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Oil, Gas & Mining Questions & Answers

We created this section of the interview guide because we kept getting questions
on what to expect when interviewing with specific industry groups.

This chapter deals with oil & gas companies and the associated energy groups at
banks. Mining is very similar (95% overlap) so we address that here as well.

Within oil & gas, we focus on the upstream, or Exploration & Production (E&P),
segment because it’s the most common one to receive questions on in interviews.

A couple points:

1. This is advanced material. You should not expect to receive all these
questions in entry-level interviews unless you have worked at a bank
before.

2. You will still get normal accounting, valuation, and modeling questions
even if you interview with specific industry groups – so don’t forget about
those.

3. I’ve divided this into “High-Level Questions” – good to know even for
entry-level interviews – and then advanced questions on specific topics
like accounting, valuation, and modeling that are more appropriate for
lateral interviews.

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Table of Contents:

Oil, Gas & Mining Questions & Answers .................................................................................. 1

High-Level Questions & Answers .......................................................................................... 3
Production and Reserves Questions & Answers .................................................................. 8
Accounting & 3-Statement Model Questions & Answers ................................................. 13
Valuation Questions & Answers ........................................................................................... 22
Merger Model and LBO Model Questions & Answers ..................................................... 30

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High-Level Questions & Answers

These are the most important questions to know for entry-level interviews with
energy and natural resource groups.

Even if you know more than the questions and answers here, you should
downplay your knowledge in interviews and set expectations low – otherwise
you open yourself up to obscure technical questions.

1. How are energy and natural resource companies different from normal
companies?

• They Can’t Control Revenue: More accurately, they can’t control the
prices they receive for their “products” (oil, gas, gold, etc.) and can
therefore only control the production side of revenue.
• Asset-Centric: All value for natural resource companies flows directly
from their assets – how much in reserves they have in the ground, how
much they can produce, and how much they can find to replace what
they’ve produced.
• Different Accounting: There are different accounting standards, more so
for oil & gas companies, and so you have to do extra work when modeling
companies and when using them in a valuation.
• Depleting Assets: When natural resource companies produce energy or
minerals, they also deplete the PP&E on their balance sheets – so they
have to spend a small fortune on finding or acquiring replacement assets.
• Cyclical: Prices for commodities such as oil and gold are cyclical and
therefore difficult to project – to get around this, you have to look at
longer time horizons and use price scenarios in models.

2. What are the different segments of the oil & gas and mining industries?

The major segments for oil & gas are upstream (also known as Exploration &
Production (E&P)), midstream, downstream (also known as Refining &
Marketing (R&M)), oil field services, and integrated majors.

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Most M&A activity takes place in the upstream segment because those
companies focus on finding and producing energy in the first place, which is the
biggest value driver in the industry.

Midstream companies store and transport energy via pipelines and land, sea,
and air transportation, and downstream companies turn energy into products
that are usable by the consumer, such as jet fuel or automobile gasoline.

Oil field service companies provide drilling, management, construction,

maintenance, and other services to energy producers.

Integrated majors (Exxon Mobil, BP, etc.) operate across multiple segments – so
they might have both upstream and downstream segments, for example.

On the mining side, companies are divided according to the minerals they extract
– gold, silver, iron, coal, and so on, or larger companies that produce many
different minerals.

3. Do these other segments outside of upstream still share the same differences
compared to normal companies?

No, not to the same extent. Everything is sensitive to commodity prices, but
other areas such as downstream, midstream, and oil field services are much
closer to “normal” companies because they are not as asset-dependent as
upstream companies.

For the integrated majors, normally you analyze each business segment
separately – so an upstream division would still have the same differences, but
the downstream and midstream divisions would not.

4. What are Production and Reserves and why are they so important for these
companies?

Reserves are how much a natural resource company has in the ground that
could potentially be extracted in the future. It’s important because everything in

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models flows from how much they have in the ground, and it’s one of the key
inputs for the Net Asset Value (NAV) model.

Production is how much the company is extracting and turning into energy or
minerals – usually it’s listed on a daily basis for energy companies and on an
annual basis for mining companies, though you see both methods used in filings.

Production is important because it’s the key driver for revenue and expenses in a
model: for normal companies you might make revenue growth or profit margin
assumptions, but for natural resource companies you make production growth,
commodity price, and per-unit expense projections instead.

5. How are the 3 financial statements different for a natural resource company?

• Income Statement: Revenue is split into categories such as gas, oil, and
downstream; COGS does not exist and all expenses are listed together;
common expenses are Production (similar to COGS for normal
companies), Taxes & Transportation, DD&A (Depletion, Depreciation &
Amortization), Accretion of Asset Retirement Obligation, G&A, Leases,
and Midstream / Downstream expenses.
• Balance Sheet: It’s almost exactly the same, but PP&E may be split into
Proved Properties and Unproved Properties; on the liabilities side, the
Asset Retirement Obligation is an industry-specific item that reflects the
cost of shutting down wells and mines in the future.
• Cash Flow Statement: Very similar, but you add back new and slightly
different non-cash expenses such as the Accretion of Asset Retirement
Obligation and the Non-Cash Derivative Losses; under Cash Flow from
Investing, you may project Asset Sales and Purchases since they’re
recurring items.

