Overview

In this lesson you're going to get an introduction to oil and gas modeling and you're going to
learn how these companies differ from typical normal companies that we look at when doing
financial modeling, and you'll get an introduction to the case study, and each segment of that
and what we're going to go through in this course.

Now oil and gas companies always attract a lot of interest, because they're quite a bit different
from normal companies in the standard modeling that you see. I would say that overall, they're
less different from normal companies compared to say, banks, and financial institutions.

The financial statements still tie together in a similar way so fundamentally, not too much is
different there, but it is different in terms of how you project revenue, how you project
expenses, and everything else flowing from those items.

[01:00]

Oil and gas is a very cyclical industry, very dependent on commodity prices obviously, and so
most of the differences that you see arise, because of its dependency on the market, as
opposed to other types of companies. So that's one of the key challenges that we'll have and
one of the key points that we're going to analyze as we go through this course.

So first off, what exactly is an energy company, or what exactly is an oil and gas company? You
hear the term thrown around a lot, but oftentimes people lump together all different types of
energy companies, all different types of oil and gas companies, when in fact they're actually
quite a bit different, and there are many different categories.

So first off we have E&P companies, or exploration and production. And this is the type of
company that you often hear about, and that people are often referring to. E&P companies
comprise the majority of M&A activity, in the oil and gas industry, and they comprise most of
the companies that you read about, that you see in the news. So these are companies that
literally go out there and try to find oil or gas, or other natural resources.

[02:00]

And so fundamentally they are a very CapEx heavy type of company, because their revenue is
going to flow directly from how much they're investing in finding new deposits of oil and gas
and other natural resources. E&P companies typically have the highest margins out of the

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energy companies that we'll go through here, and the reason is because they really have the
highest value-add activity.

Everything else in the chain after you find the oil and gas, of course is necessary, but really it's
finding the oil and gas in the first place that's going to drive the most amount of value when
you're looking at energy companies. After E&P companies, we have what are called midstream
companies. So midstream oil and gas companies focus on the transportation aspect.

So once the E&P companies actually discover the oil or the gas in the ground, after exploring for
it and spending money to try to find it, the midstream companies will take the oil and gas from
them, and then go and deliver it to refineries, or go and actually deliver it to the consumer or to
companies that sell directly to the consumer, or to other companies that need energy at that
point.

[03:00]

So, midstream companies focus more on shipping on trucking things of that nature. You don't
hear about midstream companies quite as much, because as you'd expect it's much lower-
margin business. Less value add overall, because there are certainly innovations you can make,
in terms of transportation.

But really these days in the oil and gas industry, it's mostly about finding new and
unconventional sources of oil and gas, as E&P companies do. Midstream is relatively
commoditized, and so we're not going to focus on it quite as much.

Then after that you have downstream, also known as R&M, or refining and marketing, and
these are companies that take the oil and gas supplies from the midstream companies that
have gathered it from the E&P companies, and then they take it, and refine it into the end
product.

[04:00]

So when you go to the gas station or you buy fuel anywhere else, or you're taking a plane and
the plane is fueling up, the downstream companies are the ones that actually take the raw
materials from the midstream companies, which in turn have gathered them from the E&P
companies, and they take them, and transform them into the jet fuel, or to the gas that you use
in your car.

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Now again, downstream companies, similar to midstream companies the margins here are very,
very thin, because it really is a commoditized business. Gas prices with a few exceptions are not
going to be that much different, regardless of where you go.

And so it's very, very difficult to capture much, in terms of margins or profit here, and so again
as with midstream, we're not going to spend quite as much time focused on the downstream
companies in this case study.

Another category of energy companies, are what is known as oil field services companies, so
one example here would be Halliburton. These are the types of companies that do not actually
produce, or transport, or refine oil and gas themselves, but instead they're involved with
actually going out to the oil and gas fields that are owned by their companies, and servicing
them.

[05:00]

So providing maintenance support, providing a labor force to actually go in, and service these
oil fields, oil refineries, and so on. These companies again, we're not going to pay too much
attention to in this particular case study, because they're not very common.

Also they're really very, very conventional companies in terms of the financial metrics. And you
can look at metrics like revenue, EBITDA and so on for these types of companies, because
they're not that much different.

They're not really asset-driven companies in the same way that some of these other categories
on here are. So we're not going to pay too much attention to the oil field services category. And
then the final category here, are what is known as integrated majors.

So an example is; Exxon Mobil, BP, Shell, and other huge global companies like that; Chevron
would be another example of integrated major companies. And the difference here is that
these companies operate across multiple segments.

