VALUATION METHODS FOR INTERNATIONAL OIL & GAS COMPANIES

Bachelors Thesis
Finance, University of Amsterdam
Anton Hunsucker
5830133
Under the supervision of Dr. E.J. Schroth de la Piedra

Introduction
Despite an oft-touted decrease in the last decades, oil remains the lifeblood of our economies, as a key
element in fields as diverse as transportation, energy, agriculture and industry. Fluctuations in global crude oil
prices have engendered far-reaching consequences on economic growth and political stability the world over.
Meanwhile, natural gas is increasingly gaining currency as a new, affordable and relatively clean source of
energy. While much of the worlds oil supply is presently controlled by National Oil Companies, the growth
in offshore production (as onshore exploration and production declines) has lead to a comeback of the oncedominant International Oil Company. Furthermore, these IOCs are increasingly moving into natural gas
production and integrating vertically to envelop all elements of the value chain.
Most, if not all, IOCs are publicly-traded companies. Given the often huge market capitalization of these
companies, they are the subject of much analysis by researchers and financial institutions alike, as well as a
major employer, tax-payer and investor in various regions of the globe. As such, stock ownership in these
entities may be an attractive investment and an important factor in safeguarding accountability and
responsible governance. For public ownership of these companies to function optimally, investors must have
access to reliable information as to their value. Furthermore, the wave of mergers and acquisitions witnessed
in the previous decade raises questions as to the fairness of these deals, and which party benefitted most.
Several valuation methods have been developed in the field of corporate finance to value public listed
companies. However, the oil & gas companies are burdened by a host of sector-specific problems: high
exploration investments with uncertain returns and long turnaround times, a very diverse tax environment,
and a volatile oil price underlying most assets values, to name a few. Such impediments might render
traditional or generic valuation methods irrelevant or inaccurate when applied to oil & gas companies. Over
the years, a multitude of sector-specific valuation methods and accounting treatments have been developed to
account for this discrepancy.
The aim of this paper is to conduct a survey of methods of valuation suited for ascertaining international oil
& gas companies enterprise value, as well as evaluating their effectiveness. Most valuation techniques require
a multitude of parameters and necessitate that certain assumptions be made; we shall attempt to do so in a
prudent, sound and industry-consistent manner, detailing our findings and defending the choices thus made.
Effectiveness is measured by comparing the market value of a companys common equity shares to the
output of our valuation models, using (public) company data and investment banks research publications as
inputs. Our findings will be applied in a single case study: the 2010 Petrobras share offering, the largest share
offering at that time.

Section 2 Background
Section 2.1 Oil, gas, and the industry
In 2009, oil accounted for nearly 35% of world energy use [BP Statistical Review, P41] making it the single
biggest fuel in terms of worldwide consumption. As a result, crude oil was the most traded commodity by
value and by volume [DB O&G, p. 122]. Valued at year-end prices, all the oil consumed in 2009 was worth
$1.9 trillion [BP, Excel], or 3.3% of world GDP. The oil price itself is one of the most monitored economic
indicators and is known for its volatility, which has markedly increased since 1990. Whereas global oil
consumption as a share of total energy demand is declining, the use of natural gas is on the rise, with global
consumption increasing 26.6% in the space of ten years. Furthermore, the slowing pace of oil discovery
starkly contrasts with the ongoing discovery of very large natural shale gas reserves around the world.
As key providers of energy for transportation and heating, as well as being an input to many industrial
processes, oil and natural gas are absolutely essential to societys normal functioning. Supply disruptions
and/or strong price changes have consequences far and wide, as demonstrated for instance by the two oil
crises in the 1970s and the recent efforts of European nations to become less dependent on - increasingly
mistrusted - Russia for natural gas. Energy policy is a crucial factor in economic, strategic and political
decision-making on an international level.
It stands to reason that a capital-intensive industry such as oil & gas is highly concentrated, even more so
after the consolidation wave in the 1990s and early 2000s. The industry is dominated by so-called integrated
oil companies, which span the value chain from exploration, drilling, engineering and production of crude oil
and natural gas (the upstream processes) to processing, refining, distribution and marketing of end
products (the downstream). This conglomerated dissimilarity of industry processes adds to the lack of
transparency in evaluation an integrated companys performance. A further distinction in the oil & gas
industry landscape is necessitated by ownership structures, subdividing these huge companies into National
Oil Companies and International Oil Companies. The former group consists of state-owned enterprises
operating (mainly) in their home country; the latter are publicly listed companies with operations in various
parts of the world. As non-public NOCs are less transparent and therefore harder to value, our analysis will
focus on (integrated) International Oil Companies. We will, however, be applying the same techniques to the
listed (and therefore hybrid) Brazilian NOC, Petroleo Brasileiro SA (Petrobras).
A further word is mandated on the usually combined occurrence of the words oil and gas in the industry,
as well as in this thesis. This arises from the joint presence of these resources in many fields; initially, natural
gas found during oil production was simply flared, until gaining currency as a clean, plentiful and
convenient source of energy. In a sense, while natural gas production has a very different downstream, the
upstream processes are largely similar, leading most major integrated companies to produce both. At first, this
might appear to impede valuation and forecasting by introducing a great amount of additional variables;
however, there exists a clear, consistent mechanism for jointly measuring oil and gas reserves: barrel of oil
equivalent, or BOE. Furthermore, oil and gas prices are usually linked and strongly correlated [Vilar and Joutz].
As such, we shall treat both as equivalent in the remainder of this analysis.

Section 2.2 The Market for Oil & Gas

As mentioned in the prior section, crude oil is the worlds most widely traded commodity, with total annual
turnover amounting to 1/30th of world GDP. It stands to reason that a market of such depth and liquidity is
both highly efficient and strongly globalized. The (financial) media is rife with talk of the oil price, a
ubiquitously prevailing and seemingly instantaneously propagating figure that is seen as one of the worlds
pre-eminent financial indicators. In reality, the crude oil pricing landscape is somewhat more complicated.
For one, no two sources produce crude oil that is exactly alike; the products exact chemical composition may
vary considerably [DB report]. Crude oil blends may vary in their gravity (their relative amounts of
hydrocarbon molecules of various lengths, determining density of the crude), sourness/sweetness (the
presence of sulphur, which is considered disadvantageous) and acidity. Using these three dimensions we may
group the worlds plethora of crude oil vintages into the fourteen most widely traded blends, with Maya
(a heavy, highly sulphuric crude mostly found in Venezuela and Mexico) at one end of the spectrum and
Ekofisk (a very light, sweet blend from the Norwegian continental shelf) at the other. While volumes have
changed since, two of these blends were produced most due to their desirable characteristics: Brent Blend and
West Texas Intermediate.
These two blends have since emerged as the dominant pricing benchmarks for crude oil; compared to which
other blends trade at a discount or premium depending on their chemical characteristics. Around them, two
distinct oil markets have emerged: Nymex WTI (on the New York Mercantile Exchange) and ICE Brent (on
Londons Intercontinental Exchange). Both exchanges offer a combination of spot and futures contracts,
differing in their exact composition and settlement (physically or financially). For a more complete treatment
of these exchanges we refer to [DB report]; let it for now be sufficient that there are two globally prevalent oil
prices, Brent and WTI, with the informally used moniker the oil price referring to either. Even though both
prices are differently composed, and trading volumes are dominated by WTI, these prices are highly related.
Over the past two decades, they have exhibited a correlation of 99.61% and differed by at most 20%, with a
median difference of -5.7% (Figure 1). They will therefore be considered equivalent henceforth.
160
140

