Business value is at times illusive, perfectly visible just on the horizon one moment and gone as you approach it the next.
Imagine yourself as an equity analyst. Not just any analyst, but an oil sector analyst in 1972. Through some magic power, you knew with certainty the future trend in oil prices. You were standing on the brink of one of the great bull markets in the history of the oil industry. Oil prices would increase tenfold by 1980. Your task was to determine the value of Exxon.
You suspect a tenfold increase in price will have more than a tenfold increase in earnings and cash flow. You also know Exxon has an inventory of great capital projects. Those projects have decent returns with the $3/barrel oil of 1972; return on capital should be astronomical with $30/barrel oil.
You make your estimate. You sit back and watch oil prices rise. That’s weird. A tenfold increase in the price of Exxon’s product resulted in just a doubling in the price of Exxon stock. That’s just a two percent increase after adjusting for inflation. Exxon was the largest and most powerful oil company on the planet, yet it could barely eke out a gain during one of the greatest oil bull markets in history. Wow.
When the price of a commodity goes up, like it did with oil in the 1970s, the extent to which the rise in the commodity price translates into rise in business value depends on the reasons behind the rise in the commodity price.
The price of oil is the ratio of two values. We quote the price of oil in dollars per barrel, which is the value of a dollar divided by the value of a barrel of oil. Prices increase in one of two ways: the value of the denominator goes up or the value of the numerator goes down. The price of oil can increase, in other words, if the value of a barrel of oil increases or if the value of the currency declines. Those two drivers of price have very different effects on the values of the companies that produce the commodity.
Denominator-driven price increases can create a windfall in business value for companies that produce that commodity, especially companies with access to incremental low-cost supply of the commodity or companies that possess the skills to find, develop, and produce the commodity. A price increase in this case reflects the supply and demand dynamics of the commodity and represents a bona fide increase in the value of the underlying commodity. Companies positioned to supply that commodity at a reasonable cost benefit. Business value increases.
Numerator-driven commodity price increases, on the other hand, do not translate well into business value. In these cases, an increase in the price of a commodity does not reflect an increase in the underlying value of the commodity. Society doesn’t put any more value on the underlying commodity than it did before the price increase; the value of the currency just declined.
While numerator-driven price increases might be satisfying for commodity producers in the short-term, over the longer-term the producer of the commodity finds its cost of doing business increases. When the value of a currency declines, after all, the price of everything denominated in that currency goes up. That includes not only the price of the commodity, but also the prices of the products and services associated with finding, developing, producing, transporting, refining, and distributing the commodity in question. That increase in the cost of doing business, in fact, is one of several reasons why numerator-driven price increases do not translate well into business value. Society isn’t really asking for more physical product. The economics of the business are exactly the same, the numbers all just move higher.
Yes, the price of Exxon’s product increased tenfold between 1972 and 1980, but its cost of doing business increased more than tenfold: Exxon’s capital spending increased by a factor of ten and its expenses per barrel of oil produced increased by a factor of twelve. Exxon’s oil and gas operations shockingly experienced no operating leverage as prices increased tenfold during the 1970s. That is exactly what we would expect if the primary driver of price came from the numerator, as we know it did during the 1970s.
As equity analysts, we must distinguish between these two drivers of price. Denominator-driven price increases translate to business value. Numerator-driven price increases do not, especially after adjusting for inflation.
