Sunday, 12 June 2016

The Economics of An Oil Exploration & Production Company

Last week, I mentioned that the Exploration & Production (E&P) spending budgets of oil majors hold the key to the recovery of most Oil & Gas (O&G) companies. Moreover, E&P companies are the most direct beneficiaries of the recent recovery in oil price among all O&G companies. This week, we will explore the economics of a small E&P company listed on Singapore Exchange -- Interra Resources. Interra was chosen for this analysis as it has a detailed breakdown of its Profit & Loss (P&L) statement.

Interra is involved in the exploration and production of oil in several oil fields in Myanmar and Indonesia through production sharing contracts. For Financial Year 2015, Interra's sale of shareable oil was 0.64M barrels. It earned a revenue of USD23.5M from the sale of oil and petroleum products. The average selling price works out to be USD36.87 per barrel. The total cost of production was USD34.1M, which works out to an average cost of USD53.56 per barrel. Thus, for each barrel of oil sold in FY15, Interra lost USD16.69. For Interra to turn a profit, the price of oil must exceed USD53.56. The current price of Brent is around USD50. Assuming that the price of oil that Interra sells is similar to that of Brent (a big assumption), Interra would be close to turning a gross profit.

Besides the total cost of production, Interra also breaks down the cost into 2 components -- production expenses and amortisation of producing O&G properties. The first component represents the cost to extract oil from the oil fields while the second component represents the depletion of oil reserves, which could also be viewed as the depreciation of the historical cost of purchasing the production sharing rights. The first component is a cash item, while the second component is a non-cash item as the cash had already been paid upfront when purchasing the rights. For FY15, the 2 components were USD16.9M and USD17.2M respectively. On a per-barrel basis, they work out to be USD26.52 and USD27.03 respectively. In other words, even though Interra was making a loss when selling oil at an average price of USD36.87, it was recovering cash from each barrel of oil produced as the average selling price of USD36.87 exceeded the extraction cost of USD26.52. This is why Interra (and other oil producers) kept on producing oil even though it was making a loss. Only when the selling price drops below the marginal cost of production would it make sense to shut down production.

Interestingly, in FY15, Interra made an impairment loss of USD31.8M on its producing O&G properties and almost wiped out the entire item from its balance sheet. This means that moving forward, there is not much depletion/ depreciation cost to be accounted for in the P&L statement and the only cost is the extraction cost. In 1Q16, Interra turned a small gross profit of USD0.6M. The average selling price was USD22.29 while the average cost dropped to USD17.72, which was almost entirely made up of extraction cost only.

Even though oil production looks like a passive type of investment, it is not the case. Oil production drops over time. In FY15, Interra's share of oil production dropped by 19.5% compared to FY14. Thus, although Interra almost wiped out the entire value of producing O&G properties from its balance sheet, it needs to keep on exploring and drilling new oil wells to replenish the diminishing production from existing oil wells. Even as it made an impairment loss of USD31.8M on the existing oil wells and fields, it spent USD7.9M on exploring and drilling new oil wells. This cost is capitalised, which means that it does not show up as an expense in the current P&L statement but as an asset in the balance sheet. If oil is found from these new oil wells, this cost will need to be amortised in future sale of oil products.

Lastly, Interra had this to say about its strategy for surviving the current oil slump:
"Due to the falling oil prices, the Group has adopted an extremely cautions approach with its capital and operating expenditures. All significant capital expenditures have been suspended until the current oil price situation improves."
Interra is a very small E&P company which might not represent the views and actions of major E&P companies like the oil majors. However, if correct, its views and actions suggest that the downstream oilfield services and equipment companies (e.g. Offshore Support Vessel companies and shipyards) that support the E&P companies will have a difficult time navigating the oil slump.

P.S. I am vested in Interra Resources, KrisEnergy (both recently) and a host of other O&G companies.

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  1. TBI,

    nice post.
    i guess its easier for smaller EP coy to make decisions and maneuver thru the current climate, rather than the oil majors.

    btw, what made you decide to be vested in your mentioned coy? and not the support coy?

    also, would you hazard a guess as to when oil will recover? (yea ok, it hit a year high of 52+ last week, but i wouldnt really consider that as recovery.period.)

    betcha see Rolf Suey come in soon =)

    1. Hi foolish chameleon,

      Thks :) I took a small position in Interra because I am betting on oil price to rise. Being an E&P company, it will be a direct beneficiary of rising oil price. OSV companies, on the other hand, are still reeling from the effects of declining E&P spending budgets.

      My guess is oil price will trade sideways for quite some time, as there is a lot of oil in storage.

    2. interra is indeed one of the smaller E&P coys. but there are also Rex, linc, and a couple more i cant remember their name.

      the current situation in Fort Murray, and Nigeria seems to be knocking off 1+ MMBPD but apparently still not enough to reduce the massive glut.

      perhaps this winter, people will turn on their heater and burn out all the excess glut =)

    3. Linc has gone into voluntary administration. Another E&P company is KrisEnergy.

      You can refer to the Oil Market Report for the latest oil demand and supply situation. It will take some time to reduce the oil in storage.

  2. Hi Chin Wai,

    I did not go in depth into interra but I rem some yrs ago I read they are onshore producer. This is v diff from Kris energy which is offshore producer predominantly. Offshore producer has higher initial Capex but maybe more in qty n more sustainable oil over long periods.

    Anything u have to know is the quality of oil. Lower quality oil actually sell lower bcos it more expensive to process it later.

    I am invested in KrisEnergy but just small position n has lost big time now. These pple r experienced lot n my frd is dealing with them mainly in Thailand. Keppel is their owner...

    If I were to bet, I will choose E&P co over OSV!
    Oil price up, E&P sell more ex. Direct impact.

    OSV will be squeeze by E&P players in terms of contract price even if oil price increase n looming with oversupply vessels as well.

    1. Hi Rolf,

      Yes, KrisEnergy is a bigger player than Interra. They have more oil fields in both development and production phases and are more sustainable.

      I was reading some of the OSV companies' financial statements and I agree with you that they are still some way from bottoming out. E&P companies have brighter prospects!