120
Brent
100
80

WTI
ExxonMobil
Shell (UK)

60

Shell (NL)

40

PBR (BR)
BP

20

PBR (US)

Figure 1: crude prices and major oil stocks (including Petrobras) (source: Thompson Reuters DataStream)

As can be gleaned from the diagram above, crude prices have been on the rise in the past decade and have
exhibited dramatically increased volatility in the past five years. Note how not all IOC stocks display the same
reaction to crude price fluctuations ExxonMobil and Petroleo Brasileiro appear to be more correlated with
Brent (at 88% and 93.3%, respectively) than British Petroleum (52%) or Shell (63.5% for its UK listing,
36.33% for its Amsterdam-listed common stock). The exact nature of this relationship is not known.
Osmundsen et al. note how the linkage between oil price and exploration activity (a lagged driver for
valuation) has disintegrated due to increased short-termism by investors and management; furthermore,
they describe how the market responds asymmetrically to good and bad news in the oil sector, and the
deficiency of financial reporting in truly reflecting a companys earnings potential, attaining the conclusion
that oil companies are priced at mid cycle oil prices. Additionally, Quirin et al. note, substantial time elapses between
the drilling of a well and the eventual sale of its oil, making timely well appraisal difficult and thus inducing a
lag between (book) value recognition and reserves replacement. Misund et al. conjecture that different
accounting treatments may engender disparities in oil/gas price sensitivities. Finally, there is the issue of
demand destruction, where high crude prices destroy consumers demand for end products (such as
gasoline and plastics), further dampening upwards crude price fluctuations and hurting companies profits
(DB report, Refining Overview)

Section 2.3 Issues in IOC Valuation

The process of enterprise valuation in general is hampered by numerous issues. As Damodaran [Damodaran
boek] argues, it may be seen more as an art than a science. He goes on to describe how bias affects the many
assumptions to be made, and invites analysts to post-valuation tinkering to conform with what is seen as
the norm. Assumptions may furthermore be affected by estimation uncertainty, firm-specific uncertainty and
macroeconomic uncertainty, in varying degrees of gravity. Finally, complexity arising, for instance, from
information overload may further confound the valuator. Specific valuation methods also come with
specific drawbacks, such as the difficulty of finding comparable companies when using relative valuation and
the significant uncertainty present in estimating terminal value when using discounted cashflow models
[Rosenbaum and Pearl].
In addition to these general issues, the oil & gas industry presents numerous specific conundrums affecting
company valuation. We describe mineral-related issues and regulatory issues.
Mineral-related issues pertain to the difficulties and uncertainties present in many commodities industries and
the mining and extractive industries in particular. As Quirin et al. [Quirin et al, Fundamental Valuation of Oil
and Gas Firms] note, the costs of discovering and developing oil reserves have little or no relationship to the economic value of
those reserves, to which Harris and Ohlson [Harris and Ohlson, Accounting Disclosures and the Markets
Valuation of Oil and Gas Properties] add: a major shortcoming in the view of some is that under historical cost
accounting the value added as a result of the discovery of mineral reserves is not separately reported when the discovery is made, but
is included in the income only when the minerals are produced and sold in subsequent years. As a result, under traditional
historical cost accounting, there is no basis for evaluating the full results or effectiveness of efforts to find new mineral reserves in
the year during which these efforts actually occur. In short, book values will not accurately reflect a companys future
economic potential and are hence not sufficiently useful to ascertain a companys economic value.
Furthermore, accounting return only equals internal rates of return on average internal return is always
lower during periods of high investment and higher when investments are low, or the firm possesses mostly
legacy assets [Osmundsen et al, 2005]. Quirin et al. make the case, through the use of regression analysis, that
6

industry fundamentals such as reserve growth and margin-per-barrel provide extra information over book
value on a companys stock market valuation, and are hence a relevant input to a valuation method (the paper
does not specify a valuation methodology or framework). Hermann et al. note furthermore that the price of
oil-derived products is not driven by the price of crude oil, but rather the reverse due to market dynamics
[DB report, p.123]. At any rate, the prevalence of a single pair (Brent and NYMEX) of prevalent crude prices
relegates oil producers to the role of price takers [Quirin et al], with the global oil price bearing little relevance
to their actual cost structure. This has additional implications for an IOCs balance sheet through the
variation it causes in economically recoverable reserves; we will describe this quandary later in this section,
when we cover reserve-related issues.
Regulatory requirements pertaining to the oil & gas sector are manifold. For one, International Oil
Companies operate in many jurisdictions and are hence subject to a variety of tax regimes. Corporate tax rates
the most basic levy to which all companies are subject are known to vary from 0% in Bahrain and the
Channel Islands to 55% in the U.A.E. [KPMG Corporate and Indirect Tax Report 2010]. Additionally, oil &
gas extraction itself is taxed by host governments, generally either on a royalty basis (where the extracting
company gains ownership of the resource and pays a defined percentage on the value of minerals extracted)
or through Production-Sharing Contracts (PSCs), where the government retains ownership and the barrels
recovered are allocated after exploration and development costs are recouped by the extractor. On average,
the host state receives 67% of pre-tax project NPV [DB report, p. 108]. Even then, several nations have
introduced supplementary taxation schemes such as export tax and supplementary petroleum tax [ibid],
leading to a very intricate taxation landscape for IOCs.
Reserves are also subject to extensive regulatory regimes, with those laid down by the US Securities and
Exchange Commission being most pervasive, with those dictated by the Society of Petroleum Engineers in a
secondary role. As described extensively in [DB report], these guidelines were devised with the aim of
providing investors with a realistic but conservative estimate of a companys available mineral reserves. As
such, they only allow for the recording of proven reserves, referring to resources that are recoverable from
known reservoirs that have been physically surveyed as feasible (through a process known as flow-testing)
or have already been drilled for production. According to [DB report], company practice has evolved such
that a field will only be included as recoverable once a final investment decision or FID has been taken,
committing the company to the actual development of its acreage. However, the authors of said paper go on
to demonstrate how amply leeway is afforded by the SEC; by analyzing reserve bookings from a jointlydeveloped gas field in the Norwegian North Sea, they show how the same acreage is recorded as 800 million
BOE by Shell to no less than 2 billion BOE by BP.
This ambiguity in reported reserves is aggravated significantly by the concept of economically recoverable
resources, as mentioned earlier in this section. Contrary to popular conception, oil reserves are rarely drilled
to complete exhaustion. Rather, they are exploited until the cost of recovery exceeds the crude price, in other
words, when marginal cost exceeds marginal revenue for a particular mineral source. Recall that oil & gas
companies are price takers and the prevailing set of prices bears no relevance to extraction cost; therefore, it
is fundamentally impossible to ascertain beforehand the amount of economically recoverable resources in a
particular field or resource. Note that this may also provide opportunities for business expansion: deepwater
offshore oil extraction, being more expensive than shallow-water or onshore production, was made feasible
by increasing crude prices. Recently, the oil sands in Canada have become economically recoverable, with
49% of Canadian crude production in 2009 resulting from newly-feasible oil sand processing [Canadian
Energy Overview 2009 http://www.neb.gc.ca/clf7