[06:00]

So rather than just focusing on exploration and production they may also do midstream, they
might also do downstream, refining and marketing. They may also do chemical production, so
they operate across many different segments here.

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In Exxon Mobil's case, they focus on both exploration and production, and also downstream
and they also do chemicals, and a couple other things. They don't have much in terms of
midstream operations, but they definitely operate across at least two to three different
categories here, so they're known as integrated majors.

Below them, you also have other companies that are known as mini-majors that are a little bit
smaller, but which still operate across multiple segments here. So these are the different
categories of energy companies, and we're going to come across most of these, as we go
through this case study.

But in terms of our focus, it's really going to be the exploration and production companies,
primarily, because that's where most of the M&A activity and the interest in the industry, really
is. That's where most of the value is coming from. And in terms of accounting, valuation, and
financial modeling that is really where most of the differences are going to emerge.

[07:00]

There are of course different metrics and multiples sometimes with these other types of
companies, but overall the E&P companies are the ones that are the most different. These are
the ones that are the most interesting to look at. And these are really the ones that you're
going to be asked about when you get into interviews, and you go speak with oil and gas, and
energy groups.

If you get industry-specific questions, most of them are going to be focused on the exploration
and production companies, and so that's going to be our focus in this case study. Now of course
we're also going to look at some of these other areas, because we're going to be looking at
Exxon Mobil, in addition to XTO.

So other areas will come up but certainly our focus is going to be on the exploration and
production aspect here. So how are oil and gas companies different? And here by oil and gas,
I'm really referring to exploration and production. Some of these points will apply to the other
companies, and the other categories that we just went through, but primarily here I'm referring
to exploration and production.

[08:00]

So first off most importantly, oil and gas companies mostly E&P companies, but also the others
cannot control their revenue. And what I mean by this is that if you think about a traditional,

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conventional company like Apple or Microsoft or a retail company. They have a lot of control
over the prices because they can go and say, “Okay, the Windows operating system should cost
$100," or "Our iPhone, the newest iPhone model should cost $200," or "The iPad should cost
$500" and so on.

And to an extent they are influenced by the cost of goods sold, how much it costs to make
these products, but really as long as they are covering their expenses, they can set whatever
prices they want. So they are influenced to an extent by the market, but overall they have a
great deal of leeway, over how they set their prices and therefore, how much revenue they
earn. With oil and gas companies by contrast, they do not have nearly as much control there,
because oil and gas prices are commodities.

[09:00]

They move in accordance to supply and demand on the open market. And to a limited extent,
companies can control supply somewhat, but ultimately the companies that we're going to look
at are so tiny in the global scheme of things that they have almost no control over their
revenue.

They can't control their prices. And this is going to be a huge issue when we look at the
operating model, and when we go through the valuation, because depending on what oil prices
are like our valuation for these types of companies is going to be dramatically different.

Another difference here is that oil and gas companies, especially E&P companies, are asset-
centric. And again, going back to comparing this to a normal company, so for example if we look
at a software company like Microsoft, they’re not really asset-centric because their value lies in
intellectual property, it lies in human capital.

[10:00]

It lies in the value of their engineers; their programmers, their product managers and so on,
and in what kind of new, innovative products they can develop; and how they can get
customers to spend additional sums on software and services and so on.

So it's not really asset-centric. It doesn't really depend on anything on their balance sheet. With
oil and gas companies of course, it's all dependent on their reserves. So if they have a certain
number of oil and gas reserves on their balance sheet, that's all they’re going to be earning
revenue from.

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They can explore and find new assets. They can find new reserves of oil and gas, for example.
But it takes quite a while for them to become operational and so they're very, very limited by
the assets that they have in their balance sheet, by how many of their reserves are actually
proved and developed, and producing at a certain point.

So as with banks, if you've been through the bank modeling course here, very, very asset-
centric, and we're going to have to start by projecting some of these assumptions about the
various assets, on an oil and gas company's balance sheet.

[11:00]

Another difference is that the accounting for oil and gas companies, especially E&P companies
is quite a bit different from what you see for normal companies. Now the basic statements, the
basic three statements; the income statement, balance sheet, and cash flow statement are not
dramatically different, you still see the same types of items; but what is different is that you
have different accounting standards.

And the two main ones here are called successful efforts and full-cost accounting, and the
difference is in terms of which expenses are capitalized, and which expenses are actually
expensed immediately on the income statement.

