You asked for my thoughts on Aurora Oil & Gas Limited (ASX code AUT & TSE code AEF) and the Euroz report or the company. Following are some observations, which point to what you need to consider when valuing this and other small cap oil and gas businesses.
Although AUT is a shale gas play the valuation principles, issues, and uncertainties are the same as for conventional oil and gas plays, although the risks are arguably higher for the reasons noted below.
For ease I assume the AUD=USD in the following discussion. Before proceeding I note that all of this is personal opinion and does not constitute professional financial advice. Think about it but don?t act upon it without seeking professional advice.
A truism: For a value investor, the best, indeed likely the only time it is sensible to buy oil and gas stocks is during the cyclical low in oil and/or gas prices. Invest elsewhere in the price cycle and you are either a momentum trader, or a speculator. Take a look at where we sit in the oil (NYMEX: WTI) and gas (NYMEX: Henry Hub) price cycles and make your call.
A word on reserves: Valuation should be made on Proved and Probable (2P) reserve estimates with the understanding that there is only a 50% probability that such an estimate of recoverable oil and/or gas will be met, or exceeded. Basing valuations on Proved plus Probable plus Possible (3P) reserve estimates is problematic. To quote from the most recent (March 2011) AUT Investor Presentation Slide 27 footnote ?There is a 10% probability that the quantities actually recovered will equal or exceed the sum of the Proved plus Probable plus Possible reserves.? AUT and the analysts reporting on it then proceed to ignore this quantified probability by valuing 3P reserves in subsequent valuations (in an attempt to justify the current market valuation?). Notice the mathematical and logical inconsistency?
Specific Issues attached to Shale Gas Reserves: This is quite a technical subject. However, based on the data disclosed I couldn?t get to more than 50% of the NSAI certified AUT reserves. Exponential versus hyperbolic production decline is at the core of the issue. Modest hyperbolic decline is likely, but the industry proponents are pushing aggressive extended hyperbolic decline, which (as always) will overstate reserves. The linked article gives some feel for the games that may be being played and to suggest that Shale Gas reserves my prove to be the ultimate Ponzi scheme is not out of the question: http://www.energybulletin.net/node/49342
For the more technically inclined the following links provide more discussion of the problem: http://www.oilslick.com/Commentary/?id=746&type=1
Incidentally the late great Matt Simmons (author of Twilight in the Dessert and of Peak Oil fame) was of this view.
The message is that you need to view unconventional shale gas reserve estimates with some caution, as typically more than 50% of the forecast gas recovery is projected to occur after 10 years, way beyond the experience of the industry to date, some even pushing this out recovery out to up to 45 years from the initial production!
AUT Board: Seven highly paid (for a minnow of a company) directors with two oil and gas career professionals amongst them. The balance is from investment banking, finance and legal backgrounds. It looks a bit like a lifestyle support vehicle to me. To this add the unnecessary costs of dual listing ASX and TSE and you have to question the game plan.
Operating Model: The company holds only minority joint venture, non-operated positions. Control of operations is with a third party. AUT is very much a passive investment vehicle in a shale gas play. Is this what you are looking for? The game plan may be to ?enhance? the value of previously purchased shale gas properties and then pass the parcel at some point; hence the composition of the Board.
Euroz and other analysts? Reports: Euroz disclosure is worth remembering when you read the report? ?Euroz Securities declares that it has acted as underwriter to and/or arranged an equity issue in and/or provided corporate advice to Aurora Oil & Gas Ltd during the last year. Euroz Securities has received a fee for these services. This analyst also declares that he has a beneficial interest in Aurora Oil & Gas Ltd.?
In reading the Euroz report remember AUT has near negligible production and requires another 53 well completions this year to get to its small first year production target. As a result, there is a lot of operational and project delivery risk in the business.
Perhaps unsurprisingly I cannot replicate anything close to Euroz forecast for this and subsequent years based on what I consider realistic assumptions.
Also remember that based on the AUT well data disclosed to date that the average production decline is 70% in the first year (in contrast to 0-10 % typical of a conventional gas well). As a result, the rolling production increase forecast by analysts requires an exponentially increasing number of wells to be drilled year on year and this does not appear to be fully accounted for based on my modelling. All told over 900 wells (by AUT?s estimate) have yet to be drilled (at gross joint venture cost of $6.8 million per well) and completed in the next 8 years to generate the forecast production. Work this through in terms of logistics and risks, plus capex and financials, and you will see the problem that this treadmill rapidly creates accompanied by the associated risks of capex escalation and schedule (value) slippage. It is easy to do on a spreadsheet, but quite difficult in the real world!
Reserves and Valuation: A very basic assessment metric is how much you are paying per barrel oil equivalent (BOE) of estimated 2P reserves when you buy an oil and gas stock.
Currently AUT has an enterprise value (market cap plus net debt) of $1223 million based on 416 million shares on issue.
Proved and Probable (2P) Reserves at 31 December were 22 MMBOE (million barrels oil equivalent) of which only 2.54% (560,065 barrels) was condensate, which is effectively priced as oil.
Therefore in buying AUT at the current price you are paying the equivalent of $1223/22 = $55.35/BOE.
However, 97.5% of the BOE is gas and NGL?s which is priced at $24.84/BOE (at last Henry Hub gas price of $4.14/mmbtu). Sure there are a few adjsutments for NGL content above gas thermal spec, but lets not complicate the matter. The current market price of the stock imputes a value to the reserves of roughly twice the current undiscounted revenue of the 2P production over life (assuming no gas price rise). AUT on Investor Presentation Slide 14 footnote obliquely hint at the problem?. ?BOEs may be misleading, particularly if used in isolation. A BOE conversion ratio of 6 Mcf:1 bbl is based on an energy equivalency conversion method primarily applicable at the burner tip and does not represent a value equivalency at the wellhead.? To this I might at that it grossly overstates the value under prevailing oil and gas price relativities in the USA ($4.14/mmbtu gas is equivalent to $24.84/BOE gas versus current oil price $112/Barrel WTI)
Another way of looking at it is that the certifier of AUT?s reserves estimate, NSAI, valued (10% pre-tax NPV) the 2P reserves at burner tip at $414.5 million or $18.75/BOE (pre-tax). This is more realistic, but still reasonably generous as it is based on on perfect project delivery and costings. On my estimates of production, schedule and capex (without including reserves downside) it is closer to $5/BOE atax.
As a result, we have a range of after tax valuation for the 2P reserves estimate of $110 million ($0.26/share) to $290 million ($0.70/share).
In contrast, Roger?s IV methodology yields $0.00/share based on the most recent accounts for the period ended 31 December 2010.
Last closing price was $2.94/share.
Clearly Mr Market is valuing in a remarkable amount of upside to the currently certified Proved and Probable reserves of the company.
So are you feeling lucky?
AUT Price at posting:
$2.94 Sentiment: LT Buy Disclosure: Held
(20min delay)