nsi/rnrgynfmtn/nrgyrprt/nrgyvrvw/cndnnrgyvrvw2009/cndnnrgyvrvw2009-eng.html#f4_3 ]. The wide

reserves variation made possible by volatile future crude prices thus affects reserves recognition (and hence
book value), investment decisions, field disposal and revenue estimates. An additional way through which
crude prices may affect reserves is described in [Osmundsen et al, 2005]: when the low oil price depressed oil
& gas stock in the late 1990s, it made acquisition of existing reserves (from other companies) cheaper than
exploration of new reserves, putting a (delayed) cap on organic reserves growth.

Section 3
Section 3.1 Relative Valuation
Relative valuation derives the value of an asset from the pricing of comparable assets, standardized using a
common variable. [Damodaran CH1] The relative valuation methodology is widely employed by analysts and
investors due to several advantages over income capitalization methods [Willams, 1991] such as DCF: it
requires far fewer assumptions and is hence (usually) easier, it is simpler to understand and (important in
highly volatile markets) it reflects the mood of the market when asset prices of a particular class are
buttressed by increased market sentiment, relative valuation will reflect this. Naturally, relative valuation also
provides numerous drawbacks: it requires a universe of comparable assets, it requires a standardized variable
which may be difficult to obtain and it is by definition unable to determine whether assets or companies as a
whole are over- or underpriced with respect to their intrinsic value. In reality, relative valuation prevails in the
valuation landscape. Damodaran conducted a study of equity reports in 2001, finding approximately ten
relative valuations for every discounted valuation [Damodaran CH7], noting that even when a cash flow
analysis was included, recommendations (such as buy, sell and hold) were based on relative valuation.
Damodaran describes the three steps that comprise the relative valuation methodology. First, a set
(universe in investment banking parlance) of comparable assets is to be found. Secondly, a standardized
variable must be determined with which to scale assets of different characteristics (e.g. enterprise value for
a company, size in square meters for a house, etcetera) down to a common quotient. Finally, adjustments
need be made for differences across assets, when necessary. In our analysis, the first step was already taken
when we defined our problem: valuation of integrated international oil companies. As such, our universe will
consist of the major IOCs operating at the current time.
Bank
P/E
Deutsche Bank
Jefferies
Macquarie
Morgan Stanley
Unicredit
Credit Suisse
JP Morgan
ING
Santander
Natixis
CA Cheuvreux

Multiple
EV/EBITDA EV/DACF EV/EBIT(D)AX P/CF

P/Sales

EV/EBIT EV/Capital EV/Sales

Figure 2: Multiples used in equity research on Shell and Petrobras

These are described in the Companies section of [DB report]. The choice of a standardized variable is more
convoluted. In the equity research industry, these variables are referred to as multiples, as they express asset
value as a multiple (or quotient) of a certain metric. A multiple is thus defined as the division of two variables.
Two such multiples commonly used are P/E-ratio for stocks, defined as the multiple of stock price over the
earnings per share generated by the company, and EV/EBITDA, or enterprise value over Earnings Before
Interest, Taxes, Depreciation and Amortization, for firms [Damodaran CH7]. However, these metrics may be
9

less suited in an oil & gas context. In [Osmundsen et al, 2005, RoACE] the authors state: While pre-tax cash
flow measures such as EBITDA (earnings before interest, taxes, depreciation and amortization) are commonly used in other
sectors, they lack relevance in the oil and gas industry as tax rates differ substantially. Hence, the analysts use a so-called debtadjusted cash flow measure (DACF), which in its simplest form is a post-tax EBITDA. A cursory survey of analysts
reports indicate that a large minority employs EV/DACF multiples in their analysis, while all of them using at
least P/E and EV/EBITDA ratios (see Figure 2). As a result, all three will be used in this analysis. These
metrics will be discussed further in a later section. As for the third step, adjusting for asset differences, we will
not make any adjustments given the similarities between companies in our universe.
P/E-ratio analysis
Price-to-earnings ratio, the quotient of stock price and earnings per share, is described by Perella as a measure
of how much investors are willing to pay for a dollar of a companys current or future earnings [Perella, p.45]. While the
numerator in P/E-ratios is conventionally defined as the current stock price, the denominator (earnings per
share) has several possible values, as described by [Damodaran CH7]. We shall restrict our analysis to socalled trailing P/E ratio which uses a historical earnings figure (usually from the last fiscal year, or the last
twelve months) as opposed to a forecast (a so-called forward P/E). This aids comparability (growth rates vary
among companies) and reduces the number of assumptions necessary. Furthermore, when comparing firms
by their price-to-earnings ratio, care must be taken to use ratios calculated in the same period, for market
sentiment may change relative valuations across time.
We commence our analysis by calculating P/E ratios for our universe of integrated IOCs, based on historical
stock prices, for three time periods January 2004 (the time of the Shell reserves scandal), September 2010
(the Petrobras offering) and the present month, April 2011. This will also demonstrate how multiples are
influenced by world crude oil prices which went from $30/bbl in 2004 to $78/bbl in 2010 and are
presently at $124/bbl (Brent spot prices, source:
http://tonto.eia.doe.gov/dnav/pet/hist/LeafHandler.ashx?n=PET&s=WEPCBRENT&f=W)

32.48x

35.00x
30.00x
25.00x
20.00x
11.56x
10.87x 10.26x
8.73x 8.92x
8.28x

15.00x
10.00x
5.00x

10.80x

9.17x

7.59x

4.22x
-14.65x

0.00x

Figure 3: trailing P/E multiples for IOC universe, September 2010

10

30.00x

26.40x

25.00x
20.00x
14.70x
12.10x

15.00x

10.00x

9.40x
5.90x

7.90x

9.40x

10.40x

9.60x
6.80x

7.80x 8.50x

5.00x
0.00x

Figure 4: forward P/E multiples, September 2010 (Deutsche Bank research)