6. How would you value a natural resource company?

You still use public comps and precedent transactions, but:

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• You screen based on Proved Reserves or Production rather than the usual
Revenue and EBITDA criteria.
• You look at metrics like Proved Reserves, Production, EBITDAX, and the
Reserve Life Ratio instead of Revenue and EBITDA.
• You use valuation multiples such as EV / EBITDAX, EV / Proved
Reserves, and EV / Production instead.

You could still use a DCF, and for segments outside of E&P it’s quite common
because you can still project growth and cash flows.

For E&P, though, the Net Asset Value (NAV) model takes the place of the DCF.

You assume that a company produces resources until it literally runs out, and
then make assumptions for the realized prices, expenses, and taxes to calculate
after-tax cash flows; take the net present value of those and then add in the value
of other business segments and undeveloped acreage to calculate Enterprise
Value.

You use this methodology because a natural resource company’s value lies in its
assets rather than the company as a whole, and because “Free Cash Flow” as
defined in a DCF may be very low due to high CapEx.

7. What are common metrics and valuation multiples for energy and natural
resource companies?

• Proved Reserves: How much in minerals/energy the company can extract

with 90% certainty.
• Daily Production: How much in minerals/energy the company is
producing each day.
• Oil Mix %: The percentage of Production or Proved Reserves that are oil
rather than natural gas (you could make a similar calculation for mining
companies).
• R / P Ratio or Reserve Life Ratio: Proved Reserves / Annual Production,
in other words how many years until the company depletes its resources.

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• EBITDAX: EBITDA + Exploration Expense, needed to normalize different

accounting standards.
• EV / EBITDAX: How valuable is a company in relation to its approximate
normalized cash flow?
• EV / Proved Reserves: How valuable is each unit of a company’s Proved
Reserves?
• EV / Daily Production: How valuable is each unit of a company’s
Production?

You could also use Annual Production rather than Daily Production, but daily
metrics are more common for oil & gas companies.

Note that the last 2 multiples – EV / Proved Reserves and EV / Daily Production
– are in dollars per unit (or Euros, yen, RMB, or whatever the currency is) and
are not actual numbers. A “multiple” there does not mean 2.0 x, but rather $2.50
or $10.15 (for example).

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Production and Reserves Questions & Answers

These concepts are crucial if you want to build an in-depth model of an energy or
natural resource company, but they’re not likely to come up in interviews unless
you’ve had previous experience.

It may be a good idea to learn the basic types of reserves and the most common
metrics, but you don’t need to go crazy memorizing everything here unless you
find it fun.

1. How do we measure Production and Reserves?

For oil & gas it’s easy: everything is measured in barrels (1 barrel = 42 gallons) on
the oil, natural gas liquids, synthetic oil, and bitumen side and everything is
measured in thousand cubic feet for natural gas.

Yes, even in countries that use the metric system these units are still common
though you may see slight variations elsewhere.

For mining, the situation is more complicated because there are so many
different types of minerals – but common units are tons or tonnes (1 metric ton =
1,000 kg), ounces, and carats. Here’s a chart that summarizes the key units:

Resource Type Daily Production Annual Production &

Reserves
Oil, Natural Gas Thousands of Barrels Millions of Barrels (MMBbls)
Liquids, Synthetic Oil (MBbls) or Billions of Barrels (BBbls)
and Bitumen
Natural Gas Millions of Cubic Billions of Cubic Feet (Bcf) or
Feet (MMcf) Trillions of Cubic Feet (Tcf)
Iron Ore and Coal Thousand Tonnes Million Tonnes (Mt)
(kt)
Aluminum, Copper, Tonnes (t) Thousand Tonnes (kt)
Lead, Zinc, Nickel, and
Manganese

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Uranium Tonnes (t) Tonnes (t)

Diamond Carats Thousand Carats
Gold and Silver Ounces (oz) Thousand Ounces (koz) or
Million Ounces (moz)

Do not worry about the specifics for every single item – just understand the basic
units and how mining is different from energy.

2. How do you convert between different types of energy, such as oil, gas, and
natural gas liquids? Why do we need to convert units in the first place?

You convert based on how much energy a barrel of oil (or natural gas liquids, or
synthetic oil, and so on) produces and how much energy 1,000 cubic feet of
natural gas produces.

Since 1 barrel of oil produces 5.8 million British Thermal Units of energy
(5.8MMBtu) and 1,000 cubic feet of gas produces 1 MMBtu, you round the 5.8 to
6 and assume that:

• 1 Bbl of Oil = 6 Mcf of Natural Gas

• 1 MBbl of Oil = 6 MMcf of Natural Gas
• 1 MMBbl of Oil = 6 Bcf of Natural Gas
• 1 BBbl of Oil = 6 Tcf of Natural Gas

If you convert to oil units, you get Barrels of Oil Equivalent (BOE) and if you
convert to gas units, you get Thousand Cubic Feet Equivalent (Mcfe).

