Key financial ratios to assess Oil and Gas stocks

The oil and gas industry plays a major part in a country’s and the world’s economic system as it is in the business of locating and extracting oil & natural gas reserves from below the earth’s surface, refining the constituents into energy resources which are critical for the functioning of other industries, and bringing these resources to their customers.

Due to the enormous scale and operational complexity of their businesses, the oil and gas industry is capital intensive, and it is common for companies operating in this domain to make use of large amounts of debt to finance their business operations.

Leadingly, while assessing the companies from this sector for investment opportunities, thoroughly vetting the debt obligations becomes crucial. In order to make better sense of the ratios involved in analysing oil and gas companies, one must understand the different types of companies operating in this domain.

Types of oil companies – Upstream, Midstream, Downstream and Integrated Majors

Upstream companies

Upstream oil companies take part in the exploration, extraction, and production of crude oil and natural gas. They usually operate around the early stages of the oil and gas industry with their activities including drilling wells, fitting them with the necessary equipment, and then extracting the oil and gas. Example: ONGC, Reliance Industries, Oil India, etc.

Midstream companies

Midstream oil companies are involved in transportation, storage, and wholesale distribution of crude oil and natural gas. Their operations lie in the domains of oil pipelines, oil storage tanks, and other crucial infrastructure necessary to move the oil and gas from the production site to refineries and other points of consumption. Example: GAIL

Downstream companies

Downstream oil companies are responsible for refining, marketing, and distribution of oil and natural gas products, such as petrol, diesel, jet fuel, etc. They also operate retail outlets, such as petrol pumps, and are involved in the distribution of petrochemical products like lubricants and engine oil. These companies are also known as Oil Marketing Companies (OMC). Example: IOCL, BPCL, HPCL, Indraprastha Gas etc.

Integrated majors

Integrated Majors play their part in all the aspects of the oil and gas industry, ranging from exploration of reserves to refining the crude oil and marketing the constituent products. They generally operate around multiple industry segments and have assets in both upstream and downstream sectors. Example: Oil India

Let us now understand some key financial ratios which are instrumental in determining the viability of investing in an oil and gas company.

Debt to Capital ratio

The debt-to-capital ratio serves as a gauge of the financial leverage of an oil and gas company. This ratio is considered to be important as it places emphasis on the relationship between debt liabilities and a company's overall capital base. All obligations, whether short-term or long-term are considered as debt, while shareholder’s equity and the company's debt are considered as capital.

The ratio is used to analyse the financial position of a company and what method it uses to fund its operations. Usually, a higher debt to capital ratio points towards a higher risk of the company defaulting on its payments.

Debt to EBITDA ratio

Debt to EBITDA gauges an oil and gas company's capacity to settle its accumulated debt. It tries to put a number on how likely the company is to default on its debt obligations. This ratio is helpful in calculating how many years of earnings before interest, taxes, depreciation, and amortisation (EBITDA) would be required to pay off all the debt because energy businesses often have a lot of debt on their balance sheets.

Generally, a lower ratio is indicative of the fact that the company might be able to service its debts faster.

Debt to Equity ratio

The debt to equity ratio is computed by dividing the total liabilities by the shareholders’ equity. 

The debt to equity ratio is reflective of the amount of debt used by the company in financing its assets, and a lower debt to equity ratio is generally preferred.

The debt to equity ratios of 5 oil and gas companies in India are:

Bharat Petroleum Corp Ltd: 0.64

GAIL India Ltd: 0.14

Hindustan Petroleum Corp: 1.20

Indian Oil Corp Ltd: 0.92

Oil and Natural Gas Corp: 0.09

Source: ICICIdirect, data as of Mar, 2022

Enterprise Value/Barrels of oil equivalent per day

Oil and gas companies declare their production levels in BOE, or barrels of oil equivalent. This ratio measures the enterprise value, which is the sum of market capitalization and debt minus the cash, as compared to its daily production, which is given by barrels of oil equivalent per day.

Usually, a company with a higher value of this ratio is considered to be overvalued, and a company with a lower value of this ratio is considered to be undervalued.

Enterprise Value/EBITDA

This ratio compares the Enterprise Value of the oil and gas company, which is calculated as the sum of market capitalization and debt minus the cash, relative to its EBITDA, or the earnings before interest, tax, depreciation, and amortization. Generally speaking, if a company has a lower value of this ratio, then it is considered to be undervalued, and if the ratio is higher than it is considered to be overvalued.

The Enterprise Value/EBITDA ratios of 5 oil and gas companies in India are:

Bharat Petroleum Corp Ltd: 5.93

GAIL India Ltd: 4.71

Hindustan Petroleum Corp: 6.44

Indian Oil Corp Ltd: 4.84

Oil and Natural Gas Corp: 3.65

Source: ICICIdirect, data as of Mar, 2022

Interest Coverage Ratio

The interest coverage ratio is computed by dividing the EBIT, or the earnings before interest and taxes by the interest expenses paid by the company. This ratio acts as a measure of assessing the ability of the oil and gas company to make interest payments for the outstanding debt on its books.

Generally, an interest coverage ratio which is higher than 1 is considered suitable for the company, as it means that it has enough capital to service its debt obligations. A higher interest coverage ratio also makes the company less risky to lenders.

Conclusion

To conclude, it is paramount to remember that these ratios must not be used in isolation, but in unison with others so as to obtain a holistic view of oil and gas companies and their operations. We hope that these ratios will help you to understand and evaluate this sector's stocks better.

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