Figure X shows trailing P/E multiples calculated for September 2010, by dividing the stock closing price as of
September 1, 2010 by the Earnings Per Share reported by the companies, for the first three quarters of 2010
and the last quarter of 2009, thus comprising the earnings for the last twelve months. For companies with
several stock listings (such as Shell and Repsol) we chose the most liquid stock. When necessary, currency
conversions were performed using historic interbank exchange rates. For purposes of illustration, we have
included September 1, 2010 forward P/E estimates as provided by Deutsche Bank in Figure X+1. The
disparities between the two sets of multiples are driven by forecast changes in Earnings Per Share, save for
BP for which EPS was altered to negate the drastic profitability hit incurred by the Deepwater Horizon oil
spill (rendering the trailing P/E negative at -14.65x). Note that the Galp Energia outlier is not spurious:
Galps stock has consistently demonstrated a much higher P/E-ratio than its peers, averaging 27.5x over the
November 2010 April 2011 timeframe. [DB report] cites high expectations of future earnings, relative to
current earnings, as a possible reason.
From this set of trailing multiples we can derive a multiple to value comparable companies, in this case,
Petroleo Brasileiro SA (Petrobras). Damodaran advocates using the median instead of the mean, to account
for the positively skewed distribution usually followed by P/E multiples [Damodaran CH7]. Consequently,
we arrive at a sector median price multiple of 9.04 times trailing earnings per share. Petrobras trailing EPS for
the period (calculated as earnings for the first nine months of 2010 + the last quarter of 2009) were $3.95
[company reports], thus arriving at a stock valuation of $35.71. On September 1, 2010, two days prior to
Petrobras announcement of its share offering, the PBR American Depository Share traded at $35.07 on the
New York Stock Exchange. On September 24th, it priced its offering at $34.49 per common ADS; six days
later, on the 30th of September, it announced the completion of its capital expansion. That day, the ADS was
trading at $36.27 on the NYSE. The average price during the 30-day interval (of which 23 were trading days)
was $35.86, demonstrating that Petrobras traded in line with the IOC universe during the share offering
period.

11

38
37.5
37
36.5
36
35.5
35
34.5
34
33.5
33

1-Sep-10

5-Sep-10

9-Sep-10

13-Sep-10
NYSE:PBR

17-Sep-10
21-Sep-10
TTM P/E valuation

25-Sep-10

29-Sep-10

Figure 5: Petrobras ADS share price during share offering period

It is interesting to note that despite the massive dilution brought about by Petrobras huge share offering (one
of the largest in history at approximately 70 billion US dollars) the stock price has only gone up, and the P/E
ratio has risen only very moderately. A brief survey of equity research indicates that per-share earnings are
expected to remain in line with those before the share offering, suggesting an expectation of increased
profitability. This might be related to its extensive portfolio of undeveloped pre-salt reserves off the
Brazilian cost, that are expected to come online in the next few years.
EV/DACF-ratio analysis
As mentioned above, EBITDA is of limited currency in an oil & gas context; hence, EV/EBITDA, the
valuation standard for most sectors [Perella p.45] is not widely used. Instead, DACF (debt-adjusted cash
flow) is used. Osmundsen et al. (2005) describe DACF as [DACF] normally reflects after-tax cash flow from
operations plus after-tax debt-service payments; where after-tax cash flow is the sum of net income, depreciation, exploration
charge and other non-cash items. Their key arguments for this measure are its after-tax nature (which is important,
given the extraordinary tax burden on oil & gas extractors) and its independence from financing decisions,
which aids comparability between different firms with different capital structures. Furthermore, DACF is
based on cash flow, which offers increased comparability in an industry with accounting treatments that differ
among companies, such as the oil & gas sector. As [James Sterling] notes, cash-flow analysis creates more of a
level playing field in such an environment. Furthermore, cash flow is of great importance for an extraction
company, given that Thats what an operator must use (to fund drilling or acquisitions) to replace the reserves he produces in
a given year. As such, it serves as a gauge of his ability to grow his asset base. [ibid] Corroborating this, Misund et al.
note that cash flows are more value-relevant than earnings [Misund et al, University of Stavanger]. The case
of British Petroleum offers another rationale for using a valuation metric based on cash flow: following major
environmental damage after the disaster at its Deepwater Horizon offshore platform, the company
incurred a $39.9 billion pre-tax charge, mainly as a provision for future damages. This severely dented Net
Income (Adjusted Net Income reported for the second quarter of 2010 was nearly $ 17 billion, down from
$5.6 billion in the first quarter). As the mainstay of this charge doesnt entail immediate cash outlays, cash
flow was affected to a lesser extent second quarter cash flow from operating activities was $6.75 billion, a
minor dip from the first quarters $7.7 billion.
12

We conduct our analysis as follows. First, financial data is gathered for the twelve months ending September
2010 (the month of the Petrobras share offering), by accumulating a companys first three quarterly reports
for 2010 and the fourth-quarter report for 2009 (assuming book years equal calendar years). From this data,
debt-adjusted cash flow is calculated following the method described by [Misund et al., The Value-Relevance
of Accounting Figures in the International Oil and Gas Industry]: NOPAT (Net Operating Profit After
Taxes) is first calculated as the sum of Net Income (a commonly disclosed GAAP measure) and after-tax
interest expense (where the tax rate used is the recurring tax rate on earnings before tax, listed in the companys
reports); from NOPAT we arrive at DACF by adding the figure for Depreciation, Depletion & Amortization.
The other input to our relative valuation, Enterprise Value, is defined (colloquially) as the sum of Market
Capitalization (which is available from a plethora of market data providers) and Net Debt (which is disclosed
in, or deducible from, companies quarterly reports). We thus calculate Enterprise Value as of September
2010 for each company in our IOC universe. Now, the quotient of EV and DACF constitutes our valuation
multiple. Figure X presents the results of our valuation.
24.37x

25.00x

20.00x
15.00x
10.00x

11.16x
9.32x
7.15x 7.04x

5.78x 5.44x 5.67x 5.53x

7.45x
4.83x

5.61x

5.00x
0.00x

Figure 6: EV/DACF valuation for September 2010

As above, we take the median of the multiples thus obtained to find a sector Enterprise Value multiple of
6.41 times Debt-Adjusted Cash Flow. Petrobras trailing twelve-month Debt-Adjusted Cash Flow was
calculated at R$ 43111.89 million. At that time, Petrobas had circa 9.9 billion shares outstanding on various
exchanges, from which we calculated a DACF per share of 4.37 Brazilian Real, which, using the median
EV/DACF multiple for our oil & gas universe, would imply a share price of US$ 16.23.

