Learn Oil and Gas Modeling: A Comprehensive Guide to Industry-Specific Financial Skills

Oil and gas industry

When it comes to specialized financial modeling courses, Oil & Gas Financial Modeling consistently stands out as a topic of significant interest. Initially, this might seem unexpected. However, delving into the intricacies of the oil and gas sector reveals a compelling reason for its popularity: the financial modeling techniques employed for oil and gas companies are remarkably versatile and applicable beyond this specific industry.

While the most apparent crossover is mining, the underlying principles extend to any business heavily influenced by commodity prices. Unlike sectors such as banking or insurance, which demand entirely distinct modeling approaches, oil and gas modeling builds upon a foundational understanding of general financial modeling, adapting it to the unique characteristics of the energy sector.

Comprehensive Oil & Gas Modeling Training for Finance Professionals

This article serves as an overview, derived from the comprehensive financial modeling courses available at Breaking Into Wall Street. We previously offered an Oil & Gas Modeling course which, due to popular demand, has been reinstated.

For those seeking in-depth knowledge, our Oil & Gas Modeling course is currently available at a substantial discount of approximately 60%.

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This course represents our earlier curriculum, hence the discounted price. We are committed to developing an updated version with contemporary case studies in the future. However, this current offering provides a robust foundation in oil and gas modeling principles.

Understanding the Oil and Gas Industry Business Model

The oil and gas industry, along with mining and other natural resource sectors, operates on a straightforward business premise: discover and extract valuable resources from the earth, process them into usable products, and market them to consumers.

However, a closer examination reveals inherent complexities:

Strategic Focus: Where should the primary focus lie? Is it on exploration and extraction, refining and processing, or distribution and sales? Or is it a holistic approach encompassing all stages?
Price Determination: Unlike manufacturers of software, consumer goods, or apparel who have pricing flexibility, companies dealing in commodities like oil, gas, and gold are price takers. Market forces dictate commodity prices, not individual producers.

Let’s initially address the first point and examine the industry’s segmentation:

Upstream Companies (Exploration & Production – E&P): These companies are dedicated to locating and extracting raw materials and resources from the earth.
Midstream Companies: Their core function is the transportation of oil, gas, and other commodities to downstream operators. This primarily involves extensive pipeline networks.
Downstream Companies (Refining & Marketing – R&M): These entities refine and market raw commodities, transforming them into consumer-ready products such as jet fuel, gasoline, diesel, and various petrochemicals.
Oil Field Services: These companies provide specialized services to upstream, midstream, and downstream operators, including field maintenance, infrastructure repair, technological upgrades, and security services.
Integrated Majors: Companies like BP and ExxonMobil represent integrated majors, participating across the entire value chain, from upstream exploration to downstream retail, albeit with varying degrees of emphasis on each segment. A common strategy is to concentrate on upstream and downstream operations while outsourcing midstream and service functions.

Key Differences in Oil & Gas Financial Modeling

For this guide, we will primarily concentrate on Upstream (E&P) companies. These are the most distinctive in terms of financial modeling compared to conventional businesses and are frequently encountered in finance interviews. We will also touch upon diversified, integrated majors like Exxon Mobil, as their analysis provides valuable insights into the broader industry segments.

So, what distinguishes oil and gas financial modeling?

Price and Revenue Volatility: This is the fundamental differentiator that cascades into numerous other modeling variations. Commodity price fluctuations directly and significantly impact revenue predictability.
Balance Sheet Importance: Similar to financial institutions like banks and insurance companies, E&P firms are heavily reliant on their balance sheets. The balance sheet’s primary asset is reserves, which represent future revenue and profitability potential.
Unique Accounting Practices: Oil and gas accounting employs specific line items and distinct methodologies: full cost accounting and successful efforts accounting.
Depleting Asset Base: Unlike typical companies where assets generally appreciate or remain stable, oil and gas companies experience asset depletion. As production increases and revenue is generated, reserves diminish, a crucial factor in asset valuation and forecasting.
Cyclical Market Dynamics: Oil and gas companies are inherently susceptible to commodity price cycles. Investing in energy or mining equities is akin to investing in the underlying commodities themselves, necessitating comfort with substantial price volatility.

The positive aspect is that, unlike financial services, oil and gas companies still deal with tangible products, making their financial models more relatable to standard corporate finance models.

Projecting Revenue and Expenses in Oil & Gas Financial Statements

Prior to projecting financial statements for an energy company, understanding industry-specific units of measurement is essential.

Crude oil is measured in Barrels (1 Barrel = 42 US Gallons), a unit retained even in metric-system countries. Natural gas is quantified in Cubic Feet, also consistently used globally. Mining operations utilize appropriate units: tonnes for iron ore, coal, aluminum, copper, lead, zinc, nickel, manganese, uranium; carats for diamonds; and ounces for gold and silver.