It’s super-important to get this conversion right because you pick comps based
on Proved Reserves and Daily Production – if one company’s reserves are in BOE
and another’s are in Mcfe, they are not comparable and you need to convert
everything to either BOE or Mcfe.

You can’t “convert” units for mining companies in the same way – if you could
convert iron into diamonds, you should go into business as an alchemist and
forget investment banking.

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Sometimes you do see “gold-equivalents” or similar units in a company’s filings;

all they’re doing is multiplying each mineral volume by the average realized
price, summing them up, and then dividing by the price per ounce of gold.

3. What are the different types of Reserves, and why do we care about them in
a model?

The 3 main types of reserves are Proved, Probable, and Possible.

Proved Reserves have at least a 90% chance of being extracted, Probable is at

least a 50% chance, and Possible is less than 50%.

In natural resource-lingo, 1P refers to the Proved Reserves, 2P is Proved +

Probable, and 3P is Proved + Probable + Possible.
You can further divide Proved Reserves into Proved Developed and Proved
Undeveloped, and then Proved Developed Producing and Proved Developed
Non-Producing.

In finance you care mostly about the Proved Reserves because you use it as a
valuation multiple (EV / Proved Reserves) and because you select comps based
on Proved Reserves.

Proved Reserves are also one of the key inputs for the Net Asset Value (NAV)
model and the operating model.

The other reserve types are less important, but if you wanted to be more
aggressive you could use them as inputs to a NAV model and get a higher
valuation since the 2P and 3P numbers are always higher than 1P.

4. Why can’t we just use Revenue and EBITDA to select comps? Is there a
reason that metrics like Proved Reserves or Production are fundamentally
better?

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If you used revenue or EBITDA, the numbers would shift around too much
because of changes in commodity prices. For example, if the price of oil suddenly
fell by 50% then oil companies’ revenue would also fall by 50%.

So you’d have to constantly re-adjust the selection criteria based on commodity

prices. That’s not practical, so you use Proved Reserves or Production to measure
the “size” of companies instead.

5. What are the key metrics you can use to analyze Production and Reserves?

We listed a few of these key metrics in the previous section: the Oil Mix % (for
O&G companies), the R / P Ratio or Reserve Life Ratio, and EBITDAX.

Several additional metrics you use:

• Production Costs per Unit: Annual Production Expense / Annual

Production Volume
• Finding & Development (F&D) Costs – All Sources (per Unit):
(Acquisition + Development + Exploration Expenses) / Net Reserve
Additions
• Finding & Development (F&D) Costs – Excluding Purchases and Sales
(per Unit): (Development + Exploration Expenses) / Net Reserve
Additions Excluding Purchases and Sales
• Production Replacement Ratio – All Sources: Net Reserve Additions /
Annual Production
• Production Replacement Ratio – Excluding Purchases and Sales: Net
Reserve Additions Excluding Purchases and Sales / Annual Production

Most of these are straightforward – Production Expenses per Unit gives you a
rough idea of the “cost of goods sold” on each unit of energy/minerals produced.

Finding & Development Costs indicate how expensive it is to acquire, find, and
develop additional reserves. The one excluding purchases and sales tells you
how expensive it is organically. Lower is better here – if the number exceeds the

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average realized price per unit of resources, the company’s profit won’t look so
good.

The Production Replacement Ratio tells you how much of the company’s
depleted reserves are replaced each year. If this falls below 100%, the company is
in trouble.

This ratio is more of a concern for huge companies like Exxon Mobil that have
genuine difficulty replacing more than 100% each year.

6. How do you move from Production and Reserves to a full 3-statement model
for a company?

Most revenue and expense items are directly linked to Production, or to

Revenue, which is in turn linked to Production. For Total Revenue you just
multiply the Annual Production of each commodity by the Average Realized
Price for each commodity and sum up everything.

On the expense side, normally you link Production, Sales Taxes, Transportation,
DD&A, and Accretion of Asset Retirement Obligation to Annual Production;
other expenses such as G&A, CapEx, and Exploration also generally follow
Annual Production even if they’re not directly linked.

Once you have the revenue and expenses in place, it’s just a standard 3-statement
model that links together as you would expect.

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Accounting & 3-Statement Model Questions & Answers

These questions are all more advanced than anything in the “High-Level”
section.

It’s difficult to generalize 3-statement modeling for energy companies because it

depends on the company type, the region, and how big it is – but there are some
commonalities, especially when we focus on the E&P segment.

If you’re interviewing in the US, the successful efforts vs. full cost questions are
the most likely ones here because US-based companies use different accounting
standards; outside the US these questions are less likely because IFRS ensures
that most companies use successful efforts.

1. Explain the differences between successful efforts and full cost accounting.

The only difference is that unsuccessful exploration is expensed for a successful

efforts company but it’s capitalized and added to PP&E for a full cost company.

The successful exploration expense is always capitalized under both standards.

That seems simple, but it leads to many consequences on the financial

statements:

• Operating income, net income, and PP&E are usually lower for successful
efforts companies and higher for full cost companies.
• However, full cost companies have higher DD&A expenses and more
frequent write-downs and impairment charges because they always need
to “reset” the value of their PP&E to fair market value (the so-called
“ceiling test”).