13

Section 3.2 Net Asset Value Per Share (NAVPS) valuation

Addressing some of the issues mentioned in the second chapter, such as the exclusion of most probably
reserves (2P and 3P in SPE parlance), while still maintaining a visible link to companies balance sheets is
possible by means of calculating Net Asset Value for the companies involved, on a per-share basis. NAV is
widely employed in a managed-funds and ETF context, there is a paucity of academic material of its use to
value industrial or mining companies. Online investor portal Investopedia describes the practice in brief at
[http://www.investopedia.com/articles/stocks/07/oil-gas.asp]; however, the method employed differs in
several respects from the NAV analyses widely employed by investment banks in their research publications.
In short, Net Asset Value is defined as a companys total assets minus its liabilities [SEC,
http://www.sec.gov/answers/nav.htm]. Dividing this by the total number of shares outstanding, we arrive at
the Net Asset Value Per Share, which allows for easy comparison with the companys share price. In an oil
and gas context, assets are usually defined as upstream assets plus the value of downstream assets such as
refining operations, chemicals production, and other assets. Upstream assets mainly consist of 2P reserves
(defined by the SPE as proven plus probable reserves, with at least a 50% chance of recovery) and
constitute the mainstay of an IOCs Net Asset Value. These reserves are generally valued at a single crude
price (set at the analysts discretion, either current or some long-term prediction), discounted over the
reserves extraction timeline (depending on the reserves metric used) and with the possible addition of fudge
factors or risk discounts. Downstream assets are valued as any other enterprise, either through the use of
DCF or through relative valuation. At this point, manifold assumptions have been made, resulting in widely
disparate valuations among different analysts. This contrasts starkly with NAVs traditional use in valuing
investment funds, where assets are usually valued at market prices, with little room for error and discretion.

Company
Royal Dutch Shell (GBP)
Total
Repsol
Statoil (NOK)
PetroBras (USD)

Lowest NAV
1420p
44.5
21.2
67
41.6$

Highest NAV
3754p
70.49
30.5
222
45$

Figure 7: Net Asset Values from equity research publications

Note how this valuation methodology incorporates elements from other widely employed techniques, such as
Discounted Cash Flow (DCF) and Sum-Of-The-Parts (SOTP) valuation. Discounted Cash Flow operates by
discounting, usually at cost of capital, an investments projected free cash flow [Perella, CH3] to its present
value; NAV valuation in an oil and gas context usually includes an element of discounting in its valuation of
upstream assets, either implicitly at a standard rate (when included in the companys reserve statements, as
mandated by the SEC) or performed by the analyst. Valuing a company by the Sum Of Its Parts entails
applying separate, disjoint valuations to its constituent parts and summing them. This is similar to NAVs
treatment of upstream assets (reserves) separate from downstream assets; SOTP is more general in that it
does not mandate specific methodologies for its sub-valuations.

14

A survey of IOC valuation reports by investment banks using the NAV method (mainly Deutsche Bank,
Credit Suisse, Jefferies International and JP Morgan) reveals the importance of assumptions required, and the
resulting disparity in per-share valuations. For instance, the Target Price for Shell varies from 1420p to 1644p,
and Repsol ranges from 21.2 to 30.5. Petrobras NAV range (immediately post-IPO) is smallest, ranging
from $41.6 to $45, with the share trading $35 (all figures in US dollars). One RBC analysts remarks in his
report Additionally, we believe NAV calculations for integrated oil companies can be very subjective from analyst to analyst
since companies have assets around the world (and provide few details to review), and also businesses outside of the Upstream
segment that can be more difficult to value.
Another surprising conclusion from this survey is the persistent value upside resulting from NAV
calculations. On the basis of the aggregated September 2010 financials in [DB report], we found that IOC
shares trade at premia ranging from -18.9% to -54.9% of Net Asset Value Per Share, for an average premium
of -41.2%. As the scarcity of contemporaneous NAV valuations by other investment banks for the full range
of Integrated Oil Companies precluded a comprehensive analysis, we were restricted to a smaller sample of
valuations from other research. The sample of FY 2010 valuations we used painted a more mixed picture,
with occasional positive price-over-NAV premia, though still smaller in number than discounts. Morgan
Stanley research states a sector-wide discount to NAV of 30% [MS Statoil report, October 2010] whereas
Credit Suisse puts this discount at 11% for the sector ex-BP [CS Statoil report, november 2010].
In concluding, while NAV presents itself as a straightforward, cross-comparable way of incorporating a less
conservative reserves estimate (compared to book value) in company valuations, it has numerous
shortcomings compared to its normal use in valuing investment funds. The number of assumptions and the
wide leeway afforded to analysts in choosing valuation parameters (such as multiples used in valuing
downstream assets) negatively impacts the precision and consistency of NAVPS valuations across companies
and analysts.
Due to the lack of a scientifically derived methodology for NAV valuation, the multitude of assumptions
necessary as well as the divergent methodologies employed across the industry and the lack of detailed reserve
data no NAVPS valuation will be performed in this analysis. Instead, we restrict ourselves to surveying
analysts NAV valuations, which we will use in the fourth section of this paper to value Petrobras as a going
concern.

15

Section 3.3 Discounted Cashflow Valuation

Introduction
Valuation by means of cashflow discounting is based on the intrinsic value of a company or asset, as opposed
to its market value [Rosenbaum and Pearl, ch3]. Generally, this is based on the (expected) future cashflows
generated by the asset or company, discounted back to the present at a rate that reflects the riskiness of these
assets [Damodaran, CH1]. DCF Valuation has several advantages over relative valuation, such as its
independence from market aberrations, its applicability when there are few to none comparable assets
available, and its quantifiable assumptions. The latter is also a major disadvantage to using DCF, as certain
assumptions (for instance, discount rate) have a huge impact on the valuation outcome. DCF is only as strong
as its assumptions [Pearl and Rosenbaum].
Generally, DCF analyses are based on a companys projected free cash flow or FCF defined as the cash
generated by a company after paying all cash operating expenses and taxes, as well as the funding of [capital expenditure] and
working capital, but prior to the payment of any interest expense [Rosenbaum and Pearl]. In other words, in
forecasting free cash flow one makes no adjustments for a firms capital structure. EBIT (Earnings Before
Interest and Taxes) or EBITDA (Earnings Before Interest, Taxes, Depreciation and Amortization) are usually
used as a proxy for a compays free cash flow; certain (predefined) assumptions are then made to arrive at the
FCF figure.
Based on the principle of present value, these (estimated) cash flows are discounted back to the present using a
company-specific discount rate. When valuing firms as a whole (as opposed to merely their equity or their
assets), the Weighted Average Cost of Capital (WACC) is used [Rosenbaum and Pearl]. It is derived from
several variables: a companys debt and equity ratios (as a proportion of total value), the risk-free rate and
equity premia prevailing in the companys market (usually the home country), the riskiness of a companys
assets (measured by Beta) and the (average effective) rate of taxation on the companys profits. WACC thus
represents a weighted average of the returns required by the providers of a companys debt and equity [ibid].
Given that DCF is a valuation based on a companys future free cash flow, the valuator is faced with the
challenge of establishing a sound estimate of a companys future earnings and expenses. Rosenbaum and
Pearl advocate the use of a five-year horizon, postulating that this period typically spans an entire business
cycle and allows sufficient time for the realization of planned projects. The companys value after this period
is represented by a single terminal value, usually based on the FCF for the last estimated period growing at a
certain percentage in perpetuity, discounted back to the present day. According to Damodaran, the general
formula thus becomes:

In this chapter, we shall apply above two-stage DCF model to Petroleo Brasileiro SA. Starting with our
assumptions (each dealt with in a paragraph of its own) we shall arrive at the firm value, from which we will
derive the value of Petrobras equity and thenceforth the estimated intrinsic share value.

