Valuing Commodities Companies - Looking at P/NAV

Recently, I've been trying to learn more about commodities companies building on what we've learned in class as well as discussions with colleagues. Especially as Canada is a strong resource based economy (with a currency heavily influenced by the price of oil, I'm told), it is important to understand how these companies are valued.

Shree was previously very kind to explain why commodities companies provide leveraged exposure to the underlying commodity. In fact, I'm told that this is the reason why companies trade a P/NAV multiples greater than 1.

When I inquired as to what exactly Net Asset Value (NAV) was composed of, I was told that it is essentially the Asset Value (value of the commodity "in the ground") netted by the cost it took to get that asset out of the ground. So if you had to take a snap shot of what that company was worth, you'd intuitively assume that the value of the company was it's NAV.

However, as Shree demonstrated, the markets are always moving and the price of the commodity which the company bases its value on will change. This produces option like behaviour in the price of the company. While not a perfect explaination, I was told to think of it this way:

The value of the company is related to it's NAV PLUS a premium associated with the volatility of the commodity and the probability that the price of that commodity will increase. This is analogous to Intrinsic Value (NAV) + Time Value of a call option.

Obviously, there are a host of complicated relationships related to volatility, future price expectations, supply and demand, hedging and speculation which make this basic generalization a little too simple. However, I think it serves as a good starting point for how to think about and model the price.

This is similar to what we learned in Finance II when our professor explained the example of land that contained 1M barrles of oil which could be extracted at a price of $70 per barrel when the market price of oil was $60 per barrel. While a naive NPV calculation at today's rates would imply a negative NPV, the potential for the price of oil to top $70 provides real value to the land.