Lesson 5 of 7
Energy and commodity producers
A commodity producer earns the price minus its cost per unit, a gap read at a mid-cycle price rather than at whatever the price happens to be today.
By Javier Sanz
Founder of ValueScreener. Built Ninety Nine, a securities services provider, and sold it to a tier-one global bank; ran operations and internationalization at Alpaca, the brokerage API.
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In one minute
- A commodity producer does not set the price it sells at, so its margin is the price minus its own cost per unit, and that gap can collapse fast.
- Reserves reported under SEC rules are an estimate, priced at the average of the past twelve months' first-of-month prices, so they move when that average moves.
- A commodity producer is valued at a mid-cycle price, not at whatever the commodity happens to cost the day the valuation is done.
A commodity producer sells into a price it has almost no power over, so what separates a good year from a bad one is its own cost per unit against whatever that price happens to be. The gap between the two, not the revenue line, is the business.
Cash cost per unit against the commodity price
- Producer A · lowest cost$30
- Producer B$45
- Producer C$60
- Producer D · thinnest margin$68
Commodity price: $70
The producer does not set the price
Four producers selling the identical commodity at the identical price earn four different margins, because the only thing that differs between them is cost. Producer A above earns 40 against a price of 70; producer D earns 2. A fall in price hurts every producer, but it does not hurt them equally: the highest-cost producer's margin disappears first, and its output is usually the first to be shut in, which is part of what eventually stabilises the price. In practice realised prices also differ by grade, location and hedging, so check the realised price a producer actually received, not only the benchmark.
Reserves are an estimate, priced once a year
A producer's reserves, the volumes it reports as economically recoverable, are not a physical fact alone. Regulation S-X Rule 4-10 sets the definitions for proved reserves, and ASC 932 requires the standardized measure: those reserves valued at that twelve-month average price and discounted at 10 percent. When the average falls, the same underground volume can drop out of proved reserves with nothing about the rock having changed. A reserve figure is read together with the price it was calculated at, never on its own.
Operating margin across US energy companies
- 10th percentile: −21.41%
- 25th percentile: −0.93%
- median: 10.31%
- 75th percentile: 24.58%
- 90th percentile: 37.48%
Cost curve, not multiple
Ranking producers by their position on the industry cost curve, lowest cash cost to highest, says more about which ones survive a downturn than any multiple does. A low-cost producer earns a margin at prices that put its higher-cost competitors out of business, which is the closest thing this industry has to a durable advantage: not a brand or a patent, but a geological or operational cost position rivals cannot copy.
Do it on a real 10-K
- Open the unaudited supplemental oil and gas note and read the reserve quantities and the standardized measure.
- Follow the reconciliation of the standardized measure from last year to this year, and find the line for revisions of previous estimates.
- Compare the average of the first-of-month prices used in the note with the spot price on the day you are reading it.
Value at mid-cycle
Marks describes the discipline of knowing roughly where we stand in a cycle rather than assuming today's conditions are permanent. A commodity producer valued on this year's price alone is valued on a number that has, across most commodities' history, moved by large amounts in both directions within a few years. The correction is to use an average price across a full cycle, not the peak or the trough, the same normalising idea applied to any cyclical business's earnings.
Check yourself
Two commodity producers sell at the identical market price. What separates their profitability?
- Their marketing budgets
- Their cost per unit produced
- The size of their reserves alone
Show the answer
Answer: B.
Neither producer sets the price, so the only lever left is cost. The lower-cost producer earns a larger margin at the identical price.A producer's cash cost is 45. Its margin at a price of 70 is 25. What is its margin at a price of 50, and by what percentage did the margin fall?
- 15, a fall of 40 percent
- 5, a fall of 80 percent
- 25, unchanged
Show the answer
Answer: B.
50 minus 45 is 5. The margin fell from 25 to 5, an 80 percent decline, far larger than the roughly 29 percent fall in the price itself.Why does a reserve figure change even when nothing underground has changed?
- Reserves are re-measured only once a decade
- Proved reserves are priced at a trailing twelve-month average price, so a price move alone can change what counts as economically recoverable
- Reserves are a management estimate with no regulatory standard
Show the answer
Answer: B.
ASC 932's standardized measure prices reserves at the average of the first-day-of-month prices over the trailing twelve months, so the same physical volume can be booked or written down purely because that average moved.Sources
- Regulation S-X Rule 4-10, oil and gas reserves definitions, modernized 2008.
- ASC 932, Extractive Activities, Oil and Gas: the standardized measure, discounted at 10 percent.
- Marks, Mastering the Market Cycle, 2018: cycles, and knowing where we stand in one.
What this leaves out
- Cash cost per unit leaves out the capital spending needed to hold production flat, which can be larger than the cash operating cost shown here.
- The standardized measure uses a 10 percent discount rate fixed by rule, not the company's cost of capital, and its cost and tax assumptions are the company's own.
- The bar chart and worked example use round invented numbers so the arithmetic can be checked by hand.
- Nothing here is advice about any security.