Corporate Decline Rate And Sustainable Growth - Kodiak, Sundance And Austex

by: Josh Young

Thanks to improvements in hydraulic fracturing and drilling efficiency, a number of oil and gas companies will grow their production substantially in 2013. Though how much they grow in 2013, and into the future, will be constrained by a factor that investors may not be paying enough attention to - corporate decline rate.

The corporate decline rate has always been an issue for E&P companies, as virtually all oil and gas fields decline at some point, and new wells have a tendency to decline significantly, particularly in the first few years. E&P companies with high corporate decline rates often have trouble growing and companies with low corporate decline rates often enjoy steady growth.

Kodiak (NYSE:KOG) offers an interesting case-study, as a company that has experienced rapid growth for the past few years and earned substantial returns for equity investors.

Kodiak's production growth over time can be seen here:

And its capex over time can be seen here:

One of the first things one notices comparing these two is that Kodiak's capex does not correspond linearly with production growth. Essentially, Kodiak has had to spend more and more to achieve similar levels of growth. The challenge is, new Bakken well production rates decline by over 70% from their initial 30 day production rate in the first year, and typically by over 30% in the second year. This means that Kodiak will have to replace over 50% of its 2013 production rate just to keep production flat in 2014. With capex in 2013 lower than capex in 2012, Kodiak could see limited production growth in 2014, a far cry from its 100-270% production growth rates to date.

For those who believe that can't happen, take a look at what is happening to production at Northern Oil (NYSEMKT:NOG) in 2013, and what happened to PetroBakken (PBKEF.PK) in 2010/2011. See PetroBakken's production since 2010 (they don't show production from before 2010 in their presentation, probably partly because it hockey-sticks like KOG's before proceeding to decline in 2010 and most of 2011):

And PetroBakken's stock chart showing the period from its spinoff, when production had been growing rapidly, through production slowing down all the way to slightly declining:

And Northern Oil's stock chart (even the casual observer can guess when production growth expectations peaked - early 2011, when concerns of flooding affected production):

Another oil and gas company is forecasting explosive growth in 2013 - Sundance Energy (OTCPK:SDCJF). I wrote an article discussing Sundance's reserves and touching on its valuation. In short, it trades at ~2x its proved reserve value, in anticipation of significant production growth in 2013. And grow it will, as seen in the production forecast below:

With the growth Sundance is expecting, it will run into serious headwinds in 2014. The majority of its production at the end of 2013 will be "new", from wells that are in the midst of their rapid first year decline. Sundance may have to replace more than half of its 2013 exit rate production just to keep production flat in 2014.

And finally, AusTex (OTCQX:ATXDY) is growing substantially in 2013. It is projecting growth from ~500 boepd at the start of 2013 to ~1,400 boepd at the end of 2013, or almost 200% growth. AusTex will have similar issues sustaining growth due to its likely high corporate decline rate at that point. However, one mitigating factor for AusTex is the unusually high rate of return it achieves on its wells, which along with its low cost per well, may allow it to follow in Kodiak's footsteps and continue on a multi-year path of accelerated production growth.

One reason I mention AusTex here is that it trades at a significant discount to the valuation of the other rapidly growing companies mentioned, both on a proved reserves basis and on a "flowing barrel" basis for exit 2013. Kodiak has a proved reserve value of $1.9 billion, versus an enterprise value of $3.5 billion - so it trades at just under 2x its proved reserve value. And Sundance has a proved reserve value of $160 million, versus an enterprise value of $280 million, or also just under 2x its proved reserve value. AusTex has a proved reserve value of $198 million, versus an enterprise value of $75 million, or less than 1/2 of its proved reserve value. On a proved reserve basis, $1 of AusTex stock seems to provide the same reserve value as ~$4 of KOG or Sundance stock.

On a production basis, the calculation is similar - KOG is projecting 30,000 boepd of production, versus $3.5 billion, so it is trading at ~$117,000 per flowing barrel. Sundance is projecting 4,000 boepd of production, versus $460 million market cap (it will spend its cash balance to grow production), or $115,000 per flowing barrel. AusTex is projecting 1,400 boepd, versus $85 million market cap (same effect as Sundance), or $61,000 per flowing barrel. So on a production basis, $1 of AusTex stock seems to provide the same production value as just under $2 of KOG or Sundance stock.

In summary, corporate decline rates are a real issue that companies and sometimes analysts tend to sweep under the rug. Companies like PetroBakken and Northern Oil have been impacted by high corporate decline rates, which contributed to subsequent stock price declines. As rapidly growing companies, Kodiak, Sundance and AusTex will each have this issue. AusTex seems to be trading at a substantially lower valuation than the other two, which may present a buying opportunity, particularly as production growth flattens out at Kodiak after years of tremendous growth.

Disclosure: I am long OTCQX:ATXDY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short a small number of KOG shares (the KOG short is less than 0.5% of my portfolio at the moment). AusTex is a small company with risks from being a small company, and I may buy or sell stock in any company mentioned at any time.