16

Cost of capital
Cost of capital refers to the (minimal) return expected by the providers of the firms capital, be it debt or
equity. In this analysis we will use the Weighted Average Cost of Capital, or WACC. It is composed of the
following variables:

cost of debt the companys market cost of debt (interest)

cost of equity the companys market cost of equity (return on company stock through capital gains
or dividends)
marginal tax rate based on the companys historical effective tax rate
capital structure the proportions of debt and equity to total firm capital

From these variables, we calculate WACC as follows [Rosenbaum and Pearl]:

The rationale of the method used above is that cost of debt (i.e. interest) is corrected for the companys tax
rate, as interest payments are tax deductible [Rosenbaum and Pearl]. In the following subsections, we will
derive the variables necessary, detailing our assumptions. Note that, in the light of the PetroBras share
offering, which produced a change in capital structure, WACC will be calculated based on the new capital
structure. This choice is not straightforward, given that the definitive share price (the ultimate object of our
analysis) was set almost concurrently with the capital expansion. However, given the well-documented nature
of the share offering, investors can be expected to price in the capital expansion in their value calculations,
making the new capital structure more relevant than the old. Using the estimates detailed below, we arrive at a
WACC of 15.65%.
Cost of debt
On September 30, 2010, Petrobras had intereste-bearing debts of 114,660 million reais. Most of this debt is
held by the Brazilian National Development Bank (BNDES) and an unspecified number of financial
institutions, with bonds coming in third at 19.5% of total debt. While the company discloses the holding and
term structure of this debt, it does not specify explicitly the interest rates paid on each category. Therefore,
we shall use the companys publicly traded bonds as a proxy for overall debt cost, using the current yield as
advocated by [Rosenbaum and Pearl]. Average current yield for all maturities outstanding was 5.95% (source:
Yahoo Finance)
Cost of equity
Petrobras equity cost is calculated using the CAPM (Capital Asset Pricing Model) formula, which uses the
markets risk-free rate (usually ten-year yields on the sovereign debt of the companys home market) plus a
market risk premium multiplied by the firms beta, a measure of company riskiness relative to the market. For
a complete description of the CAPM framework we refer to [Berk and DeMarzo, Corporate Finance].
Given that Petrobras is a Brazilian company with ample financial, political and resource (i.e. the location of its
oilfields) to its home country, we shall use Brazils government debt as a proxy for risk-free rate. As
advocated by [Rosenbaum and Pearl], we select bonds based on their maturity matching the horizon of our
analysis. At the time of the offering, in September 2010, Brazilian government bonds due in 2017 yielded
17

11.92 percent [source: http://www.businessweek.com/news/2010-09-17/lula-pares-real-bond-sales-as-yieldsincrease-brazil-credit.html]. As such, we shall use a 11.92% risk-free rate. Note that, at the time, US treasuries
yielded around 4%. This discrepancy is largely accounted for by the difference in rating (BBB or BBB- for
Brazil, AAA for the United States). Notably also, it exceeds PBRs cost of debt by a large amount.
Beta is sourced from [Damodaran] the average beta for Integrated Petroleum is 1.21.
Several methods exist for deriving market risk premium. Fernandez and del Campo conducted a survey of
premia used by analysts in 2010, and arrived at an average premium of 5.8% for Brazil, using a sample of 36
analysts [Fernandez and Del Campo, Market Risk Premium used in 2010 by Analysts and Companies: a
survey with 2,400 answers]. We shall use this premium in our analysis.
Using the figures detailed above, we arrive at a cost of equity of 18.94%.
Marginal Tax Rate
As defined above, we will use the historical effective tax rate as a proxy for marginal tax rate. Note that, as
detailed in the second chapter of this thesis, one should exercise caution when generalizing the taxation
landscape for international integrated oil companies, which are not only subject to corporate tax but to a
variety of royalties and extraction taxes (with widely differing deductibility regimes) as well. The 2010
effective tax rate for Petrobras was 28%.
Capital Structure
According to Rosenbaum and Pearl, capital structure ratios must be calculated using the market value of
equity. Based on the new capital structure and combining Petrobras multiple stock listings, we arrive at a
market capitalisation of 396.848 million reais. With gross debt, as above, amounting to 114.660 million reais,
we arrive at debt-to-value and equity-to-value ratios of 22.42% and 77.58%, respectively.
Free Cash Flow
Seeing as we are conducting this valuation from the perspective of 2010s third quarter, we will not include
2010 in the sum of discounted free cash flows. Rather, we will first calculate the 2010 free cash flow
historically and, by using estimates for its constituent parts, calculate FCF forecasts for 2011-2015, using a
simple growth rate thereafter.
2010 Free Cash Flow
Using Petrobras 2010 annual report and the formula given in [Rosenbaum and Pearl], we arrive at the
following calculation:

18

Free Cash Flow calculation (millions of reais):

EBIT:
Less: Taxes (payable)
EBIAT:
Plus: D&A
Less: Capital Expenditure
Less: Change in Net Working Capital
Free Cash Flow:

47057
10250
36807
14881
76411
4390
-29113

Figure 8
As can be seen, 2010 FCF was negative due to unsustainably high levels of capital expenditure. This is to be
expected given Petrobras ambitious growth strategy it plans to spend US$ 224 billion in the 2010-2014
timeframe, or 357 billion reais valued at current exchange rates [2010 Annual Report]. In fact, the context of
this analysis a 120.2 billion reais equity offering was undertaken mainly to acquire the production rights to
5 billion BOE of deepwater oil reserves, an investment of 74.8 billion reais. Coupled with record outlays on
exploration and refining [ibid], cashflow is likely to remain negative for the time being.
2011-2015 cash flow projections
Given the companys ambitious growth strategy, we forecast investments continuing at the same pace until
tapering off in 2015 and settling around their pre-offering trend. Earnings and all derived figures are expected
to grow at 8.5% annually (a consensus figure derived from estimates by 6 banks) as investments start to pay
off and now fields enter production. Depreciation & amortization is expected to retain its historical growth,
given the long asset lifetimes reported by the company. Net Working Capital change is expected to remain
equal, as both sides of the NWC equation are expected to grow with earnings. Based on these assumptions,
FCF is expected to remain negative until 2014, with a stable point achieved in 2015 after major investments
are concluded.
Growth after 2015
Based on the 2015 cash flow estimate, the terminal value after 2015 is calculated, based on a 7% growth to
perpetuity. Several factors impede the development of a sound long-term growth estimate for Petrobras:
volatility of crude oil prices, macroeconomic instability (mainly pertaining to the Brazilian economy), the
uncertainty of future deepwater drilling in the US Gulf of Mexico and the development of green power
sources in the coming decades.
Base-case DCF value per share
Using the formula given at the beginning of this section, we arrive at a DCF valuation for the company of
93,038.65 million Brazilian reais. Deducting Net Debt of 57,122 million reais we arrive at a total equity
value of 35,917 million BRL. Dividing by the total number of shares outstanding (post-issue) we arrive at an
implied share price of 3.638 BRL, or 2.11 US dollars valued at the monthly average interbank exchange rate
of the offering period. On September 24 2010, the first day of the offering, the American Depository Shares
were priced at $34.49, and by the time the offering concluded on the 30 th, this price had risen to $36.27.
Hence, we conclude that the two-stage DCF model significantly understates Petrobras share value compared
to the market.
19