Company reserves (quantifying available resources) and production (extraction and sales volume) are measured using these units.

Financial projections for natural resource companies commence with segment-specific production forecasts, derived from reserve estimates and historical production trends.

Consider a company with 12,000 billion cubic feet (12,000 Bcf) of natural gas reserves and an annual production of 500 billion cubic feet (500 Bcf). Future production might be projected with a modest increase, especially if the company invests in exploration and new resource development.

For instance, projections could assume 550 Bcf production next year and 600 Bcf the following year. These figures should be validated against equity research and reserve levels to ensure realistic depletion rates (avoiding assumptions of 100% reserve depletion within a short timeframe). Production volumes are then subtracted from total reserves, ideally offset by reserve replacement through capital expenditures on exploration and development.

Revenue forecasting is more complex due to price volatility.

The solution lies in utilizing scenario analysis in financial models.

Developing “low,” “mid,” and “high” price scenarios (e.g., $40, $70, and $100 per barrel of oil) allows for evaluating a range of potential financial outcomes based on commodity price fluctuations.

Further refinements include incorporating hedging strategies and acknowledging that realized prices are typically below benchmark market prices due to transportation, marketing, and sales commissions.

Expense projections are multi-faceted. They are categorized into production-linked expenses (estimated on a per-unit basis) and non-production-linked expenses (fixed or semi-variable costs).

Production-linked expenses are typically estimated on a dollar per barrel of oil or per cubic foot of gas basis. Non-production-linked costs, such as stock-based compensation and administrative overhead, are often projected as a percentage of revenue or other relevant metrics. Analyzing historical financial filings helps discern cost behavior and inform projection methodologies.

For a practical illustration of these projection techniques, view this sample lesson from our Oil & Gas Modeling course on Price Hedging and Revenue by Segment.

Income Statement Structure for Energy Companies

Energy company income statements deviate from the standard Cost of Goods Sold/Gross Profit and Operating Expense format common in other sectors.

Instead, they are structured around Revenue, Operating Expenses, and Other Income/Expenses. Typical line items include:

Revenue: Often segmented by Upstream, Midstream, and Downstream activities. Upstream revenue is further categorized by energy commodities: Gas & Natural Gas Liquids, Crude Oil, and Miscellaneous.
Expenses:
- Production Expenses: Costs directly associated with resource extraction.
- Taxes, Transportation & Other: Levies and logistical costs.
- Exploration Expenses: Costs incurred in discovering new resources.
- Depreciation, Depletion, and Amortization (DD&A): Encompasses standard depreciation and amortization plus depletion, reflecting the consumption of reserves.
- Selling, General & Administrative (SG&A): Overhead and administrative costs.
- Derivative Fair Value Gain / (Loss): Gains or losses from hedging activities.
- Accretion of Discount in the Asset Retirement Obligation (ARO): The increase in the present value of future decommissioning costs.
Other Income / (Expenses): Includes interest income/expense, investment gains/losses, and gains/losses on asset disposals, partnerships, and royalty trusts.

The overall presentation mirrors standard income statements: Revenue less Expenses equals Operating Income; Operating Income plus Other Income/Expenses equals Pre-Tax Income; and Pre-Tax Income multiplied by (1 – Tax Rate) equals Net Income.

A notable characteristic of oil and gas company income statements is substantial deferred income taxes. Often, 75% or more of income tax expense is deferred, representing non-cash tax charges in the current period. This arises from significant depreciation, depletion, and amortization (DD&A) and differences in book and tax accounting treatments. Deferred taxes are a crucial consideration in cash flow statement analysis.

Balance Sheet Peculiarities in Oil & Gas

Shareholders’ Equity in oil and gas companies is largely consistent with standard corporate balance sheets.

Assets and Liabilities are categorized into Current and Long-Term classifications, with industry-specific line items.

E&P companies may present Property, Plant, and Equipment (PP&E) separately, detailing reserve classifications (Proved, Unproved, and Other, reflecting reserve certainty).

Current Assets: Cash & Cash Equivalents, Accounts Receivable, Inventories, Derivative Fair Value (hedging instruments), Income Tax Receivables/Deferred Tax Benefits, and Other Current Assets.
Long-Term Assets: Investments, PP&E (Proved, Unproved, Other, and Accumulated DD&A), Goodwill & Other Intangibles, and Other Long-Term Assets.

On the Liabilities side:

Current Liabilities: Accounts Payable, Current Portion of Debt, Derivative Fair Value (hedging), Deferred Income Taxes, and Other Current Liabilities.
Long-Term Liabilities: Long-Term Debt, Pension Benefits, Deferred Income Taxes, Asset Retirement Obligation (ARO), and Other Long-Term Liabilities.

