An empirical study on the valuation of oil companies

• Author: Sujit K Sukumaran,Rajesh Kumar Bhaskaran
• DOI: http://doi.org/10.1111/opec.12064
• Date: 01 March 2016
• Published date: 01 March 2016

An empirical study on valuation of

oil companies

Rajesh Kumar Bhaskaran* and Sujit K Sukumaran**

*Professor, Institute of Management Technology,Dubai International Academic City, UG-02, P O Box:

345006, UAE. Email: rajesh@imtdubai.ac.ae

**Associate Professor, Economics Area, Institute of Management Technology,Dubai, UAE. Email:

sujit@imtdubai.ac.ae

Abstract

This study examines the determinants of value creation for the world’slargest oil and gas companies.

The study was based on 82 oil companies. The financial performance analysis for the period 2009–

2013 reveals that the average total revenues increased from $39.82 billion in year 2009 to $68.87

billion in year 2013. The largest oil firms in terms of average revenues were Exxon Mobil, Royal

Dutch Shell and Sinopec during the period 2009–2013. Three major market value variables were

regressed on various independent variablesrepresenting performance, the financing, investment and

dividend policy variablesof oil firms. The empirical analysis finds that dividend policy and cost effi-

ciency are important determinants of valuation of oil companies.The higher the liquidity position of

the energy firms, the higher is the value creation in the market. The study establishesnegative rela-

tionship between capital intensity and value creation. It can be viewedthat market is sceptical about

high capital expenditures by oil and gas firms. Higher cash flows result in increase in value for oil

firms in stock market. Higher working capital efficiencyleads to higher value creation. Undervalued

stocks in the oil sector tends to have higher potential for valueappreciation. Focus on effective asset

utilisation is a value increasing activity for oil and gas sector firms.

1. Introduction

The fundamental determinants of the value of oil and gas sector companies are its

reserves, level of production and commodity price at the time of valuation. All these

factors potentially impact the equity value of the firm. Oil and gas companies differ in the

context of the size of their reserves, earnings, growth potential, ownership, corporate and

financial structure, degree of integration, and property portfolio. It has to be emphasised

that the primary value of any companydepends on its cash flow and earnings which in turn

depends on the quantity and quality of the product and the sales price. Net asset value is a

major valuation metric used to evaluate oil and gas companies.

Production is an important measure of performance as it determines gross revenue. Pro-

duction is derivedfrom reserves and the inventory of capital assets. The primary assets of an

oil companyare its oil and gas reserves, that is, hydrocarbons below the surface that have not

©2016 Organization of the Petroleum Exporting Countries. Published by John Wiley & Sons Ltd, 9600 Garsington

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91

the

yet been produced and are economically viable to extract. One of the unique

features of the industry is its depleting asset base, which needs to be replaced through drill-

ing and acquisition. Provedreserves are estimated quantities of oil and gas that are expected

to be economically producibleas of a given date by application of development projects.

Basically the value of a companyis deter mined bythe cash flow, growth and risk char-

acteristics.Value creation for a firm is a function of identifying and managing value drivers

that have the greatest impact on value creation. Value drivers can be classified as growth

drivers, efficiency drivers and financial drivers. Value driver analysis is an important tool

in strategic planning analysis. Organisations that create long-term value in terms of share-

holder wealth are expected to create value for all stakeholders. From the shareholders’

point of view,the wealth created by a company through its actions is reflected in the market

value of the company’s shares. Profitability and growth are basically considered as the

major determinants of firm value. The ability of a firm to create value by distributing cash

flows to its stakeholders depend on its ability for cash generation from its operating activ-

ities and access of additional funds through external financing. The two basic sources of

external financing are debt and equity financing. A company’s ability to borrow today is

based on projections of its future cash flow generation.

The shareholder returns basically depend on prices, costs, investments, volume of

products sold and riskiness of firms in an industry.The variables representing these factors

can be considered as determinants of shareholder value. Working capital and fixed capital

investment are the twocomponents of investment value drivers.

Management’s investment choices and financial policy are also value drivers in the

context of riskiness of cash flows for the company. Scale economies for firms in purchas-

ing, manufacturing, distribution and research can generate value drivers in operating

margin, working capital investment and fixed capital investment. The link between value

chains and value drivers as reflected bysales g rowthrate, operating profit margin, income

tax rate, working capital investment, fixedcapital investment and cost of capital are basic

building blocks of shareholder value creation.

Financial risk arises for shareholders on account of the increased leverage due to addi-

tional debt in the capital structure. The financial leverageincreases would lead to increased

variability of cash flowsas fixed interest payment is bound to increase. Hence shareholders

expect higher returns for highly leveraged firms.

The most important performance indicator among international oil and gas firms had

been the Return on Capital Employed (ROCE). It is an important measure used by stock

market analysts in oil and gas sector.The flaw is that ROCE is hyped during the periods of

disinvestment. Cash flows are positively related to the valuation of oil and gas firms. The

high volatility of oil markets would result in oil producers searching for new ways to

decrease costs for the purpose for increasing margins. In the context of low oil prices,

firms with low gross margins faces much difficulties. Firms with higher gross margins will

OPEC Energy Review March 2016 ©2016 Organization of the Petroleum Exporting Countries

92 Rajesh Kumar Bhaskaran and Sujit K Sukumaran