs. This is really where especially onshore conventional producers have been focusing on because they've been cutting exploration and development costs, they're not finding more oil, but they've really been getting more efficient. They've been trying to, and they've had to because of this downturn. You see these estimates where most producers I've seen that are just onshore shale producers, their production costs come down 20%, 30%. Walk us through that.

Muckerman: Almost sometimes on an annual basis.

O'Reilly: Yeah, it's crazy. Walk us through what production costs entail, how they're getting better at it, I guess, and maybe a few more names that are doing well.

Muckerman: Yeah, so you're looking at ... you've got the drilling activities, which is basically setting up shop, drilling the wells, and then the completion aspect, which is the majority of the cost. You're looking at generally 60% or above for the completion side, and that's the fracking and the extracting. What you've seen over the last year or so is companies do everything but the completion stage, because it is the most expensive and it can be done relatively quickly. It's just very capital intensive, very labor intensive, and very resource intensive because you're dealing with proppants, you're dealing with all the fluids, the sand, the silicone, whatever they might be using. That does vary by field. If you're looking at some of the drilling costs across the four major basins in the U.S., the Bakken, drilling cost is $1 million.

O'Reilly: For a well?

Muckerman: For a well is about $2.5 million in the Bakken, Marcellus, just under two, Eagle Ford, right around two, and Permian right around two. This all comes with different depths, different horizontal lengths. By depths and horizontal lengths I mean the depth straight down that these wells are being drilled and then the lateral and horizontal length is basically the length of the frack stages that they're drilling out, which are getting several thousand feet now, and then within that several thousand feet, you've got several fracking stages that they go through to access multiple different portions of this well. The Bakken is the deepest and the longest generally, with the Marcellus being the shallowest and less long underground horizontally, left, right, north, south, east, west, wherever the heck they're trying to get this oil from. Then, on top of that, you've got the profit and fluid and completion costs that are different.

You might expect, because the Marcellus is the shortest and less deep that it would be the cheapest, but no, it's actually the most expensive when it comes to proppant and fluid costs. It just varies quite widely, which is why you see companies choose to specify in certain basins ... you've got some companies like an EOG (NYSE: EOG) that spreads itself all around.

O'Reilly: They're mostly in Eagle Ford.

Muckerman: Yeah, they're the largest producer in Texas. They're one of the largest producers in North Dakota. They've got a small percentage of assets they're trying to grow internationally, but for the most part they're the largest domestic oil producer in the U.S.

O'Reilly: I see a lot of players in their latest quarterly earnings, they're talking up ... just focusing on the Permian. Why?

Muckerman: Well, compared to the Bakken and Marcellus ...

O'Reilly: This is West Texas, for everybody that doesn't know.

Muckerman: Oklahoma as well. What you're looking at here is a field that's kind of been looked at last, but it has supposedly tremendous reserves. The Marcellus got tapped very heavily for some oil, but mostly natural gas. The Bakken and Eagle Ford have just been the darlings of the shale energy revolution, with Harold Hamm basically pioneering up in the Bakken and a little bit into southern Alberta. The Eagle Ford was just a rush. Everyone wanted in on that. The Permian has kind of been one of the last low-hanging fruits to be discovered, and it's just got multiple different layers to it. They can tap a well, drill a little bit deeper, tap another whole resource formation, and they call them a stacked play, basically, where you see these wells stacked on top of each other where you can access them at different depths.

O'Reilly: Before we move on, how have companies been able to drop these production costs so much, like you just said, like 30%? How are they doing that?

Muckerman: One thing is you've been seeing greater wells drilled per rig, so you've seen pad drilling is what they call it. Rather than having to completely disassemble a rig, move it to a new well site and then reassemble it and drill again, these rigs are basically movable. In some instances, they'll just basically put them on tracks almost like ... not like a railroad, but the same general idea.

O'Reilly: Like excavator tracks.

Muckerman: Yeah, yeah, exactly. You've got these rolling wheels on basically a bulldozer track that they can move those in quadrants around a well site. You're drilling multiple wells with the same rig, so it shortens the time frame and the manpower that you need to disassemble and reassemble. The longer laterals with more fracking stages in those laterals, so you don't have to ... you're just drilling that one well and then accessing many, many, many more points within that well, and then you've obviously got optimization with the proppants and the fluids that they use just in testing.

In the major fields in the United States, the Bakken, the Eagle Ford, the Permian, and offshore Gulf of Mexico, drilling and completion costs have come down roughly 25% to 30% since 2012. That's basically the bread and butter of the United States. If you stripped out those four basins, we're not producing hardly any oil.

O'Reilly: Right, yeah. OK, cool. All right, so moving on. I'm an oil company, Sean Oil. Someday, I've spent a bunch of money on exploration development costs. I go out and I drill these wells, which is production costs. The byproduct, of course, are reserves and these are measured on the balance sheet of these oil companies, or, in this case, Sean Co., as PV10. What the heck is PV10?

Muckerman: PV10 is, if you've been in finance for a little while or you're just new, it's basically discounted cash flows that you expect to receive from this oil, so you take your reserves minus the cost that you expect to have to outlay to extract those reserves, and then discount it by 10% back to the present value.

