The debt double standard for Canadian vs American energy producers
The 49th parallel isn't just a border between Canada and the United States. It also represents an important line for the amount of debt investors are willing to tolerate in their energy producers.
Investors and CEOs have both learned the hard way. Canadian producers with more than 2X debt to cash flow–sometimes even 1.5:1–get no love from the stock market. Typical conservative Canadian investors–they have almost no tolerance for debt.
South of the border, energy producers can carry big debt relative to their cash flows and still get high valuations from stock investors.
Comparing the recently acquired North Dakota Bakken producer Kodiak Oil and Gas (KOG) with Canadian Bakken producer Lightstream Resources (LTS) shows the stark difference.
There's lots of similarities:
For 2014 Kodiak guided for production of 39,000 to 42,000 barrels per day. Lightstream’s 2014 guidance–updated for recent asset sales–is actually a little bit higher at 43,000 to 45,000 barrels per day.
Conclusion: Production levels are similar.
They're both light oil producers, so they similar levels of cash flow. Lightstream’s first quarter annualized EBITA was $753 million while Kodiak’s first quarter 2014 annualized EBITDA level is $716 million.
Conclusion: EBITDA levels are similar.
Cash flow dictates debt capacity. With similar levels of production and cash flow/EBITA it's no surprise that Lightstream and Kodiak carry similar levels of debt–$2 billion and $2.3 billion respectively.
The Debt to EBITDA ratio of each company using its first quarter 2014 run rate annualized therefore looks like this:
Lightstream – $2 billion / $753 million = 2.65 times
Kodiak – $2.3 billion / $716 million = 3.21 times
So it may surprise you to know the reputations of these stocks in the market; that is Lightstream having a weak balance sheet, and Kodiak doesn’t–despite Kodiak carrying more financial leverage than Lightstream.
This is the debt double standard and it shows up in how the market values these very similar companies.
Kodiak is about to be required by Whiting Petroleum (WLL) at a slight discount to where the stock has recently been trading.
The all-in (debt plus equity) price tag that Whiting is paying for Kodiak is $6 billion. That means that Whiting is paying roughly $150,000 per flowing barrel and 8.4 times EBITA.
Meanwhile the very similar Lightstream at its recent share price carries an enterprise value of $3.5 billion which means that it currently trades at $79,000 per flowing barrel and 4.6 times EBITA.
If Lightstream were to trade at the same multiples of production and EBITA as Kodiak its share price would be $22 or $23. (To be fair, Canadian energy producers also trade at a small discount to US ones because of the Canadian "differentials"; our oil prices are lower because of pipeline constraints south, east and west of Alberta.)
Instead Lightstream’s shares languish between $7 and $8.
Now don’t take this to mean that I’m terribly bullish on Lightstream, because I’m not. I know the rules of the game and I play by them.
This management team is in the penalty box for past disappointments. In late 2013 they cut in half a dividend that they had forever said was sustainable and then also subsequently reported a very disappointing 2013 reserve report. Add to that capital spending that went over budget in 2013 resulting in very poor capital efficiency and you have a group that has a lot to prove.
I’ve used Lightstream because it was very similar to Kodiak in size, leverage and oil weighting.
Lightstream’s valuation predicament clearly shows how debt averse Canadian investors are relative to their American counterparts.
Other Canadian producers that carry much less leverage have valuations that are very similar to Kodiak’s. Companies like Crescent Point Energy or Raging River which have debt to EBITDA ratios at 1X or less regularly trade for $150,000 per flowing barrel or higher.
Take away the debt and the assets are valued similarly.
There Are Other Variables To Consider – A Big One Is Decline Rate
Kodiak and Lightstream are similar but there are differences.
Lightstream is diversified across a few oil plays while Kodiak is focused on the Bakken/Torquay. The profitability and payout times of the wells that each company is drilling is similar, but Kodiak’s wells are much more prolific and expensive to drill.
One big difference that should actually make Lightstream’s production more valuable than Kodiak is–Lightstream has a lower decline rate; i.e. the rate at which its production is declining naturally is lower than Kodiak's.
Both companies are pure plays on horizontal oil production. In the first couple of years these horizontal wells have extremely high rates of decline. Production at the end of the first year of the life of a well can be down by more than 60%.
By year three or four those decline rates settle in around 20% per year and get a little better from there.
Both Kodiak and Lightstream have close to 40,000 barrels per day of production, but because it has been growing so rapidly Kodiak’s production is much newer than Lightstream’s.
That means that it is declining much more rapidly and is going to require considerably more capital to just offset those declines in the coming year.
With two-thirds of its production less than two years old, Kodiak likely has a corporate decline rate that exceeds 40%. Lightstream which has more mature production has a decline rate that is around 27%. Over 40% is bad, under 30% is really good for light, tight oil plays.
Fair Or Not–These Are The Rules of The Game
Like it or not (and I’m sure companies like Lightstream vote “not”) this debt double standard is the rule for investing in Canada. A consequence of that is Canadians use more equity and have more shares outstanding than American producers.
If a CEO doesn’t want his company to suffer from a big valuation discount, he or she has to run with a clean balance sheet.
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