Aurora Oil and Gas (AUT.AX) is a well-managed oil company with a highly economic acreage position in the core of the Eagle Ford Shale oil play. The Eagle Ford Shale was recently highlighted in a Wall Street Journal article, and has received a lot of press, even more attention from the Sell Side, and has been the focus of a number of some of the largest and most successful oil and gas companies, attracting capex dollars and scarce oil services and drawing increasingly high transaction valuations.

As a pure play company in such a play, Aurora naturally draws investor attention, and achieves a premium valuation. And as a well-run, well-managed small-cap oil company, it deserves a premium valuation. However, Aurora is not trading at a premium valuation, it is trading at an absurd, stratospheric valuation and is likely to descend most of the 70% or so it would need to trade back in line with the most recent highest private market transaction comps. Also, importantly, there are shares available to borrow, and the stock is primarily owned by momentum driven retail investors.

Aurora currently has a market cap of $1.4 Billion AUD, with roughly $75 million in cash and no debt. It owns 15,760 net acres primarily in the condensate window of the Eagle Ford Shale in Karnes County. It has current net production of 1,660 BOEPD (barrels of oil equivalent per day).

There are a couple time frames in which to value Aurora - ranging from the present to 4 years from now, when their field has been nearly fully developed. And there are several valuation metrics that can be used to construct a range of potentially appropriate values.

To be conservative, let's start with the highest valuation Aurora could achieve with its current asset base, assuming the company management's assumptions about well production, reserves, and costs are correct. Management is projecting production will level out around 22,000 barrels of oil equivalent per day by 2014. At $70,000/BOEPD (the appropriate metric considering the high decline rate of the production and that some of the production is natural gas), this gets you to a valuation of $1.54 billion. Management has hired a 3^rd party reserve engineering firm (not so different from credit rating agencies - garbage in, garbage out). The pre-tax 3P valuation awarded by this firm is $1.4 billion.

These numbers represent maximum values for the company's current assets. Virtually every other oil company trades at a large discount to their 3P value, which is often viewed as a ceiling value for a stock. Also, there are almost no oil companies that trade on flowing barrel metrics based on production 3 years out. And, these assume management estimates are accurate, which is unlikely for several reasons. The most obvious is the estimated well cost - management assumes a $6.5 million cost to drill and complete wells. Currently, it costs ~$8.5 million to drill and complete a typical Eagle Ford well, and that number is continuing to rise with the tightness in oil service capacity.

More realistic valuation estimates would include a production metric for year end 2011 production, a 2P valuation, and recent transaction comps. Management projects 2011 year end production will be 5,000 BOE/D. At the same $70,000/BOE/D metric, Aurora would be worth $350 million. The 2P value provided by the 3^rd party reserve engineering firm, using management's rosy production assumptions and low-ball well capital costs, is $442 million. And the recent Marathon/Hilcorp transaction metric of ~$20,000/acre and $70k/BOE/D of current production implies a value of $431 million.

And a bear case valuation would simply give credit for current production, or $70,000/BOE/D, or $116 million, plus some small amount of credit for acreage value, perhaps $5,000/acre, getting you close to a $200 million valuation. This would be conceivable in an economic downturn where the price of oil came down substantially and oil companies reverted to trading for their 1P reserve value without much upside development valuation credit.

The short thesis is simple - the Marathon deal illustrates the current private market value of the asset and gives you a good idea as an investor of what a low cost of capital, sophisticated private investor would pay for it. And if other public companies with similar acreage positions, like PetroHawk (HK), were to trade for metrics similar to Aurora, they would trade for 3 times their current share prices. And similar companies in other oil fields trade for far lower metrics. Northern Oil (NOG) of blog-bashing fame, has 150,000 acres in the Bakken and currently produces over 5,000 BOPD, but has a similar $1.4 billion market cap.

So on both a fundamental and relative value basis, Aurora is grossly overvalued. Its current market value likely derives from the 3P value management has reported to unsophisticated retail Australian investors and from unrealistic service cost estimates and production growth assumptions. For Aurora to be worth its current market valuation, it would need to grow production 13x in a short period of time, which is an unrealistic expectation. Or it would need to be valued based on aggressively booked 3P reserves, which virtually no other public oil companies are valued on. As momentum wanes in the stock and more attention is paid to its valuation, the stock is likely to fall back to earth, yielding a potentially substantial return to investors who short the stock here.

I skipped a number of steps here to get this out the door in a timely manner. On P/E, P/CF, EV/EBITDA, etc. metrics, Aurora is almost immeasurably expensive and is trading way in excess of its comps. In the absence of meaningful traditional valuation metrics, the key here is the Marathon transaction, which gives me a lot of comfort that the asset is not worth anything close to what it is trading for, and it gives the market an easy and simple target valuation. The sell side has started to catch on, with Scotia Capital, a well-respected Canadian bank, taking the unusual step of pounding the table recommending shorting this stock based on valuation. For a more articulate short thesis and additional reasons to short the stock, see their note from June 2^nd.

The main risk to a short thesis is they issue equity and use it to buy additional assets. However, while that could reduce the return from a short position, management has historically overpaid for assets and there is likely a limited secondary market for shares of Aurora at the current nose-bleed valuation.

I am short Aurora Oil stock and may buy or sell the stock at any time without further notification. I do not currently own stock in other companies mentioned here and may buy or sell these stocks without further notification. I am not compensated by any of the companies mentioned here.