While many items are familiar, key industry-specific balance sheet accounts warrant attention:

Derivative Fair Value: Can appear across all balance sheet classifications (current/long-term assets/liabilities). Energy companies utilize hedging to mitigate commodity price risk. Derivatives are contracts that guarantee prices, such as “Even if oil prices fall to $50 per barrel, I can still sell oil at $60 per barrel.” Asset-side derivatives represent long positions, liability-side derivatives are short positions.
PP&E: While common, oil and gas PP&E is often segmented by reserve categories: Proved Reserves (90%+ probability of recovery), Probable Reserves (50%-90% probability), and Possible Reserves (<50% probability). Accumulated Depreciation, Depletion & Amortization is a significant contra-asset reducing Gross PP&E to Net PP&E.
Asset Retirement Obligation (ARO): Decommissioning oil and gas wells and fields incurs substantial costs. ARO represents the present value of these future closure costs, increasing over time as new wells and fields are developed (reflected in the accretion of the asset retirement obligation discount on the income statement).

Cash Flow Statement Nuances

Oil and gas cash flow statements largely resemble standard formats: starting with net income, adding back non-cash charges, adjusting for working capital changes, and then detailing investing and financing activities.

Differences primarily lie in the magnitude and frequency of certain items:

Depreciation, Depletion & Amortization (DD&A): Extremely high for oil and gas companies, often exceeding net income.
Other Non-Cash Expenses: In addition to standard non-cash items, includes ARO accretion, gains/losses on asset, partnership, and royalty sales, and potentially dry hole expense (related to unsuccessful exploration under Successful Efforts accounting).
Investing Activities: Capital Expenditures (CapEx) are substantial for natural resource companies, often exceeding net income. Asset sales are also frequent, as companies actively acquire and divest assets.
Financing Activities: Due to large capital requirements and commodity price volatility, oil and gas companies exhibit significant financing activity. Large debt issuances and repayments, along with potential equity financing, are common.

Interconnectedness of Financial Statements in Oil & Gas

The financial statements are intrinsically linked:

Production and Revenue Projections: Begin by projecting annual production by commodity, then create low, mid, and high price scenarios to model revenue under different price environments.
Expense Forecasting: Project expenses as either production-linked (Production, Taxes, Transportation, DD&A) or non-production-linked (Stock-Based Compensation, Derivative Gains/(Losses)).
Cash Flow Statement Construction: Start with net income, incorporate non-cash charges (primarily from the income statement), and ensure working capital changes align with balance sheet projections.
CapEx and Reserve Management: Link CapEx to production and translate dollar investments back to resource units (Barrels, Cubic Feet, Tonnes, Ounces) to track Reserves. Decrease reserves by production, increase by discoveries and acquisitions, and decrease by reserve sales.
Debt and Equity Financing: Model financing activities using a debt schedule. While simplifying assumptions are possible, energy companies typically require consistent capital raising, necessitating realistic financing estimations.
Balance Sheet Population: Most balance sheet items are derived from the cash flow statement or linked to income statement accounts (e.g., accounts receivable to revenue). Some items (Goodwill) may be held constant or simplified.

To illustrate real-world financial statements, examine XTO Energy’s statements prior to its acquisition by Exxon Mobil.

For diversified oil and gas companies, financial statements reflect the broader scope of operations, including midstream and downstream activities. Examine Exxon Mobil’s financial statements for a comprehensive example.

Successful Efforts vs. Full Cost Accounting

Accounting for exploration costs distinguishes oil and gas companies. While acquisition and development costs are always capitalized, and production costs are expensed, exploration costs have two accounting treatments:

Successful Efforts Accounting: Only exploration costs directly leading to commercially viable discoveries are capitalized. Costs of unsuccessful exploration are expensed.
Full Cost Accounting: All exploration costs, both successful and unsuccessful, are capitalized as PP&E.

Successful efforts is generally mandated under IFRS and favored by larger companies able to absorb the immediate earnings impact of expensing unsuccessful exploration. Full cost is more common among smaller companies seeking to present higher earnings. Full cost accounting necessitates periodic impairment testing of capitalized exploration costs, potentially leading to write-downs if book values exceed market values.

The “dry hole expense” mentioned earlier represents unsuccessful exploration costs expensed under successful efforts accounting.

