Valuing oil companies

Oil exploration companies tend to have a high degree of uncertainty as to their future prospects. I want to give a brief flavour of how this uncertainty is typically priced in.


They are usually evaluated on a fundamental basis, such as EV/2P (Enterprise Value/Proven and Probable Reserves P90+P50) and the reserves estimates are risked.

Example
Let's say an exploratory well is priced at a potential value of 50p per share. Analysts might feel that the chance of success of this well is 25%, so the risked value would be 50p * 0.25 = 12.5p per share. Enterprise value would then be theoretically calculated as a multiple of these reserves.
The Dana experience

This process of analysing Dana's reserves led to analysts coming to a mean price target of around 1,400p. So why was Dana so trading so far below this?

I think the answer could lie in the type of irrational decision making processes outlined above. Over the last year Dana has had some notable exploration failures which could have caused negative sentiment towards the company (the availability heuristic).

Investors get emotionally affected by near-term misses. Similarly, these failures could have caused investors to attribute the failures to the management team rather than just the inevitable randomness of an exploration programme (the fundamental attribution error).

Usually, these failures should have no effect whatsoever on the value in the ongoing programme and investors should just put them down to bad luck. Investors aren't so rational though and I reckon they sold off Dana too aggressively as a consequence. The company was being blamed for bad luck. At least, that is what the Korean National Oil Corporation appears to believe!

Other stocks to look at

I believe a similar sort of situation to Dana's took place with Gulfsands Petroleum (LSE: GPX), which was subsequently the subject of an approach from the Indian Oil Corporation. This sort of situation creates opportunity and I reckon two shares I currently hold, Soco International (LSE: SIA) and Valiant Petroleum (LSE: VPP), present similar opportunities.
In 2008, Soco had some technical difficulties with drilling at Te Giac Den in Vietnam, which disappointed holders. Investors may be over compensating for this now, given that Soco has taken on drilling on a sole risk basis and was expected to begin operations here last month.
Valiant had some operational and weather related difficulties with its Don Southwest and Don West fields. This caused production in 2009 to be slightly lower than estimates and its reserves also had a small downward revision. However, Valiant has an active drilling campaign this year, which could unlock value. They also have fields under development which are due to start producing over the next few years.

On a sector level, I believe that the levels of inherent uncertainty in sectors like oil exploration and biotech/pharmaceuticals can often create the opportunities to find mispriced companies.