What 4 x EBITDA means for oil stocks

And why Headwater is worth ten times EBITDA

Energy investors often value oil & gas stocks at a multiple of EBITDA and 4 x is a typical metric. Why? What does it mean?

First, investors should note that all oil or gas wells suffer declining output once in production. Oil wells in the Western Canadian Sedimentary Basin typically have 30% decline rates and gas wells often decline at 40% a year. In both case, the economic life of a well is usually on the order of ten years, after which it may still produce but at a nominal rate and eventually will be capped and closed.

If you think of a single well or group of wells with a 10-year life that had a capital cost of $20 million and produced 1,000 Boe/Day of intial production with a 30% decline rate (that would be a “blockbuster” well so think of it as a set of wells), all-in operating costs, royalties, transportation, etc. of $20 per BOE, and a 10% discount rate, the DCF value of that well at a steady $80 per BOE commodity price would be ~CAD$70 million and first year EBITDA would be ~CAD$18 million assuming CAD$2 million G&A. Valued at 4 x EBITDA, the well would be worth CAD$72 million. Four times EBITDA is more or less the same as the DCF valuation noted. It is a useful rule of thumb but caution is warranted - it is helpful in comparing two companies but can lead to over and undervaluation.

Two things are clear. First, drilling a well (more likely a group of wells) for $20 million that had a DCF value of $70 million is serious value added. Second, valuing producing wells at 4 x EBITDA implies a 10% DCF and a constant commodity price at the metric above. In secondary markets like NYSE or TMX, we are buying current production and implicitly making assumptions about decline rate, netbacks, life of wells, etc. But some companies have much more costly capital efficiency, less productive wells, higher decline rates, and higher operating costs. Valuing those companies at 4 x EBITDA will have a negative outcome.

Other companies, like Headwater (HWX.TO) have better capital efficiencies, different operating costs, lower decline rates and better economics overall. As a result, they are worth a lot more than 4x EBITDA. Headwater can add 1,000 Boe/day for about $13 million and has all-in operating costs, royalties, transportation costs of ~CAD$25 a barrel and at CAD$80 per Boe creates a DCF value of about CAD$50 million for a $13 million capital outlay with first full year cash flow about three to four times that initial capital cost. As a result, Headwater can grow rapidly while throwing off tons of free cash flow, with its growth gated only by the physical nature of its reservoirs, the time it takes to evaluate the geology and plan drilling and infrastructure investments, and the availability of rigs and construction equipment to drill wells and build necessary infrastructure. I model Headwater production ending 2022 at a run-rate of ~20,000 Boe/day with 2023 ending at ~25,000 Boe/day and a December 2023 cash balance approaching CAD$500 million.

In my view, Headwater’s stock value is closer to 10 x EBITDA than 4 x EBITDA which yields a share price of about CAD$20 versus the current CAD$7.50. Ultimately, the market will recognize the value of self-financing rapid growth with plenty of optionality from a surging cash balance.

I own 15,000 shares of HWX.TO. I expect to add more over time.