Energy company market value reflects only current energy price

5 Jul 2012 by Jim Fickett.

Energy stock prices react too strongly to the current price of energy, even though future profits depend on the long-term energy price trend.

I have argued before that Encana's share price implied an unrealistically low value for gas in the ground (The most persuasive argument that Encana is undervalued is based on reserves). To put it another way, the share price shows investors assume the gas price will stay low forever, so that Encana will never make any money on the gas they have in the ground.

A friend recently challenged the whole argument, asking, “But how do you know that when the gas price rises, the share price will also rise?” It is a good question and, of course, one never knows for sure how the market will react to anything, especially in the short term. But one can look at historical correlations.

I am currently updating my analysis of the value of Devon Energy, and decided to check the historical correlation of enterprise value and energy price. Enterprise value is what one would need to buy out all other owners, and own the whole company free and clear; it is calculated as market cap plus debt, minus cash. So enterprise value divided by reserves tells you what value the market is currently placing on each barrel of oil or each thousand cubic feet of gas known to be producible.

The following graph compares, for Devon Energy, enterprise value divided by reserves, on the one hand, and the market price of the gas and oil they sell, on the other.

The correlation is very strong. I.e. on any given day, the market more or less assumes that today's oil and gas price will persist forever. This is, of course, remarkably stupid. While it is true that the best predictor of tomorrow's energy price is probably today's energy price, there are times, including the present, when it is perfectly clear that today's energy price does not represent the coming decades well.

All data are taken from Devon's annual reports. Oil is measured in barrels and gas in barrels of oil equivalent (BOE – 6000 cubic feet of gas has about the same heat content as one barrel of oil). The average price per BOE reflects the particular mix of oil and gas sold by the company each year, and includes the effects of any hedging.