If you invest in individual stocks, you may be familiar with SEC filings. These contain a trove of information on businesses. If you own oil and gas companies, there is one particular measure within those filings that is worth paying attention to, and worth learning about given it is unique to energy firms.
It’s often referred to as “PV-10” or the “standardized measure”, which is the after tax version. The SEC requires all oil and gas companies to give the discounted value of the reserves they expect to extract over the next 10 years.
The most recent detail behind this comes from the the SEC’s Modernization of Oil and Gas Reporting and the associated Financial Standards Accounting Board (FASB) Topic 932 in 2010. Even though the methodology is fairly complex, the basic goal is to give investors a good sense of what companies are worth.
How PV-10 Works
They estimate the oil and gas they are reasonably certain they can produce over the next 10 years subtract costs and discount it back to today’s money at 10% per year. This can then be helpful in indicating the companies value. For purists, companies are worth the sum of the cash flows that they are expected to generate and so this measure gives a sense of the cash flows that management expects.
How To Use PV-10
PV-10 can be a useful cross-check on valuation. You can take the PV-10 value, and if it’s based on an oil price that’s similar to the current one, the subtract the debt and roughly you have an assessment of equity value over the next 10 years. Of course, if development goes far worse than expected or prices fall, it may prove too optimistic. But it’s a useful rule of thumb for energy valuation to complement other techniques.
Criticism of PV-10
Of course, PV-10 is not a perfect measure and a few criticisms apply.
Pricing: One major one is that for simplicity calculations are done using the year-end price for oil and gas, and that’s the carried forward over the next 10 years. That can be a weak assumption for two reasons. Firstly, the process of updating a PV-10 measure is annual and so the price may become out of date. For example, many companies that filed statements ending on December 2017 used an assumption of $50 (per barrel) oil, which was the price at the time. The oil price is now more than 40% higher at over $70. That can make a big different to the estimates of reserve value. For example, oil that cost $60 to produce, wouldn’t have been included at the end of 2017’s analysis, but is now profitable, and barrels that were expected to be produced anyway are now more profitable.
Secondly, we have a better estimate of future oil prices than looking at the price last month. We can look at what the futures market is forecasting. For example, oil may be at over $70 today, but the forward curve has the oil price drifting downward in the coming years.
So there can be two improvements to the price. The first is updating to the current price, especially if the PV-10 analysis was done some time ago, the second is reflecting the futures curve rather than a static price. At times when the oil price has moved a lot or is expected to move a lot in future, these two modification can make a big difference.
Reserve probability: In the energy industry nothing is certain. Only reserves that are more likely than not to be realized and in most cases where development is expected to start within 5 years are included. This leads to two sources of risk. On the one hand reserves that are 11 years away from development or less certain may be excluded. Secondly, even though management has high confidence that the reserves will be extracted, there’s always a chance that something goes wrong with the estimates or the associated technology and so the energy reserves turn out not to be as promising as forecast. It appears that that there are risks on both sides here, but these are risks to be aware of.
Valuation mechanics: Of course, one can also debate the valuation mechanics. For example, is 10 years the right forecast period? Is 10% a fair discount rate? Using standard assumptions creates comparability between companies, but what is an appropriate set of assumptions for Exxon or BP, is likely different to a micro-cap energy producer.
PV-10 is a useful valuation yardstick, though like all valuation measures it is imperfect. Oil and gas investors should be aware of its uses and limitations as you can be sure others on the other sides of your trades will be.