Outside the US, successful efforts vs. full cost is less of a concern because IFRS
limits the application of full cost – so most companies use successful efforts and
you don’t have to worry about normalizing anything.

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2. So why would a company ever want to use successful efforts accounting? It

seems like full cost accounting is much better in terms of net income and
therefore EPS.

This statement is not necessarily true. Yes, full cost companies often have higher
operating incomes and net incomes, but high impairment charges may reduce
both of those and actually make them lower.

For example, if commodity prices suddenly dropped a full cost company would
have to record an impairment charge to reflect that – and so its operating income
and net income might fall by quite a bit.

In general, small and startup companies prefer the full cost method and larger
and more diversified companies use successful efforts because it’s easier for the
larger companies to absorb the unsuccessful exploration expense.

But again, it’s a trade-off: a full cost company could easily end up with massive
impairment charges that result in lower net income, EPS, and PP&E.

3. Let’s say a successful efforts company has a successful exploration expense

of $100 and a dry hole, or unsuccessful exploration, expense of $100. Walk me
through how the 3 statements change when we record these expenses.

On the income statement, operating income falls by $100 because of the

unsuccessful exploration expense. Assuming a tax rate of 40%, net income is
down by $60.

On the cash flow statement, net income is down by $60 so cash flow from
operations is down by $60; the successful exploration expense of $100 is recorded
under cash flow from investing, so that is down by $100 and the net change in
cash at the bottom is down by $160.

On the balance sheet, cash is down by $160 but PP&E is up by $100 because of
the $100 in additional successful exploration expense, so assets are down by $60.

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On the other side, shareholders’ equity is down by $60 because of the $60
decrease in net income, so both sides balance.

4. Now let’s say they become a full cost company with the same expenses.
Walk me through the 3 statements once again.

There are no changes to the income statement for a full cost company. On the
cash flow statement, cash flow from investing falls by $200 because both the
successful and unsuccessful exploration expenses are capitalized, and so cash is
down by $200 at the bottom.

On the balance sheet, cash is down by $200 but PP&E is up by $200 because of
the capitalized exploration expenses, so neither side of the balance sheet changes
and it remains in balance.

5. I’m looking at a successful efforts company’s cash flow statement right now,
and they’re adding back the dry hole expense in cash flow from operations
and then counting it as part of their CapEx under cash flow from investing.
Why are they doing that?

There is inconsistent treatment of the dry hole expense among successful efforts
companies – according to the accounting rules, you should not show the expense
on the cash flow statement at all.

But in real life, some companies actually add back the expense under cash flow
from operations and then subtract it out again under cash flow from investing,
therefore capitalizing it and adding it to their PP&E number.

Unfortunately there’s no rhyme or reason to this – it’s just an inconsistency and

something you have to be aware of when analyzing the financial statements.
There’s a good article on the subject right here:

http://findarticles.com/p/articles/mi_qa5447/is_199907/ai_n21443806/

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6. How do successful efforts and full cost accounting apply to mining

companies?

Similar to the question above, many mining companies use a method that’s in
between successful efforts and full cost.

The exact rules are company-dependent, so you have to go by what they say in
the financial statements and follow whatever standard they’ve been using.

7. Let’s say we’re comparing 2 companies, 1 that uses successful efforts and 1
that uses full cost. How can we normalize EBITDA to make the numbers truly
comparable?

Similar to the EBITDAR metric for airlines and retail companies, you can
calculate EBITDAX – Earnings Before Interest, Taxes, Depreciation/Depletion,
Amortization, and Exploration – by adding the Exploration expense on the
income statement to EBITDA.

For full cost companies, EBITDAX is the same as EBITDA because they don’t
record an Exploration expense on their income statements at all – but for
successful efforts companies EBITDAX will always be higher.

If you did not do this, EBITDA would seem higher for full cost companies – but
that reflects different accounting standards rather than actual cash flow.

8. Walk me through what happens on the 3 statements when the asset

retirement accretion expense goes up by $100.

The asset retirement accretion expense relates to the asset retirement obligation, a
liability on a natural resource company’s balance sheet – it reflects how much it
will cost to shut down the mines or oil/gas fields of that company in the future.

If the expense goes up by $100, operating income on the income statement falls
by $100 and net income falls by $60 assuming a 40% tax rate.

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On the cash flow statement, net income is down by $60 but the asset retirement
accretion is a non-cash expense, so you add it back and cash at the bottom is up
by $40.

On the balance sheet, cash is up by $40 so total assets are up by $40; on the other
side, the asset retirement obligation is up by $100 but shareholders’ equity is
down by $60 due to the reduced net income, so both sides are down by $40 and
the balance sheet balances.

9. Let’s say we’re looking at an energy company that uses derivatives for
hedging purposes. They record a realized gain of $60 and an unrealized gain of
$40. Walk me through the 3 financial statements.