Sensitivity Analysis
Given the manifold uncertainties present in valuing oil companies, and in using the DCF method, a sensitivity
analysis is mandated to provide a range of probable valuations for Petrobras equity to supplement the base
case given above. Due to their significant value influence, fundamental estimation difficulty and wide range
of values used by investment analysts covering Petrobras we select two variables: WACC and Terminal
Growth Rate. The results of this analysis are shown below:

Terminal Growth Rate

Sensitivity Analysis (share price, BR$)

Weighted Average Cost of Capital
12%
14% 15.65%
5%
10.07
4.1
0.96
6%
13.5
5.95
2.16
7%
18.37
8.32
3.64
8%
25.63
11.49
5.51

18%
-2.03
-1.31
-0.47
0.55

Figure 9
These results demonstrate that our base case is at the lower end of the valuation spectrum: PBRs stock price,
and the mainstay of analyst estimates, are consistent with a significantly lower WACC (Deutsche Bank
employs at 10% rate, Santander uses 9.5%) and a somewhat higher growth rate. Both variables are affected by
Brazils status as an emerging market, with a history of high and unpredictable inflation, and by the numerous
complicating factors in valuing oil and gas companies. Discarding negative stock values (brought about by the
unprofitable near term), Discounted Cash Flow gives us a valuation range of US$ 0.56 to US$ 14.87 for each
PBR common share.

20

Section 3.4 Real Option Valuation

Valuation using option-like models presents a radical departure from the other techniques employed in this
analysis. As Damodaran states, assets that have the potential to create cash flows in the future but do not
right now are among the most difficult to value. Discounted cash-flow and relative valuation models do not
explicitly allow the modelling of uncertainty, whereas this is a key element in real option valuation (the epithet
real distinguishes from options as financial products). According to [Paddock, Siegel and Smith], the
efficient use of option valuation techniques absolves the valuator from the task of estimating future
commodity prices or using risk-adjusted discount rates when using the Black-Scholes-Merton model for oil &
gas leases, in fact, as [Berk and DeMarzo] write, even the expected return of the asset is no required input
when we use the Black-Scholes Option Pricing Model.
Given the highly uncertain nature of future crude oil prices, the use of real option valuation methods is
gaining currency in the oil & gas context. Furthermore, real option models allow for higher flexibility
[Damodaran CH1], allowing the owner of an asset to change course during the investments lifetime based
on new information. Such flexilibity is hard to value otherwise, but highly pertinent in oil field development
[Paddock, Siegel and Smith], where a field owner may cut production when crude prices fall below extraction
cost.
Numerous applications of Real Option Valuation exist in the field of oil and gas. [Menabde] uses multiple
versions of the Black-Scholes formula in combination with Monte Carlo simulation on the 2P reserves of two
large IOCs, finding their shares significantly undervalued by the market. [Lund] uses a dynamic-programming
approach to explicitly model production flexibility (e.g. how much wells to drill), demonstrating potential
improvements in offshore oil production. [Babajide] follows a similar path, using custom-made decision trees
to show NPV improvement in variable oil field development. Finally, [Damodaran] demonstrates the
valuation of an oil field using the Black-Scholes model. We will emulate his approach in this analysis.
Petrobras and the Onerous Production Assignment
The case study analysed in this paper, the R$ 120.2 billion secondary offering by Petrobras SA, offers a
potentially interesting case for option valuation. As stated in the companys 2010 annual report, R$ 45.5
billion went to the balance sheet mainly for net debt reduction whereas R$ 74.8 billion was paid to the
Brazilian state for the production rights (the onerous production assignment) of up to 5 billion BOE in the
countrys offshore Santos Basin in the next 40 years. This represents a real option purchased (at US $8.51 per
BOE) by the company to develop these fields for its own profit. Given the significant technical challenges
imposed by the location of these reserves (at several kilometers below the surface in a highly corrosive
environment), their extraction is only warranted by a sufficiently high crude price.
The Onerous Production Assignment as a Real Option
As Damodaran demonstrates, we may value an undeveloped natural resource as a call option that pays off as
soon as production revenues exceed development cost. In order to do so, we need several variables: the
amount of reserves, valued at contribution margin (current market unit price less marginal extraction cost),
the (fixed) cost of developing the reserve, the timespan during which the option may be exercised, the
variance in value of the underlying asset, the risk-free rate and the cost of delaying development. We will now
briefly cover our assumptions.

21

Reserves
As clearly stated in the terms of the Assignment, the extractable amount is 5 billion BOE. Petrobras mentions
pre-salt extraction cost of approximately $25 over its whole portfolio, which we use as a proxy, given that
many of the adjacent fields are already under development by the company. Based on the Brent crude price at
the time of the offering, this leads to a marginal value of $53.81 per BOE, and a total reserves value of US
$269.05 billion. This figure is discounted back to 2010 value, given that production is to start after 2014.
Development cost
This comprises the capital expenditure required to extract the oil, such as the purchase/lease and transport of
oil rigs and floating production facilities, seismic surveys, pipelines and tiebacks and other cost not directly
attributable to single barrels of oil. Initially, the company planned a $33 billion outlay to develop these fields,
but updated this to $73 billion in 2011 for the 2010-2014 period (after which the fields are ready for
production). Given that the company reports a weighted average useful life of 20 years for Equipment and
other assets, we anticipate a full replacement of all assets halfway through the Assignments lifetime, and
adjust accordingly.
Lifetime of option
We take the lifetime of Petrobras extraction rights as granted under the Assignment as the lifetime of this
option, which is 40 years.
Variance of asset
Oil price variance was calculated using the natural logarithm of the Brent crude price from the 20 years
leading up to the date of the Assignment offering, and calculated to be 0.3812.
Risk-free rate
As in our DCF analysis, we base the risk-free rate on long-term Brazilian government debt yield. At the
moment of the offering, this was 11.92%.
Cost of delaying development (normally: dividend yield)
In line with Damodarans example, we use the opportunity cost of extraction as a percentage of value: the
amount of oil that can be extracted and sold in one year. In an analysis commissioned by the Brazilian House
of Representatives, initial flow for the all Assignment fields was estimated to be 163,500 barrels per day. This
amounts to 1.19% of the total amount of reserves. Note that this figure is likely to increase as extraction
facilities are put into place.
Results
Using the dividends-modified approach demonstrated in [Damodaran], we arrive at an option value of US
$158.2 billion, a significant upside to the US $43.4 billion paid to the Brazilian Union for the production
rights. Several factors contribute to this disparity: the option is already in the money given the high value
of reserves compared to expected development cost. However, the market has expressed skepticism
regarding Petrobras reported per-barrel extraction cost, with analyst estimates ranging between $11 and $40
(engendering a range of real option values from $199 bn to $113.8 bn). The companys use of a single
22

extraction cost for its entire portfolio might also skew the estimate towards a more favourable number, as not
all fields are at the same depth. Furthermore, capital expenditure (the exercise prise of the real option) is
notoriously hard to predict (as demonstrated by the companys revision of its $33 billion estimate to $73
billion), even moreso considering the 40-year Assignment lifetime. Finally, estimated production figures (the
dividend yield) are not published by the company, and the estimate commissioned by the Brazilian House
of Representatives to account for this deficiency is likely to be lower than the true figure (which is in turn
dependent on CAPEX). Growing the production estimate to 2.5%, or ~350,000 barrels per day (as opposed
to the current 163,500) cuts the option valuation almost in half, to $88 billion (resulting in values from to
$112.1 to $63.87 billion accounting for the range of extraction cost).

