Sometimes I do stupid things and this weekend, I’m going to say that getting into a Twitter debate about CDEV, SMOG and whether or not shale is a viable business falls into the category of stupid. If I closed my eyes and imagined what it must be like to be a politician on the opposite side of the aisle debating someone, I think the conversation I had would be a close proxy. I should know better, but if you are a frequent reader of the hottakes or have read the book, you know the only fights I back away from are at football stadiums.

So, in today’s post and ahead of the Q4 and YE2019 reporting that will be happening in February, I want to do a deeper dive into SMOG. I get a lot of questions on this topic and I don’t think it’s well understood, in part, because it doesn’t make most E&P equities attractive to buy. Before we do, let’s review what SMOG (the standardized measure of oil and gas) actually is. Here is a good overview.

https://www.stout.com/en/insights/article/understanding-sec-oil-and-gas-reserve-reporting/

Unlike in any other industry (maybe with the exception of pharmaceuticals which will be the subject of another post), in oil and gas we have the ability to value our asset directly. We don’t depend on customer preferences, brand management or advertising revenue. We lease rock; that rock allows us to drill wells that produce oil and natural gas; those well’s performance are able to be predicted based on the offsets; and we can calculate a discrete value. Of course, assumptions matter- like the price deck, but the SEC mandates that calculation (which is the arithmetic average of price on the first day of each month. Full stop). Also, a PUD may not be on the books for longer than 5 years. For LOE and capex in the calculation, 3rd party reserve auditors are provided the company financial statements. Is there massaging of “one off charges”? Sure. But that’s pretty direct input and validation of the company’s assumptions, don’t you think? And importantly, every company that is publicly traded has to do it.

So, while I don’t try to do specific company examples, in this case because Jagged Peak closed their sale to Parsley Energy on Friday, they are a good place to start to demonstrate the discussion in practice.

JAG’s SMOG at YE2018 was $1.543 billion. Their long term debt at Q3 2019 was $705.269 million. They have 213 million shares outstanding. This means their SMOG less debt divided by share count is $3.93/share, which means that they traded at 209% of their SMOG. I’m not saying that’s good, bad or indifferent. I’m just reporting the math. Is everybody with me? (also, in case you are curious, Parsley trades at 155% of their SMOG).

CDEV, the object of the heated debate over the weekend, and one of the three companies I mentioned on Bloomberg last week (and a company I am personally long) had a YE2018 SMOG of $2.48 billion, debt of $1 billion, 280 million outstanding shares and meaning a SMOG valuation of $5.28/share. On Friday, they closed at $4.42 so trade at 84% of their SMOG. So on one hand, I have one company that sold at 209% of it’s SMOG and on the other, a company that trades at 84%. It’s not the only thing I look at, but it makes me focus on the winners (and the losers).

So to me, if I believe US oil production in declining (I do) and that that puts a floor on oil price (I do) and I believe that consolidation MUST occur to gain efficiencies through G&A reductions (I do) and I believe that the major reserve auditors do a good job so I can count on the reserves to be in the range of the ultimate outcome (I do) THEN if I am going to own an E&P company, I should own ones that look relatively cheap (I do).

You don’t have to agree with me. You can point out all the reasons why this approach is wrong and how you can model company performance and development plans yourself in the greatest Excel model ever built and that you have done it for all the company’s in the U.S and that is why you own or are short, or avoid the sector entirely. The most succinct description I’ve had from an “anti-SMOG-er” is that “I’ve experienced first hand the dishonest of many pubcos, it’s part of the culture and it comes from the top. To say that all execs are unethical isn’t fair, but I’d wager it’s 60/40 bad to good.” Which is a long way of saying “I don’t believe their SEC numbers.” If that’s your view, I can’t argue.

But for me, and I think I’m a pretty good reservoir engineer, I couldn’t build that model for every company and I know I don’t have insight into their development plans so I use SMOG. Moreover, I think that even though management teams do really stupid things, I don’t believe they are fraudulent. Call me an optimist…