On the income statement, you record both the realized gain and the unrealized
gain, so operating income is up by $100 (normal companies may list these under
pre-tax income, but for energy companies they are usually part of operating
income). Net income is up by $60 assuming a 40% tax rate.

On the cash flow statement, net income is up by $60 but you subtract the
unrealized gain because it’s non-cash, so cash is up by $20 at the bottom.

On the balance sheet, cash is up by $20 and the derivatives line item on the assets
side is up by $40 due to the unrealized gain, so total assets are up by $60. On the
other side, shareholders’ equity is up by $60 because of the net income increase,
so both sides balance.

10. Why do energy and natural resource companies have high deferred tax
expenses? How can we estimate them in a model?

They have high deferred income tax expenses because they have high PP&E
balances and they depreciate PP&E differently for book and tax purposes – that
difference creates deferred tax liabilities (DTLs) or deferred tax assets (DTAs).

You could attempt to estimate these differences, but it’s almost impossible unless
they give you detailed numbers for everything – so you usually just assume a

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percentage for current income taxes and a percentage for deferred income taxes,
based on historical averages.

11. What are common non-recurring charges and add-backs for energy and
natural resource companies?

When you’re calculating EBITDA and EBITDAX, there are the usual DD&A,
Stock-Based Compensation, and Restructuring-type items to add back.

But there are also a couple of industry-specific items:

• Asset Retirement Accretion (a form of amortization)

• Non-Cash or Unrealized Derivative (Gains) / Losses (appears on the cash
flow statement)
• Impairment Charges and PP&E Write-Downs (more common with full
cost companies)
• (Gain) / Loss on Sale of Assets (appears on the cash flow statement)
• Environmental Remediation

You have to be really careful when adding back these charges because sometimes
companies embed these items in DD&A and sometimes they list the expenses
separately – read the footnotes.

12. How do you take into account the uncertainty of commodity prices when
projecting revenue for a natural resource company?

You create scenarios for different prices – for example, you might have a low,
base, and high case and assume $40 per barrel of oil in the low case, $70 in the
base case, and $100 in the high case.

Generally you assume that the prices stay the same each year, i.e. that it’s $40 per
barrel in years 1 through 5 of the low case. Otherwise it gets confusing to assess
the impact of different prices on the model.

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13. Why might a natural resource company use hedging, and how do you
incorporate it into a 3-statement model for the company?

With hedging, a company uses derivatives to provide “insurance” against a

sudden drop in commodity prices.

For example, if oil is currently at $70 per barrel the company might buy contracts
that guarantee it the ability to sell oil at $50 per barrel as downside protection.
Then, if the price drops to $40, they can still sell their oil at $50 and revenue
won’t drop as much.

The downside is that if oil prices jump to $100 per barrel the company won’t
realize the full benefit because they paid many for those contracts that are now
worthless – so their average realized price (including the cost of the contracts)
might be $90 instead of $100.

You could try to use the actual numbers for derivatives, but in an operating
model it’s more common to use simpler percentages and to assume a % increase
over market prices in the downside case, and a % decrease below market prices
in the upside case.

In addition to hedging, you also have to take into account the differential
between market prices and realized prices – so the complete formula for revenue
would be Annual Production * Average Market Price * Price Differential *
Hedging Percentage.

14. Hedging seems like a good idea to smooth out a company’s revenue – why
do many natural resource companies, especially large ones, choose not to use
it?

Because of the downside pointed out above: that if commodity prices rise, the
company would not realize the full benefits.

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Large, multi-national companies like Exxon Mobil tend not to use hedging at all
because they produce so much energy that hedging wouldn’t even be effective:
there are not enough derivatives available to cover all their production.

15. How do you determine which expenses on the 3 statements are linked to
Production and which are not?

Usually companies point this out explicitly in their filings by saying that certain
expenses “trend with production.” If they don’t list that, just think through
which expenses would depend on energy/mineral production:

• Production Expense
• Sales Taxes
• Transportation
• Depreciation, Depletion & Amortization (DD&A)
• Accretion of Asset Retirement Obligation

The first 3 are dependent on how much is extracted, transported, and sold, so
they are linked to production; DD&A is also linked to production because each
unit produced depletes the company’s reserves. Each unit produced also makes
it more expensive to shut down the operation in the future, which explains the
asset retirement accretion.

G&A, Capital Expenditures, and the Exploration expense could go either way
but generally they will be linked to Production as well: the more a company
produces, the more employees it needs and the more it needs to spend to replace
its depleted reserves.

Stock-Based Compensation, the Derivative Fair Value Gain or Loss, Impairment

and Restructuring Charges, and Interest Expenses should not be linked to
production because they are not directly correlated. They will be linked to
revenue, based on historical averages, set to 0, or dependent on other schedules
(interest and debt).

16. How are revenue and expense projections different for mining companies?

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The expense side is very similar: you just decide which expenses are Production-
linked and which trend with revenue or move independently.

The revenue side is more complicated because for mining companies, you
assume that a certain number of tons or tonnes are mined but that each ton/tonne
only contains a small amount of the mineral you’re looking for. So you need to
make a few more calculations to get to the annual Production numbers.

