Houston, We Have a Problem – Free Cash Flow, Net Asset Values and the Agency Question

Recent carnage in public E&P land is accelerating debates around the sustainability of current business models as well as the methodologies used to value those businesses. While the industry has walked back from the capital outspend ledge, at least for the moment, we still see analyst reports highlighting EBITDA multiples and forward multiple compression. Acreage values may be more insightful, but the “right” answer is heavily reliant on spacing and development assumptions. More recently, free cash flow and annual free cash flow yields have entered the discussion, but the durability of those cash flows remains open for debate.

None of these methodologies, nor the business plans that they attempt to quantify, address the key issues facing the industry. How do depletion rates evolve as drilling activity fluctuates? What commodity price is needed to generate a fully loaded economic return on a drilling program? How does that change as inventory is depleted? The reality is that the public equity markets provide a feedback loop to the industry. Until very recently, the overly simplistic short-hand valuation methodologies used by many industry participants reinforced self-defeating behaviors which never addressed the fundamental question: what creates actual economic value for shareholders, and how do you measure it?…”