The Trouble with Valuing Energy Companies
Pegging normal energy prices and shifting cost structures make these firms difficult to value accurately, says Morningstar International Manager of the Decade David Herro.
John Coumarianos: Another thing that jumps out about your portfolios, or that is noticeable, is the energy exposure. You've been light on it, I think, for most of the decade. And that hurt you a bit in '07, I believe, at least relative to your peers. Talk about how you view energy and how difficult it is to value energy companies.
David Herro: Well, energy is not something we naturally shy away from, but you kind of are getting at the point of it. They're very difficult to value accurately, because they're dependent upon the price movements of a commodity. So what we start off with is we try to estimate what is the normal price of the commodity when we're trying to price one of these businesses.
Coumarianos: Something like oil or natural gas.
Herro: Oil. We'll say it's 65 or 70 or 75. And we base that on what's kind of the marginal cost plus a profit. So just kind of using standard economic theory, what is the normal price, the belief is that if price goes well below it, as Microeconomics 100 tells you, capacity leaves, the high-cost production disappears, and prices drift back up. If price goes much above that equilibrium price, 65 or 70, say if it goes to 140, demand slows down, so the supply curve shifts to the right. That causes the price to drop.
So you have to come up with what you believe is a normal price. That's one thing.
Number two, then, is, when you're looking at a particular company, you have to look at their cost structure. And this cost structure is ever-so-changing. And sometimes, in fact, it moves with price.
And one of the perfect illustrations of this is Petrobras in Brazil. Because here's Petrobras, sitting on these huge, huge reserves of oil off their coast. The question is not how much oil is there. The real question is how much is it going to cost to get it to market. And this is also another big problem, whether it be the energy business or the mining, which is even worse. The cost of extraction and the difficulty of extraction, again, is very hard to price.
So what we'll do is we'll buy it when the underlying commodity price is cheap, the stocks are burnt out, and no one likes them, and the only things that could happen are good things, or the propensity for good things, as opposed to hoping for perfection in either the price of that commodity or the cost of extraction.
So they are a lot more difficult to value. That doesn't mean we ignore it. It just means that we have to almost layer in another risk premium as a result of that.
John Coumarianos does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.