So different companies do this differently and this creates a problem, because if we look at
metrics like EBITDA or more oil and gas-specific metrics, like EBITDAX, which is a variant on
EBITDA we have to be very careful when we calculate it, to make sure that we're comparing
apples to apples.

If different companies expense certain expenses, and different companies capitalize certain
expenses we have to be very careful when going through their filings, and looking at their
accountings to make sure that we're using the same types of numbers.

[12:00]

Another challenge is that for an oil and gas company their assets are always depleting, so as
they produce more oil and gas their assets on their balance sheet are always going down, which
means that they're always in this cycle where they have to keep finding new assets. They have
to keep replacing the old assets on their balance sheet; otherwise eventually their production is
going to go down; their revenue's going to go down.

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And in the long-term, there are only a finite amount of resources on the planet, so eventually
the supply of oil and gas is going to run out. Now of course this is very, very far off into the
future, but there's only so much in terms of fossil fuels on the planet.

And so we're going to have to reflect this in our valuation and in our operating model and
actually, one of the valuation methodologies we look at will be dependent on this very fact.
That over time the assets will go to zero, and so you can actually value a company, in many
cases by looking at how long it takes for those assets to go to zero.

[13:00]

So this is something that's going to come up in numerous spots in the operating model and
valuation, and something that is just totally different from normal companies. Even if you
compare this to banks; well banks are also balance sheet and asset-centric; but the difference is
that their loans are never really going to go to zero.

They might decline, but they're not really a finite resource. They can always issue more loans.
They can always get more loans on their balance sheet. But with oil and gas companies by
contrast, you're limited by Mother Nature. You only have so much in terms of fossil fuels, and
so that is going to determine in large part, how your operating model and valuation here work.

And then one final, big difference here is that oil and gas companies are very cyclical. So when
oil and gas and other commodity prices are high, valuations for these types of companies will
tend to rise quite a bit, when they're lower the valuations are going to fall.

And the same is true in the operating model, when the prices are high the revenue is going to
go up by a lot, when the prices get lower the revenue and the profit margins, for these types of
companies, are going to fall for quite a bit.

[14:00]

So with this one, we cannot really do too much about this, because it's impossible to predict
these types of cycles. But what we can do is come up with a couple different methods to deal
with the fact that there are cycles in the industry, and that these companies have limited
control over their prices and their revenue.

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So the key challenges in this course and in this case study. So first off we have to figure out how
we're actually going to project oil and gas prices. This is more difficult than it sounds, because
it's not just a simple matter of assuming a certain number each year.

You have to look at multiple different scenarios here. You have to take into account what the
prices have done historically. And with normal companies scenarios are something that you
may look at, if you have extra time, and your MD wants it, or someone else wants to see
multiple scenarios.

But with oil and gas companies scenarios are essential, and you cannot even really create an
operating model or a valuation, without taking these into account. So we're going to spend a lot
of time, looking at several different approaches to coming up with scenarios for commodity
prices here.

[15:00]

Another challenge will be that in many cases, especially with more diversified oil and gas
companies, it's going to be difficult to go from their filings, to actually creating our own
projections.

And what I mean is that with these types of companies they often do not give us enough
information about their production capabilities, their refining capabilities to actually allow us to
make detailed revenue and expense projections.

Now if you've been through the advanced modeling case study, you'll see that in that case
study as well, we also had some difficulties there because they gave us limited information in
their filings, we did not really know enough in many cases to come up with really detailed
numbers. And we're going to run into the same exact problem here.

So the company that we're going to be focusing on, XTO Energy, there is actually quite a bit of
information in their filings, so it's not going to be as much of an issue. But with Exxon Mobil, it's
going to come up, because they operate across so many different segments, they’re a very
complex entity, and so we're going to run into some difficulties there, in terms of getting our
projections.

[16:00]

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So we'll look at a couple ways around that and some alternatives, if we do not have enough
information in the filings, to actually come up with detailed projections. Another issue here is
coming up with normalized accounting.

And I mean this in a couple different ways. I mentioned before how different oil and gas
companies have different accounting standards, successful efforts versus full cost. But beyond
that some companies focus on oil, some companies focus on gas; some companies do a mix of
both.

Pretty much all the companies out there have some element of oil and gas production, but the
focus is different and some companies, oil dominates, some companies gas dominates. So
we're going to have to take that into account and make sure that we're comparing everything
on an ‘apples to apples’ basis, so we're going to have to make sure that we convert properly
between units for oil and gas and for reserves, for daily production and other metrics like that.

