An oil and gas producer has proved reserves of oil and gas sold at a discount to the benchmark. Build its net asset value and show what a wider oil differential costs.

The NAV is about USD 1,241 million, Rs 10,550 crore, of which oil is Rs 10,237 crore and gas only Rs 313 crore. Oil nets USD 49 a barrel on 4 million barrels a year, USD 196 million; gas nets USD 1.0 per mcf on 6 bcf, USD 6 million. Ten years at 10% is an annuity factor of 6.14. A USD 3 wider oil differential cuts the netback to USD 46 and removes Rs 627 crore, 5.9% of the NAV.

Because the asset runs out. A factory can run for fifty years; a field produces its reserves and stops. So the sector values the cash each barrel and each mcf will earn, discounted over the years it takes to produce them: a net asset value, not a multiple of this year's profit. It is like valuing a bottle of a rare whisky by the glasses left in it and the price of each glass, not by how many you drank last year. Reserves are the glasses; the netback is the price of one glass.

The netback is what a unit earns the company after the price is cut for where and what it is, and after the cost of getting it out of the ground. Bhadrik's oil sells at USD 75 less a USD 6 differentialThe discount or premium to the benchmark price that a producer actually receives, reflecting transport to market, crude quality and local supply and demand., USD 69, less USD 20 of lifting cost: a netback of USD 49 a barrel, 65% of the benchmark. Gas sells at USD 3.0 less USD 0.8, USD 2.2, less USD 1.2 of cost: a netback of USD 1.0 per mcf, a third of the benchmark. The gas netback is thin, which is the first thing to say out loud: a small move in the gas differential or cost changes its value a lot.

Produce evenly, so each year sells 4 million barrels and 6 bcf, which is 6 million mcf. Oil earns 4 million times USD 49, USD 196 million a year; gas earns 6 million times USD 1.0, USD 6 million a year. Ten equal years at 10% is an annuity factor of 6.1446, so oil is worth USD 1,204 million and gas USD 37 million, USD 1,241 million together. At Rs 85 a dollar, one million dollars is Rs 8.5 crore, so the NAV is about Rs 10,550 crore. Note what discounting did: the undiscounted cash is Rs 17,170 crore, and ten years at 10% takes almost two-fifths of it away.

Take it straight off the netback. At USD 9 the netback falls to USD 46, annual oil cash to USD 184 million, and oil NAV by USD 73.7 million: Rs 627 crore, 6.1% of the oil value and 5.9% of the whole. Each dollar of differential is worth Rs 209 crore, exactly as much as a dollar off the benchmark. That is the point an energy desk wants heard: the benchmark is on every screen, but the differential is set by pipeline capacity and local demand in the basin, and it can widen while the benchmark stands still. Gas is more fragile still: USD 0.3 of extra gas differential removes 30% of the gas value, Rs 94 crore, because the netback is only USD 1.0 to begin with.

Close with the limits, because a real NAV has more lines than this. Production is never flat: fields decline, so cash is front-loaded and the NAV is a little higher than the even-spread assumption gives. Royalties and tax come off the netback and can take a third or more of it, so confirm the regime before quoting a number to anyone. Prices are not flat either; a bank would run the forward curve or a long-term deck. And proved reserves are the floor: probable and possible reserves carry value too, at lower confidence. The structure holds for all of them: volume, netback, timing, discount.