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Valuation Questions & Answers

The most likely questions here are the ones on Net Asset Value (NAV) models,
since those are specific to energy and natural resource companies.

The differences with public comps, precedent transactions, and the DCF are good
to know but those methodologies are not dramatically different – so focus on the
NAV-related questions.

1. How do you calculate Equity Value and Enterprise Value differently for a
natural resource company?

Equity Value is the same: take the common shares outstanding, add in dilution
from options, warrants, convertibles, RSUs, performance shares, and any other
dilutive securities, and multiply by the current stock price.

Enterprise Value is similar: start with Equity Value, subtract cash and cash-like
items, and add debt, preferred stock, non-controlling interests, unfunded
pension obligations, and similar liabilities.

But there are 2 new potential additions:

• Net Value of Derivatives: For companies that use hedging and therefore
carry derivatives on their balance sheet, the net value of the derivatives
might count as a cash-like item to be subtracted.
• Asset Retirement Obligation: This is a new type of liability that’s specific
to natural resource companies – it reflects the cost required to shut down
mines, oil fields, and wells in the future, discounted to its present value.
You might add this as a debt-like item.

Please note that these two items are not universally added to calculate
Enterprise Value – some banks count them and some do not.

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2. How is an oil & gas company’s capital structure different from a normal
company’s capital structure? What impact does that have on the valuation?

Generally, oil & gas companies carry significantly more debt than “standard”
companies in other industries like technology. They may have over a dozen
different tranches of debt, often in the form of high-yield debt with bullet
maturity.

They do this because they constantly need to find and acquire new reserves, and
they may not always have sufficient organic cash flow to do so.

This difference doesn’t directly impact the valuation, but it’s one of the reasons
why P / E multiples are not as meaningful for natural resource companies: a
higher-than-normal interest expense can distort what P / E tells you.

3. How are comparable public companies (public comps) and precedent

transactions (M&A comps) different for natural resource companies?

The mechanics of picking similar companies and transactions and then using the
median (or 25th percentile, or 75th percentile, or whatever you want) multiples to
estimate value for the company you’re analyzing are the same.

The differences:

• You might screen based on Proved Reserves or Daily Production rather

than traditional metrics such as revenue or EBITDA.
• You would list metrics such as Proved Reserves, Daily Production, the
Reserve Life Ratio, and EBITDAX rather than traditional ones like
revenue, EBIT, or EBITDA.
• You use multiples such as EV / EBITDAX, EV / Proved Reserves, and EV /
Daily Production instead.

Note that once again, EBITDAX is not a universal standard – outside the US it
isn’t necessary most of the time, and even in the US many banks still just use
EBITDA.

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4. Let’s say that one of my public comps has a Reserve Life Ratio of 15 and
another has a Reserve Life Ratio of 10. Which one will have higher EBITDA
and EBITDAX multiples, and why?

All else being equal, the one with the Reserve Life Ratio of 15 will have higher
EBITDA and EBITDAX multiples. Remember that the Reserve Life Ratio is
Proved Reserves / Annual Production – a company with 15 rather than 10 can
generate profits for a longer time period and may not need to explore and
acquire as frequently.

Investors would reward that by valuing the company with the higher Reserve
Life Ratio more highly.

5. What are the flaws with looking at revenue and P / E multiples for natural
resource companies?

Revenue multiples make little sense because revenue is almost completely

dependent on commodity prices: rather than reflecting how much the company
is producing or expanding, revenue multiples usually just reflect prices for oil,
gold, gas, etc.

P / E multiples are not accurate because natural resource companies because

often have high interest expenses, high deferred tax numbers, and high non-cash
charges such as DD&A and Impairment.

It’s not necessarily “wrong” to use these multiples, but usually EBITDA,
EBITDAX, Proved Reserves, and Daily Production are preferred.

6. What’s the normal range for EBITDAX, Proved Reserves, and Daily
Production multiples?

This one is dangerous to answer directly because the range depends on the
geography, the sub-industry, and the type of company you’re looking at. In the
case of Proved Reserves and Daily Production, it also depends on the

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measurement units – MBOE? MMBOE? Bcfe? And it gets even more fun on the
mining side.

If they really press you for an answer, just say that EBITDAX multiples are
usually in the same range as EBITDA multiples for normal companies, around 5-
15x and more like 5-10x for natural resource companies.

The production and reserves-based multiples vary so much that you’re better off
saying that it depends and avoiding a direct answer.

7. Could you create a standard DCF for natural resource companies? How is it
different?

You could still create a standard DCF, and it works almost exactly the same way.
There are 5 potential differences to note:

1. You will have additional non-cash expenses (e.g. Asset Retirement

Accretion) in addition to the standard ones like DD&A and Stock-Based
Compensation.
2. You would use Daily Production, EBITDA, or EBITDAX for the terminal
exit multiples rather than Free Cash Flow-based multiples.
3. For the Gordon Growth method usually you assume 0% long-term growth
because oil & gas assets get depleted over time and there’s only a finite
amount in the ground.
4. You could use the oil & gas industry standard 10% discount rate rather
than calculating WACC.
5. For the sensitivity tables you would look at commodity prices as one of
the variables rather than revenue growth or EBITDA margins; other
variables might be the discount rate and terminal growth rate or terminal
multiple.

