Josh Young's  Instablog

When investors think of the Mississippian play, they generally think of Chesapeake (CHK) and Sandridge (SD), which have amassed the largest positions in the play. Or they think of Range Resources (RRC), which has drilled some of the best wells in the play, or Shell (RDS-A), Devon (DVN), Petroquest (PQ), or other well known companies amassing large positions in the play. Or they might think of Red Fork (RDFEF.PK) and Osage Exploration (OEDV.OB), which are Mississippian pure-plays that earned some of the highest stock returns in the past year.

But few investors have heard of Austex Exploration (ATXDF.PK), which is up 25% in the past 3 days. Austex has the most leverage to the play (enterprise value/acre), some of the best results (over 1000 boepd horizontal well and 100 boepd vertical wells), and enough running room to grow production over 1,000% over the next few years.

Austex has two core areas. The first, 5,500 acres in Southern Kay county, is adjacent to Range's position, and is in one of the most productive and oil saturated areas of the play. Austex participated in a horizontal well drilled by Range that, at 45 days in production, was still producing over 1,000 barrels of oil per day! And Austex has drilled several vertical wells in the area that have been coming on at over 100 boepd (I've been cautioned to only expect 50 boepd per vertical well, but each well to date has IP'd at over 100). This 100 boepd IP rate is impressive considering it only costs $500k per well, and that Austex is drilling two wells per month. In fact, there are 7 wells currently either drilling or in completion, which should be coming online soon and should rapidly increase production. And there is lots of running room, with 150 vertical or 35 horizontal drilling locations on the property.

Austex's other core area is 17,000 net acres in NW Kansas. This area had been considered fringe until Apache (APA) leased over 550,000 acres surrounding Austex's position. The land value of Austex's position surged on that news, and Apache's interest in the area is a validation of the concept Austex is pursuing there and increases the chance of the field being economic.

In summary, as Austex continues to grow production by drilling highly economic Mississippian wells, it will gain a higher profile, and it becomes more likely to follow Red Fork's path to becoming one of the best performing stocks in the market (Red Fork was up from 34 cents last year to a high of $1.18 in May). Up 25% in the past 3 days on meaningful volume, Austex is on its way.

Disclosure: I am long ATXDF.PK.

Gale Force Petroleum (GFP CN or GFPMF.PK)

Gale Force Petroleum is a Canadian-traded roll up of conventional oil properties in the US, primarily in East Texas, Oklahoma and West Virginia. It is off the radar, rapidly growing, trades at a discount to its proved reserve value and to its peers, and is opportunistically executing new deals to continue its production and value growth.

GFP has approximately 50 mm shares outstanding. At 20 cents per share, its market cap is $10 mm. It has net debt of about $6 mm, for an enterprise value of $16 mm. As of the end of 2011, it had over 275 boepd of production, 90% of which was oil. GFP is targeting 350+ boepd of production by the end of June 2012 from the properties it owned as of the end of 2011.

Why do I care about a $10 mm company? It is very rare to find a small publicly traded oil company that is:

Trading at a discount to its PV-10 value - GFP's last reserve report indicated a proved reserve value of approximately $40 mm, implying a $0.68 stock value (net of debt), 240% higher than the current price of $0.20. This reserve report includes neither the impact of recently increased production nor the Marcellus deal - proved reserves could increase by $5 mm from those factors, implying a potential stock value of $0.78 (net of debt), almost 290% higher than the current price!

This reserve report was prepared by Harper & Associates, which has provided reserve engineering to Ultra Petroleum and Range Resources among other clients, and was filed with Canadian securities regulators as a 51-101 report. It seems reasonable to expect the reserves to increase markedly in the next reserve report as this report was from June 2011 and production has increased substantially since then.

Trading at a discount to its private market asset comps - GFP's current 275 boepd has a private market value. In the areas its fields are in, production with low decline rates and high % oil to gas ratios currently sell for over $70,000 per flowing barrel. This implies an over $19 mm transaction value for the year end 2011 production, or an over 30% premium (net of debt) to the current $0.20 stock price. Additionally, with minimal capex Gale Force should be producing between 350 boepd and 400 boepd by the end of June, which implies an over $24 mm transaction value, or an 85% premium to the current stock price. This doesn't include the value of the Marcellus deal or of future deals Gale Force may enter into.

Free cash flow positive - Unlike most small oil companies, Gale Force generates significant free cash flow beyond its maintenance capex and overhead costs. I estimate the current run rate free cash flow at over $1.5 mm per year. This implies a low trailing free cash flow multiple, particularly when considering the rapid growth rate. Another way to look at this is that GFP could pay a $0.03 per share dividend with 100% cash flow coverage, just from year end production levels, a 15% yield relative to a $0.20 stock price.

Low decline rate - Many oil companies have production bases that are rapidly declining, in some cases at 40% or more per year. In order to grow, they first need to replace that production. Gale Force doesn't have that problem - management estimates that the properties that constituted the production base at the end of 2011 have less than a 5% decline rate. This means that incremental production at Gale Force almost immediately goes towards production growth rather than replacing depleted production; this will allow Gale Force to grow more rapidly and less capital intensively than its peers.

Well managed - The comparatively high free cash flow levels and concomitant low overhead and maintenance capex is indicative of bottom-line focused management. This is rare in the growth-at-any-price oil and gas exploration and production industry, especially among smaller companies. It helps provide some comfort regarding downside protection - management is unlikely to squander cash flow from the properties, which makes asset-level valuation metrics more relevant and reliable.

Also, management has so far earned excellent returns on deals, and has shown discipline in only entering into deals that offer both exceptional returns and comparatively few risks. The strategy is inherently lower risk, in that it is focused on acquiring proved reserves for low prices, not engaging in wildcat exploration or the recent fashionable approach of land speculation in unconventional or shale plays.

