Energy and Commodity Producers

Why this matters

A software company can raise its prices. An oil producer can't. One barrel of oil of a given grade is the same as another, so every producer receives the market price, and that price can move a long way in a short time. The usual signs of quality, such as brand and customer loyalty, hardly apply. What matters is cost, reserves, and how the company behaves through the cycle. The examples here use oil, and the same reasoning carries over to natural gas, metals, and other commodities.

Price takers and operating leverage

Most of a producer's costs don't fall when the price does. Wells still have to be run, and the money spent finding and developing them is already gone.

Company E produces 10 million barrels a year	Oil at $70	Oil at $50
Revenue, $ millions	700	500
Cost of running the wells, $30 a barrel	(300)	(300)
Depletion, $15 a barrel	(150)	(150)
Profit before tax	250	50

The price fell 29%. Profit fell 80%. That's operating leverage, and it works in both directions: the same move upward would lift profit just as sharply. A producer's earnings in any one year say more about the price that year than about the company.

This is why cost per unit is the first thing to compare. A producer whose total cost is $45 a barrel survives at a price that bankrupts one whose cost is $60. In a commodity business, being the low-cost producer is the main lasting advantage, as Competitive Advantages described for cost leaders generally.

Reserves

A producer's main asset is what it has left to sell, and the balance sheet doesn't show its value. The figures are in the reserves disclosures in its annual report.

Under SEC rules, proved reserves are quantities that can be estimated with reasonable certainty to be economically producible under existing conditions. The price used to decide what's economic is the unweighted average of the first-day-of-the-month prices over the preceding twelve months. Probable reserves are less certain to be recovered than proved reserves, and possible reserves less certain again.¹

Two things follow from that definition:

• Reserves are estimates. They rest on geology and engineering judgment, and they're revised every year.
• Reserves depend on price. Oil that's profitable to extract at $70 may not be at $50. When prices fall, some barrels stop counting as proved, and reported reserves shrink although nothing underground has changed.

	Amount
Proved reserves at the start of the year	122 million barrels
Produced during the year	(10 million)
Added through discoveries, development, and revisions	8 million
Proved reserves at the end of the year	120 million barrels
Reserve life (120 ÷ 10)	12 years
Reserve replacement (8 ÷ 10)	80%
Spent on finding and developing reserves	$240 million
Cost per barrel added ($240 million ÷ 8 million)	$30

Company E has twelve years of production left at the current rate. It replaced only 80% of what it produced, so it's slowly shrinking. And each barrel it added cost $30 to find and develop, twice the $15 a barrel of depletion it's charging for the barrels it sold.

Three measures come out of that table:

• Reserve life is proved reserves divided by yearly production. A short life means the company must keep finding more just to stand still.
• Reserve replacement is reserves added divided by production. Below 100% for several years means the company is liquidating itself, whatever its profits say.
• Finding and development cost is what was spent divided by the reserves added. It's best averaged over three to five years, because discoveries are uneven. It shows what it costs today to replace a barrel, which is the true long-run cost of staying in business.

The rest of this lesson is for members

Still to come in this lesson: Depletion, Two accounting methods, Hedging and debt, What to check, the key takeaways, and 2 quiz questions with explanations.

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