23

Section 4 Results
In this section we will aggregate the results produced in Section 3 with the aim of arriving at a range of
enterprise values for Petroleo Brasileiro SA at the time of its secondary offering.
The Financial Balance Sheet for Petrobras
As described in [Damodaran], the financial balance sheet (as opposed to the accounting balance sheet) values a firm
as a going concern, with a potential for growth, instead of a mere collecting of historically acquired assets.

Assets
Assets in place
(investments already made)
Growth assets
(investments yet to be made)

Liabilities
Debt
(borrowed money)
Equity
(owner's funds)

Figure 10: The Financial Balance Sheet (adapted from [Damodaran])

This framework provides a useful basis for valuing Petrobras at the time of the secondary offering, where the
companies assets in place were to be drastically increased by the acquisition of the 5bn BOE production
rights under the Onerous Assignment, which we deem growth assets. In this way, we integrate valuing Petrobras
from a historical perspective (as when using trailing multiple valuation or book value) with valuation methods
based on forecasting (such as Discounted Cash Flow)
Valuing Petrobras Assets in Place
As described in Section 2 of this paper, an oil companys accounting balance sheet significantly undervalues a
companys true assets, by constraining the amount of reserves that may be recognized. When valuing Assets
in Place, we use 2P reserves (P50, with a 50% chance of succesful extraction). As 2P reserves are not
disclosed by the company, we use a NAV consensus for the third quarter of 2010, sourced from equity
research. Net Asset Value, discussed in Section 3.2, includes estimates of a companys total oil reserves, net of
firm debt, and is usually stated on a per-share basis. We use consensus Net Asset Value on a per-firm (as
opposed to per share), and correct for Debt deduction. In this fashion, we arrive at an estimate for Assets in
Place of US$ 286,462.7.
Valuing Petrobras Growth Assets
In the context of this analysis, the Petrobras secondary offering, the Growth Assets comprise the 5bn BOE
production rights acquired under the Onerous Production Assignment. These were valued using Real
Options in Section 3.4 of this paper, as this method is ideally suited to investment decisions fraught with high
levels of uncertainty. We will use the Real Options base case of US$ 158.2 billion as value estimate of
Petrobras Growth Assets.

24

Debt and Equity Value

Petrobras net debt, at the time of the secondary offering, was 57,122 million BRL; at historical average
exchange rates, this amounted to US$ 33,130.8 million. Petrobras Equity may now be calculated as the
difference between Total Assets and Debt; producing the following Financial Balance Sheet:

Assets
Assets in place

Liabilities
286,462.7 Debt

33,130.8

Growth assets

158,200.0 Equity
(owner's funds)

411,531.9

Total

444,662.7 Total

444,662.7

Figure 11: Petrobras FBS, September 2010

Value per share
As of September 2010, prior to the Secondary Offering, approximately 9.9 billion PBR shares were
outstanding, listed on several exchanges. By using Equity Value calculated above, we arrive a value of
US$41.68 per share. This is a moderate upside to the PBR share price (for its American Depository Receipt)
of $34.92, demonstrating high investor expectations of company growth.

Overview of Valuation Results

Based on the valuation experiments conducted in Section 3 and the previous paragraph, we may now draw up
a range of target prices for Petrobras shares. Table X below lists all the outcomes in ascending order, as
well as the market value for the companys New York listing (both before the offering was announced, and
after it was completed) and a consensus value derived from banking research at the turn of the third quarter
of 2010.

Value Per Share, US Dollars

Discounted Cash Flow, Low
Discounted Cash Flow, High
EV/DACF Multiple Analysis
PBR (NYSE, pre-offering)
P/E Multiple Analysis (TTM)
PBR (NYSE, post-offering)
Going Concern (NAV + ROV)
Equity Research Consensus

0.56
14.87
16.23
35.07
35.71
36.27
41.68
41.83

Figure 12

25

Section 5 Conclusion
This analysis has demonstrated that the oil industrys peculiarities, as described in Section 2, have a
confounding effect on the valuation landscape for international integrated oil and gas companies, in our case
Petroleo Brasileiro SA. Reserves uncertainty, accounting issues, an intricate taxation landscape and long
project lead times are only a few of the issues that render conventional valuation techniques inaccurate or
cumbersome to use.
While econometric evidence on its usefulness is mixed, book value will consistently understate a companys
true value by being limited to including proven reserves, those with a 90+% likelihood of extraction.
However, market value generally does not entirely reflect probable reserves (those with a 50% likelihood),
as demonstrated by a vast majority of IOCs trading at a discount to their (estimated) Net Asset Value.
Also, the long lifetimes of oil and gas projects, as well as a highly unpredictable and increasingly volatile price
for these products, make forecasting earnings within standard industry horizons a formidable task. The
constant depletion of reserves obliges companies to ceaselessly explore and develop new fields, with varying
cash outlays and success rates. As a result, a companys market value will not accurately reflect the present
value of its current cash flows extrapolated into the near future (as demonstrated by our DCF analysis),
whereas longer-term forecasts are fraught with numerous sources of uncertainty.
In the end, two methods were found to be most accurate, be it for wholly different reasons. The first one,
Price-to-Earnings ratio, a prime example of one-size-fits-all valuation techniques, proved very accurate in
prediction share price based on trailing earnings per share and a universe of integrated international oil
companies. To some extent this is to be expected, as all comparable companies in the universe are plagued by
the same valuation issues; hence, the market is likely to filter them out to the best of its abilities, thus
producing a multiple estimate reflecting this. Another surprising finding is that the massive equity dilution,
brought about by the companys secondary share offering, precipitated no discernible effect on expected
earnings per share. In other words, investors demonstrate a high degree of confidence in the companys
growth prospect.
The second method that demonstrated encouring results in the context of this analysis comprised a
combination of Net Asset Value, as estimated by equity research providers such as investment banks, and
Real Options Valuation (a methodology with ample credentials in the oil & gas industry), whereby the former
reflects the companys total current reserves and the latter constituting a comprehensive valuation of the
companys growth potential. This framework allows us to value the company as a going concern and sidestep
some of the numerous issues that pervade the oil & gas valuation landscape.

26