Growing rapidly - on a per share, debt adjusted basis, GFP is growing faster than almost all of its peers. This past summer it was producing around 150 boepd, and it is on track to be producing 350 boepd this summer, or a 233% growth rate. Obviously it is impossible to continue to grow indefinitely at this rate, but with the recently announced Marcellus deal having closed and with other deals in the pipeline, it is possible Gale Force can continue to grow more rapidly than its peers, building off its low-decline production base and financing a substantial portion of its growth with free cash flow and low cost bank debt.

Has a hedging program - Gale Force currently holds some puts on oil production in 2012 and has indicated that it intends to hedge out the majority of its "PDP" (proved developed producing) production for the next two years, locking in a high oil price and reducing risk to cash flows in case oil prices fall. Hedging is potentially a value-added strategy because Gale Force could potentially monetize hedges at a sufficiently low oil price and use the cash to buy back low-priced stock or acquire distressed assets, creating more value for shareholders.

Recent deal - ongoing value creation

On January 31st, Gale Force announced the financing of a liquids-rich Marcellus shale project. Gale Force purchased a 0.255% working interest in several producing wells, producing approximately 20 boepd (50% liquids) net to GFP. In addition, GFP will have a 1.125% working interest in 50-100 additional wells drilled on the 10,000 gross acre lease. 50% of GFP's working interest is reversionary to the seller after a 25% IRR is achieved.

This Marcellus deal is indicative of the types of deals Gale Force has executed and highlights the company's ongoing value creation across several dimensions.

Low cost of entry - Gale Force paid nothing upfront for very valuable leases - in the area, leases have recently sold for in excess of $10,000 per acre. And the reversionary interest is substantially better than industry standard - a 25% IRR hurdle before a 50% split is much better than the typical "1/3 for 1/4" deal and joint venture deals.

Cost advantaged operations - The operator of the property is a multi-billion dollar public company that was able to leverage its large Gulf of Mexico oil service contracts to secure discounted drilling and completion services, leading to a $6 million well cost, versus $7 million for nearby operators.

Excellent economics - The liquids rich Marcellus shale in Wetzel County, West Virginia, is one of the most highly economic new fields in the country, despite its high gas content and low current natural gas prices. Wells drilled in the area exceed a 30% IRR at $3 gas and $90 oil. Obviously there is substantial upside potential in the case of a natural gas price recovery. Also, early production numbers are indicating the first wells may be twice as good as expected, which should flow-through to even higher than expected well economics, returns and production growth for Gale Force.

Risks - Obviously GFP is a risky investment. GFP is an illiquid stock, its growth strategy is dependent on capital markets, and its revenue, cash flows and intrinsic value could be negatively impacted by lower commodity prices, particularly oil, which could be somewhat mitigated through an active hedging program. There is also execution risk, although that is somewhat mitigated by an excellent execution track record to date.

There is also the risk the company stays below the radar, the equity stays cheap, and the company isn't able to use the equity as currency for acquisitions. This came up in conversations with the CEO - I think in that case the company would likely sell off assets and either use the proceeds for acquisitions or distribute them to shareholders. Also, being off the radar is largely a function of size, and the company is rapidly growing into the "radar zone".

Additional questions and answers - color from the CEO

I circulated the above thesis among a small circle of investment manager and investment banker friends. The following few questions came up, which I passed along to the CEO of Gale Force and to which he responded. Please find the questions and his responses below. Obviously, like the rest of this thesis, I believe this is not material non-public information, but rather color around information already found in public filings, highlighting certain aspects and risk factors of Gale Force.

1) Are these low cost / mature well opportunities recurring or "one-off" deals?

Initially, GFP's business plan was written for a 18-24 month opportunity to access undervalued/underdeveloped properties as a result of (a) the financial crisis 2008-09 that resulted in numerous over-leveraged companies and general lack of access to capital causing property prices to decline significantly, and (b) higher oil prices making fields in mature basins economic again (i.e. $20 netbacks at $60 oil), and (c) new technologies allowing for cost-effective recovery of additional reserves. We are in a secular bear-market, and we believe the opportunities are in place for 5 years, as far as the eye can see.

2) How concentrated is the production at the wells? (I.e. do you get 90bbl from one well and 10bbl from 9, or is it spread out)

Spread out. Largest well currently does 25 bbls per day plus some gas. New wells coming on-stream in the next 12 months are expected to do 50 bbls per day plus gas.

3) How is the decline rate for these wells 5% while market is 40%? Is this sustainable?

Decline rate used by GFP's third-party engineers is 8%.

4) In their presentation they have ~$50mm of prospective acquisition opportunities, which one project consisting of the bulk of that. Where does this $50mm come from?

GFP has dozens of acquisition opportunities, is currently in various stages of evaluation/negotiation on a dozen properties. The presentation only includes the next 2 likely to be purchased by the company.

Disclaimer: The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing. The author will not undertake to supplement, update or revise such information at a later date. The author was not compensated to prepare this report but may have other commercial relationships with Gale Force or other parties mentioned. The author may hold a position in the securities discussed, and may add to or sell this position at any time.

Disclosure: I am long GFPMF.PK.

Additional disclosure: The views expressed are those of the author and do not necessarily represent the views of any other person. The information herein is obtained from public sources believed to be accurate, reliable and current as of the date of writing. The author will not undertake to supplement, update or revise such information at a later date. The author was not compensated to prepare this report but may have other commercial relationships with Gale Force or other parties mentioned. The author may hold a position in the securities discussed, and may add to or sell this position at any time.