Oil & Gas Modeling for Valuation Purposes

Standard valuation methodologies – public comparables, precedent transactions, and Discounted Cash Flow (DCF) – are applicable to oil and gas companies. However, industry-specific metrics and multiples are employed:

Limited Use of P/E and Revenue Multiples: P/E ratios are less reliable due to tax complexities, high depreciation, and potential impairment charges. Revenue multiples are less relevant due to commodity price-driven revenue volatility.
EBITDAX Metric: EBITDAX (Earnings Before Interest, Taxes, Depreciation, Amortization, and Exploration Expense) is used instead of EBITDA for E&P companies to normalize for accounting method variations in exploration expense (successful efforts vs. full cost). EBITDA may be used for diversified or non-E&P companies.
Production and Reserves Multiples: Valuation multiples based on Proved Reserves and Daily/Annual Production are common, reflecting the asset-centric nature of oil and gas companies. Enterprise Value is the numerator, and multiples range based on company specifics and market conditions.
Industry-Specific Screening Metrics: Beyond revenue and EBITDA, screening metrics include Proved Reserves, Production volume, R/P Ratio (Reserves-to-Production), % Proved Reserves, and % Oil Mix.

While valuation mechanics remain similar, metric selection and interpretation differ.

DCF analysis is applicable, but traditional Unlevered Free Cash Flow DCFs have limitations:

High Capital Expenditures: CapEx heavy nature can depress Free Cash Flow, overemphasizing Terminal Value.
Perpetual Growth Assumption: Assuming perpetual growth for depleting resource companies is questionable.

DCFs are more suitable for midstream, downstream, and oilfield services companies.

For E&P valuation, the Net Asset Value (NAV) model offers a more relevant intrinsic valuation approach.

Net Asset Value (NAV) Model Explained

The NAV model contrasts with DCF by abandoning perpetual growth assumptions. It projects company value based on existing reserves and production until depletion.

NAV Model Steps:

Commodity, Revenue, Expense, and Cash Flow Tracking: Create columns to track reserves, production, and prices for each commodity, projecting revenue, expenses, and cash flows.
Production Decline and Revenue Projection: Apply production decline rates (e.g., 5-10% annually based on historical trends). Project production and revenue until reserves are exhausted, using the lower of projected production or remaining reserves.
Expense Projection (Limited Scope): Focus on Production and Development expenses linked to production. Exclude Exploration and corporate overhead for asset-level valuation.
Discounted After-Tax Cash Flows: Calculate annual after-tax cash flows (Revenue – Expenses) * (1 – Tax Rate). Discount cash flows using a standard 10% discount rate (common in oil & gas, not WACC).
Incorporate Other Assets and Segments: Add value from undeveloped land or midstream/downstream operations using EBITDA multiples or per-acre valuations. Sum values to derive Enterprise Value, then Equity Value, and Implied Share Price.

The NAV model is widely used in commodity-based sectors, offering a resource-centric valuation perspective.

For a practical NAV model example, view this sample video on setting up the revenue side of an NAV analysis for XTO Energy.

Sum of the Parts Valuation

Sum of the parts valuation is prevalent in the energy industry, particularly for diversified companies like ExxonMobil. It involves valuing individual business segments (upstream, midstream, downstream) separately and aggregating values.

Segment valuation can employ different methods: EBITDA multiples for midstream/downstream, and Proved Reserves or Production multiples or NAV for upstream.

Oil & Gas M&A and LBO Modeling Considerations

Merger models in oil and gas largely follow standard M&A modeling principles. Key industry-specific considerations include:

Purchase Method: Stock acquisitions are frequent due to high leverage and limited cash reserves in oil and gas.
Commodity Price Alignment: Ensure consistent commodity price assumptions for both acquirer and target to avoid misleading deal economics.
Limited Revenue Synergies: Revenue synergies are unlikely due to commodity price dependence. Expense synergies may arise from production cost reductions.
Accounting Standardization: Normalize accounting methods (successful efforts vs. full cost) if acquirer and target use different standards.
Commodity Price Sensitivity: Include commodity price sensitivities in deal analysis due to their significant impact on deal viability.

Contribution analysis or accretion/dilution calculations can be based on non-financial metrics like Production Per Share or Proved Reserves Per Share, especially for stock deals.

LBO models for oil and gas are also largely standard, with commodity price sensitivity being critical. However, oil and gas LBOs are rare due to:

Volatile Cash Flows: Commodity price swings create unpredictable cash flows.
High CapEx Requirements: Large CapEx burdens debt repayment capacity.
Existing High Leverage: Limited capacity for additional LBO debt.

While some PE firms specialize in energy, they typically focus on less volatile segments like utilities and power generation rather than E&P.

Mastering Oil & Gas Modeling

Oil and gas financial modeling presents unique challenges and nuances. The core differentiators are commodity price volatility and depleting assets. Understanding these aspects, along with industry-specific accounting and valuation methodologies like NAV, is crucial for success in energy finance.

Further Learning Resources

This article is a concise overview of key concepts from our comprehensive financial modeling courses at Breaking Into Wall Street.

For deeper learning, enroll in our Oil & Gas Modeling course at a ~60% discount.

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