What is Netback?
Netback or Operating Netback is a calculation which is generally used in the oil and gas industry which is used to measure the oil and gas sales revenue by a netting of the royalties received and other cost related to production and transportation i.e. it is a non-GAAP KPI which is exclusively used in the oil and gas industry to act like a benchmark performance indictor to demonstrate the performance comparison between competitors, operations and time period.
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For eg:
Source: Netback (wallstreetmojo.com)
Features of Netback
- It is specific to the oil and gas industry only.
- Netback is a layman’s word that can be described as gross profitGross ProfitGross Profit shows the earnings of the business entity from its core business activity i.e. the profit of the company that is arrived after deducting all the direct expenses like raw material cost, labor cost, etc. from the direct income generated from the sale of its goods and services.read more per barrel.
- It can be used as a benchmark index to compare two oil company competitors.
- It also allows the analyst to compare the operations of two oil producers.
- It is a non-GAAP measure, so it means different companies can use different techniques to arrive at the netback calculation.
- It shows how efficient a company is in the business of extracting oil/gas and selling it as a commodity/product.
How to Calculate?
Netback Formula = Price (Sales Revenue) – Royalties – Production Cost – Transportation Cost
Thus, it gives us the gross profit per barrel of oil where the sales obtained or the revenue generated from selling per barrel of oil is considered as the price of the barrel. From this, we need to deduct the royalties paid for selling the oil. The overall production cost involved starting from the extraction of oil to selling it, and finally, the transportation cost to supply the oil/gas to end consumers. After deducting all the three factors mentioned above from the sales revenue, we finally arrive at the gross profit earned per barrel of oil, which is called the Netback.
Example
A basic example can be explained in a scenario where suppose Aramco world’s largest oil-producing company has its operation in Saudi Arabia, where it extracts oil to supply all around the globe. Let us assume for every barrel of oil which it extracts. It pays $10 as royalties, $15 as production cost i.e., mainly consumed in the extraction of oil, and $10 as the transportation cost to supply the oil. Now let us consider per barrel of oil selling at $120.
Netback Formula = Price (Sales Revenue) – Royalties – Production Cost – Transportation Cost
- = $120 – ($10+$15+$10)
- = $85
Thus we can say Aramco’s operating Netback is $85, and this can be used as a comparison benchmark with other players or competitors to compare their operation efficiency.
Netback Agreement
Oil and gas producing companies have gone to an extent where they are selling their products under what we call netback agreements. This contract or agreement assures the customer or the buyer of oil/gas of a commercial margin or cut off while also assuring floor prices for the producing companies to cover up the cost of production. This leads to a win-win situation for both parties. Again some are worried of such an agreement because during the 1980s, similar kind of agreement by oil producers who were having a surplus of oil and were eager to sell the same in the market resulted into a drastic drop in the prices of oil as netback pricing forced the refiners to maintain its business irrespective of the sharp drop in oil prices.
Importance
- It is used as one of the most efficient benchmark indices or KPI measures in the oil and gas industry.
- It is useful when we want to compare the performance of two different players in the oil/gas industry.
- It helps in assessing a company without the impact of non-operating costs and other financing costsFinancing CostsFinancing costs refer to interest payments and other expenses incurred by the company for the operations and working management. An enterprise often borrows money from different financing sources to run their operations in return for interest payments and capital gains.read more.
- It acts as a type of efficiency ratioEfficiency RatioEfficiency ratios are a measure of how effectively a company manages its assets and liabilities and include formulas like asset turnover, inventory turnover, receivables turnover, and accounts payable turnover.read more research analyst who is covering the position of the company.
- By keeping track of the netback/BOE over a period of time, we can evaluate the efficiency of the producer’s production, selling, and transportation capacity.
- A high number of the netback/BOE will show how a business is coping up with the price volatility in the market where a higher number suggests that in times when prices are declining, the company still stays profitable.
Advantages
- It is a KPI that helps to assess the efficiency of the company and also helps in comparing the same with other competitors.
- It gives us a measure of the gross profit earned per barrel of the sale made.
- It helps research analystResearch AnalystResearch analyst is a profession where the main task includes research on specific fields, analyzing the facts and figures, interpreting the analysis, and finally presenting the same to a structured audience that can relate to marketing, finance, operations.read more to analyze the financial health of the company and how efficient the production of a company is.
- It helps exploration and production firms to compare the cost of production with other competitors.
- The prime advantage is that it helps companies strategically plan on which product the companies should focus on producing.
Disadvantages
- Since it is a non-GAAP measure, different companies may use different formulas and ways of calculation to arrive at the measure.
- It is a non-standardized method of calculation.
- The formula does not take into consideration any kind of operating or any sort of fluctuating cost.
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