8. Walk me through a Net Asset Value (NAV) model.

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In a Net Asset Value model, you assume that the company never increases its
existing reserves – so there’s no additional CapEx over time and the company
literally runs out of energy or minerals at some point in the future.

You create a NAV model with the following steps:

1. Pick a starting number for the Reserves – usually this will be Proved
Reserves (1P), but you could also go with 2P or 3P in more aggressive
models.
2. Project Production and Realized Prices. Usually you assume that
Production grows for a few years and then declines as the Reserves go to
0; Realized Prices are usually held constant in future years and are tied to
historical averages.
3. Project the Production and Development expenses and Taxes to calculate
After-Tax Cash Flows. Tie the Production expenses to historical averages
on a per unit basis; you can find estimates for future Development
expenses in the company’s filings. After-Tax Cash Flows = Revenue –
Production – Development – Taxes.
4. Calculate the Net Present Value of the After-Tax Cash Flows. Use the NPV
function in Excel and your discount rate, normally 10% for oil & gas.
5. Add the value of undeveloped land and the value of the other business
segments such as chemicals, midstream, and downstream. You can
estimate these with simple EBITDA multiples based on comps for each
segment.
6. Work backwards to calculate Equity Value (i.e. add cash, subtract debt,
and so on) and calculate the per share price.

It’s similar to a DCF but there’s no Terminal Value, which is arguably a good
thing, and there’s a much smaller CapEx expense since you assume no future
expansion.

9. What’s the advantage of a NAV model over a traditional DCF?

There are 2 big problems with a DCF for an E&P-focused company:

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• A DCF values a company at the corporate-level, but natural resource

companies are balance sheet-centric and should be valued based on their
assets instead.
• Natural resource companies often have extremely high capital
expenditures that reduce their Free Cash Flow and may even make it
negative; this distorts a traditional DCF and sometimes turns it into
nothing more than a simple Terminal Value calculation.

A NAV model gets around those problems by valuing the company on an asset-
by-asset basis (the producing assets are valued first, followed by undeveloped
land and then other segments such as chemicals and midstream) and by
eliminating growth CapEx.

Arguably the NAV is more conservative than the DCF as well, since you assume
that the company stops producing after a certain point in time rather than the
constant growth implied by a DCF.

10. Let’s say that my NAV model is producing values that are far too low –
which variables and assumptions should I tweak to boost the valuation?

1. Use Proved + Probable Reserves (2P) or Proved + Probable + Possible (3P)

rather than just Proved Reserves.
2. Assume higher Production numbers in the earlier years.
3. Make more aggressive assumptions for Realized Prices – but be careful
that they’re still in line with historical numbers.

Of these, #3 is the most problematic because companies have no control over

commodity prices – so it’s better to start with the first two.

11. Normally we prefer a NAV to a DCF, at least for E&P-focused companies.

But what are some of the flaws with the NAV model? Are there certain types
of natural resource companies where it doesn’t apply?

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You could argue that a NAV model has similar problems to a DCF because
you’re still projecting numbers far into the future, which is inherently unreliable
– and variables like commodity prices are almost impossible to get right.

You’re often projecting even further into the future than with a DCF because a
company’s reserves might last for 10-20 years – so it might be even more
dependent on far-in-the-future assumptions.

Also, a NAV model would not work as well for non-E&P-focused companies
such as oil and gas transportation or refining firms, or oil field services
companies.

They are not asset-centric and operate more like normal companies, so a
traditional DCF is better there.

12. How is a NAV model different for mining companies?

It’s the same idea, but you might have to go through a few more steps to project
revenue – remember that mining companies extract tons and tons of minerals
from the ground but are only able to use a small fraction. So you would have to
make extra assumptions for the usable percentage.

13. Why do we only subtract out Production and Development expenses in a

NAV model – isn’t it inaccurate to skip over G&A and other expenses like
DD&A?

You leave out expenses such as G&A because those are considered corporate
overhead, and you are valuing the company strictly on an asset-by-asset level.

Some expenses are ambiguous – for example, sometimes you’ll see Taxes and
Transportation subtracted out on the argument that they’re linked to production
from individual assets.

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But that’s the reasoning behind it – when in doubt, look at the “mini-NAV” that
companies have in the PV-10 section of their filings and see which expenses they
have subtracted.

Other expenses like Depreciation, Depletion & Amortization are not included
because they’re non-cash in the first place and would therefore be added back
even in a traditional DCF. You’re also not assuming any growth CapEx so you
don’t want to include matching DD&A.

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Merger Model and LBO Model Questions & Answers

I would be shocked if you got anything on merger models and LBO models for
natural resource companies in interviews, simply because there’s not much to
say – neither one is dramatically different from the “standard company” models.

Still, there are a few points to keep in mind if you have super-advanced
interviews.

