Hess: Updating Valuation Methodology for U.S. E&Ps

We have adjusted our valuation methodology for U.S. exploration and production companies. Our multistage DCF valuation incorporates five years of explicit projections for a fixed period, typically five years. Terminal values are derived by assuming firms eventually earn their cost of capital in perpetuity. This contrasts with our previous methodology, which modeled the harvesting of all existing company assets. The change brings our E&P valuations in line with Morningstar’s standard equity research methodology.

For an industry facing secular decline, it might seem counterintuitive to switch to a perpetuity method. However, we maintain our long-held view that oil demand will keep growing in the short run before slowly declining over a multidecade horizon. We agree that electric vehicles and renewables are effective substitutes for oil, but light-duty vehicles account for less than half of crude consumption and there are no viable alternatives for the remainder (aviation, shipping, and petrochemicals). As production from existing wells declines quickly, the industry will have to keep developing oil and gas reserves to meet this persistent demand, and firms should receive credit for the ability to continue generating returns as a result (even when their current inventories are exhausted). Because our multistage DCF now implicitly incorporates this, the impact on fair value estimates is typically positive (with an average increase of 5%-10%).

In Hess’ HES case, the impact is much higher because its transformative assets in Guyana will drive industry-leading volume growth throughout our explicit forecast window, resulting in over 200% EBI growth by 2032 (which raises the terminal value in the perpetuity calculation). Nevertheless, our updated fair value of $117 per share is still 25% below the market price and our thesis, that we like the company and its exceptional assets but think investors have gotten too carried away on shares, is intact.