O'Reilly: The reason I asked you that and what I wanted to impress upon our listeners is it involves a lot of guesswork.

Muckerman: Yes, it does. Yeah.

O'Reilly: They have to do it. It belongs on the balance sheet.

Muckerman: It's basically just a way to kind of create a standard across the industry, because you've got these oil reserves that have varying levels of degree of certainty that they can be extracted. You look at what they call the three Ps: proved, possible, and probable. Probable and then possible. Proved is we got 90% certainty. Probable is 50% certainty, and possible is 10% certainty. When you're looking at PV10, that's generally only proved.

O'Reilly: From what I've seen, most companies only talk about the first two, right?

Muckerman: Ten percent certainty, that's not really much to hang your hat on. Sometimes you look at a junior company, they want to talk about that because they want to show these big boys, hey, you've got the technology to probably increase the likelihood of this, so maybe you can buy it. Then they become probable or they become proved for you. For us, that oil's probably never coming out of the ground, but we own it so if you want it, come buy is.

O'Reilly: Got it. OK.

Muckerman: Then you can use that number ... you put enterprise value over that so you can get an idea of if the enterprise value is less than the PV10, that company is most likely undervalued based on what they hold in the ground.

O'Reilly: Are you saying my Sean Co., my Sean Oil is undervalued?

Muckerman: I don't know. What's your EV-to-PV10 ratio?

O'Reilly: I drink your milkshake. Interesting dynamic over the last two year, companies, just because of the price of oil, were having to decrease their reserves. Why?

Muckerman: That goes, again, to the value of the reserves. Yes, you have the barrels of oil but in order to claim it as an asset you have to monetize it. They have to use an industry standard for estimating the price of oil in the future. That's how banks determine loans; they determine credit ratings. That's how you can basically value the balance sheet.

O'Reilly: They do that twice a year.

Muckerman: They do do that twice a year, and you've seen a lot of pain. You've seen, I think, over 80 bankruptcies now because of these restrictions that banks have to place on these companies because they're like, "Well, the loans we gave you on oil was over a hundred bucks," aren't quite as secure with oil at the $40 range. That's just the cyclical nature of this beast that you're talking about when it comes to oil and gas, and that extends right to material mining as well.

O'Reilly: Got it. Who has the biggest reserves?

Muckerman: Well, ExxonMobil (NYSE: XOM) has just about 25 billion barrels of oil.

When you compare that to EOG is around 2.1 billion barrels, so 10 times EOG, and EOG is the largest domestic producer.

O'Reilly: Now, were most of Exxon's reserves offshore? Where is it?

Muckerman: They're so spread out geographically. I'm not 100% sure of the breakdown, but they are a very big offshore player, strictly because to be a big offshore player, you have to be a supermajor. Other companies are trying to catch up, because it is the most expensive and the most guesswork involved, I guess, might be a good way to put it in terms of exploration, you really have to have a secure balance sheet to even think about going out and searching for that. You've seen Exxon with the 25 billion barrels of oil under their reserves. This last year they only replaced 67% of their production, versus a 10-year average of 115.

O'Reilly: Did they cut their exploration budget to $30 million?

Muckerman: No, they did not. If they did, that's basically the salary of maybe someone in the C-suite.

O'Reilly: This is the top 10 executives, that was what they made last year.

Muckerman: That's another thing you want to look at, reserve replacement ratio. You want to make sure the company you're investing in is finding more than they're producing. Obviously some years are going to be worse than others, but a long-term average of 115% isn't too bad.

O'Reilly: Got it. Is that the industry average?

Muckerman: No, that's Exxon's 10-year average. Then you look at EOG, they said they replaced 192% of their reserves last year.

O'Reilly: Boom. Mic drop.

Muckerman: Mic drop.

O'Reilly: Mic drop. Before we head out, I want to just thank you again for going over these terms and sharing your knowledge and everything. If you were to be one of our listeners and go to your computer and go to Fool.com and start looking at some oil producers and stuff, how would you use these three metrics?

Muckerman: Just basically as a comparison across companies. If you're seriously looking to invest, that might be a way to find some that are undervalued, but you want to make sure that they're operating properly. Reserve replacement comes to mind to make sure that they're still actually going out there and they're capable of producing while they're ... I mean, finding while they're producing. Then the other two, EV over PV10 and EV to reserves, that's just a good benchmark to compare valuations outside of P/E and price to cash flow and price to revenue. This business is so cyclical, you really want to understand the size of their asset base and compare that to the price of their stock.

O'Reilly: Awesome. All right, Taylor, thanks for your time.

Muckerman: You got it.

O'Reilly: Have a good one.

Muckerman: Thank you. You, too.

O'Reilly: That is it for us, Fools. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at industryfocus@fool.com. One again, that's industryfocus@fool.com. As always, people in this program may have interest in the stocks they talk about, and The Motley Fool may have recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program.

For Taylor Muckerman, I'm Sean O'Reilly. Thanks for listening, and Fool on!

Sean O'Reilly has no position in any stocks mentioned. Taylor Muckerman owns shares of Tesla Motors. The Motley Fool owns shares of and recommends Tesla Motors. The Motley Fool owns shares of EOG Resources and ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.