1. How is a merger model for a natural resource company different?

It’s not much different at all – the few differences that do exist:

• Commodity prices may be an important assumption in the model and in

your sensitivity tables.
• The PP&E write-up may not be a simple percentage estimate (see next
question).
• Synergies are calculated differently (see questions #4 and #5).
• You may have to adjust accounting standards if you have a successful
efforts company buying a full cost company or vice versa.
• In a contribution analysis you will look at metrics such as NAV, Daily
Production, and Proved Reserves.
• You can calculate natural resource-specific accretion / dilution metrics,
such as NAV per Share, Production per Share, Proved Reserves per Share,
and so on.

Overall, merger models are far less different for energy and mining companies
than accounting, operating models, or valuation.

2. Normally for the PP&E write-up in a merger or acquisition, we make a

simple assumption such as 5% or 10% of the current PP&E book value. How
might this be different for a natural resource company?

For natural resource companies you might look at the PV-10 value in their filings
and use that as the fair market value instead.

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Example: A company has done an internal NAV analysis and pegged the fair
market value of their PP&E at $100 in the oil & gas supplemental section of their
filings. On the balance sheet it’s currently listed at $50.

Rather than assuming a 5% or 10% write-up, we might just use that $100 value
and therefore record a $50 write-up for this company in an M&A deal.

3. What’s the flaw with making an assumption for revenue synergies in a

merger model between 2 natural resource companies?

There are only 2 ways to boost revenue as a natural resource company: hope for
higher prices or boost production.

Commodity prices are beyond the control of any single company, even giants
like Exxon Mobil and BHP Billiton. So in a merger model you can’t say, “As a
result of this acquisition, oil prices will magically rise to $100 per barrel!”

Production increases are more plausible, but you run into another problem:
mines and oil/gas fields take years to develop and it’s impossible to flip on
additional production instantly.

As a result, revenue synergies are rarely taken seriously for natural resource
companies.

4. Revenue synergies might be unrealistic, but what about expense synergies?

Could you make assumptions for those?

Sure. You could look at all the standard ways to reduce expenses, from CapEx
synergies to operating lease consolidation to headcount reduction.

Just remember that most expenses for natural resource companies are on a unit-
of-production basis, so your assumptions need to reflect that. Rather than
absolute dollar amounts, you should frame expense synergies in terms of $ per
Mcfe, $ per BOE, or $ per ton.

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5. Can you explain what natural resource-specific accretion / dilution metrics

are and why we might look at them in addition to the standard EPS accretion /
dilution?

The 3 most common ones are NAV per Share, Daily Production per Share, and
Proved Reserves per Share.

You calculate them as you would expect: take the buyer and seller’s Net Asset
Values from the NAV models and add them together, make balance sheet
adjustments (reflecting cash used and debt issued) and then divide by the new
share count to get the new NAV per Share.

The others are even easier: just add the Daily Production and Proved Reserves
from the buyer and seller and divide by the new share count post-transaction.

You look at them because EPS is not always a meaningful metric for natural
resource companies due to non-cash charges, odd tax treatment, and so on – a
deal that looks bad on an EPS basis might look much better if you think about it
in terms of NAV per Share or other industry-specific metrics.

6. What’s the downside of these natural resource-specific metrics? Are there

cases where they would not be meaningful?

The downside is that these metrics may not always be meaningful: for 100% cash
or 100% debt deals, for example, Daily Production per Share and Proved
Reserves per Share will always be accretive because there are no new shares
issued in the transaction.

NAV per Share is meaningful no matter the form of payment, but there you run
into problems with companies calculating NAV slightly differently, using
different commodity price assumptions, and so on.

7. Do you think natural resource companies are good targets for leveraged
buyouts? What are the advantages and disadvantages?

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Generally oil & gas and mining companies are poor targets for LBOs, which
explains why they’re rare in these industries.

They don’t have stable or predictable cash flows due to their dependency on
commodity prices, they have a huge need for ongoing investment in the form of
CapEx, and usually they have high debt loads already.

The other characteristics that PE firms look for such as a low-risk business
profile, market conditions that depress stock prices, strong management teams,
and opportunities for cost reduction are company-dependent but are often
untrue.

Their only real advantage is that they do have hard asset bases that can be used
as collateral, but even there you run into a problem: PP&E values on the balance
sheet are linked to commodity prices, so the value of their assets could shift
around significantly.

8. When you’re creating an LBO model for a natural resource company do you
use EBITDAX for the leverage ratios and other metrics?

No – remember that EBITDAX exists only to normalize accounting standards

between successful efforts and full cost companies.

EBITDA is the standard used in leveraged finance and by anyone looking at the
debt profile of a company, so it’s far more common in LBO models no matter
what type of company you’re analyzing.

9. How are the sensitivity tables for an LBO of a natural resource company
different from those of a normal company?

Rather than looking at variables like revenue growth and EBITDA, you would
look at commodity prices and how they impact the IRR.

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You would also select a wider range for the exit multiples since the industry is
extremely cyclical: 2x to 8x EBITDA might be too wide a range for a normal
company, but it’s not unreasonable for natural resource companies since you
have no idea where the cycle will be when the PE firm exits.

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