[17:00]

If we're not comparing these on the same basis, then it's going to be very difficult to come up
with any kind of valuation for the companies that we're looking at. And then another challenge
here, will be diversified versus specialized companies; what I mean is that some companies only
do exploration and production; and maybe some elements of downstream and midstream.

But a lot of the companies out there will only focus on one of those so they might only do
exploration and production, they might only do midstream, they might only do downstream
and so on, whereas other companies like Exxon Mobil are very diversified.

And so once again, going back to the second point here, for those types of diversified
companies it's going to be difficult to go from their filings to their projections, especially when
they give us limited information, and they're not really telling us everything about each
segment of their business. So those are the key challenges. To go over the different parts of this
case study now, and what we're going to be learning in this course, first up we're going to cover
accounting for oil and gas companies.

[18:00]

We're going to go through a few sample financial statements for these types of companies. See
some of the different items that are on their statements, and also how they compare to the
statements of a normal company.

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We're going to look at what I’ve mentioned before successful efforts versus full cost
accounting. We're going to look at how you go from the reserves on an oil & gas company’s
balance sheet to calculating their income statement, and other financial statements.

So we'll see how you can actually use that information, and go from their reserve numbers and
their production numbers to their actual financial statements. We're also going to look at some
key metrics and ratios for these types of companies.

Then we're going to go into an operating model. We're going to focus on XTO here, because
they're the company that's getting acquired. So we're going to go through and look at how you
project their production levels, the oil and gas prices that they can realize, and some of the
other metrics, and then go through, and look at a full three statement model for XTO.

We're also going to look at elements of Exxon Mobil's model, but as you'll see there's not
enough information in a lot of cases, to really do a proper job of projecting, the entire model
for Exxon Mobil so our focus is going to be on XTO there.

[19:00]

Then we're going to go into a valuation, and look at a couple different methodologies. We're
going to still use public company comparables, precedent transactions. But in addition to the
standard methodologies, we also have a new one called a NAV model or net asset valuation
model.

And in this model we basically go with the assumption that we went over before, that their
assets are depleting over time. And we see how long it takes to deplete their assets and how
much in free cash flows they can realize from their assets, and we use that to value the
company.

So it's a bit of a twist on the traditional DCF, still somewhat similar but certainly some
differences there, that are interesting to look at. Then we're going to go through and look at the
actual merger model between Exxon Mobil and XTO.

Now this was a merger that was announced, really an acquisition that was announced at the
end of 2009. One of the largest the industry had ever seen, at that point in time, certainly the
largest over the past few years, around $41 billion in terms of enterprise value.

[20:00]

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So this merger model similar to what we saw in the advanced modeling course if you've been
through, also going to be quite complex here. We're going to go through this in quite a bit of
detail, and focus really on how it's different, for these types of companies versus what you see
for normal companies, in a merger or acquisition scenario.

And then following that we're going to look at a hypothetical scenario, and do an LBO of XTO
energy. We're going to look at this and see how feasible it would have been, and how the
returns for a private equity firm or private equity firms, acquiring XTO would have been like.

We're going to pay special attention to the sensitivity here in terms of the oil and gas prices,
because that's going to have a huge impact on the returns, for an LBO of this type of company.
So that's a quick overview of the case study, and the different parts here that we're going to be
going through. Again, the Exxon Mobil/XTO deal was announced at the end of 2009, a huge,
$41 billion deal at that point in time.

[21:00]

This was really about Exxon Mobil trying to make a grab for natural gas reserves, because
natural gas prices were relatively lower at the end of 2009. So it's really about them expanding
their natural gas reserves, and natural gas production capabilities.

Also keep in mind that, as I've been going through this I've mentioned many metrics that are
applicable to oil and gas companies, but a lot of what I mention here in these differences also
apply to mining and other natural resource companies.

The exact metrics and multiples may be different, but the fundamentals in terms of the assets,
the asset-centricity of these companies, the assets being depleted over time, the lack of control
over prices, those apply equally to other commodity and natural resource companies, as well.

So keep in mind as you're going through this, that a lot of what we're going to do, does not
apply to just oil and gas companies, but really to anything that's in the commodities business,
that’s in the natural resources business. So that's a quick overview of what you're going to get
in this course.

[22:00]

Coming up next in the next lesson we're going to get into the accounting lessons, and we're
going to go through the financial statements of an oil and gas company, and look at how they

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are similar to the statements of a normal company, and also how they're different and what
some of the items on their statements actually mean.

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