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Company Background

Northern Oil & Gas (NYSEMKT:NOG) is one the largest non-operators in the Bakken and Three Forks formations within the Williston Basin in North Dakota and Montana. A recent U.S. geological survey (April 2013) predicts that there is 7.4 billion barrels of undiscovered, recoverable (with current technology) oil within the Bakken and Three Forks formations.

NOG has a market cap of just under $1 billion with an enterprise value of $1.43 billion. Working with partner Bakken operators, the company's main business is crude oil and natural gas exploration, development and production. In 2012, average production was 10,865 barrels of oil per day. As of June 30, 2013, NOG owned 182,400 net acres of leasehold properties, about 50% of which had been developed.

Total revenue for FY 2012 was $311,573,000, a 108% increase from FY 2011. Total operating income was $129,137,000 in FY 2012, a 92% increase from FY 2011. Total production also increased 95% compared to 2011. Proven reserves grew 44% compared to 2011.

As of December 2012, its revenue breakdown was as follows:

Oil Sales

$288,382,000.00

Natural gas and GL Sales

$8,256,000.00

Loss on Settled Derivatives

$(391,000.00)

Gain(loss) on Mark-to-Market of Derivative instruments

$15,147,000.00

Other Revenue

$179,000.00

Total Revenues

$311,573,000.00

As of Oct. 26, 2013, NOG is trading at a price of $16.37/share, with the following:

  1. Trailing P/E of 19.41
  2. Forward P/E of 12.31 (FYE Dec. 31, 2014)
  3. EV/Revenue of 4.66
  4. EV/ EBITDA of 6.8

Investment Thesis

Northern Oil & Gas is one of the largest leaseholders in the Bakken and Three Forks formations. Over the past three years, the company has tripled its operational cash flow. It continues to grow with the acquisition of additional leasehold properties. Due to the fact that it is a non-operator, NOG has much lower overhead than other operating companies. Despite this extreme growth and low overhead, NOG only trades at ~20 times its earnings (as of Nov. 10, 2013). It can be assumed NOG is improperly priced and is trading at a discount to its intrinsic value due to the following reasons:

  1. As stated above, NOG has grown exponentially in the past several years. Its assets have doubled from 2010-12 (although they have been met by high debt liabilities), and its operational cash flow has tripled in the past three years. Increasing leasehold acquisitions, NOG has allocated its capital so it is in the position to continue such growth at least several years to come. The market, however, has not compensated for this growth. As stated above, NOG is trading at a P/E of just 20. Given these statistics, I believe NOG is undervalued.
  2. Since NOG's primary source of revenue is the sale oil and natural gas, it is fair to assume it does not offer a product advantage to its customers. However, NOG does have an advantage against other oil companies in the same region that should attract investors. That advantage is its extremely low overhead. Most other players in the same region bare extremely high production costs, reducing profits. Working in conjunction with operating companies, NOG is able to reduce these costs significantly. This advantage (as well as others) also put NOG in a good position for an acquisition by a larger company (mentioned in the catalyst section).
  3. Even if NOG does not exceed its future earnings/growth estimates, and is priced perfectly, it is still a good investment given its forward P/E (FYE 2014) of 12.3. Similar companies in the same region trade for much higher P/E ratios.

These reasons show that NOG may be undervalued, and show that even if the market is correct about its valuation, it is still a profitable investment.

Catalysts

NOG is undoubtedly a long-term growth play. However, several catalysts may cause a steep increase in the price of the stock, over the next one to 12 months. These catalysts include:

  1. New and improved completion technology (specifically Whiting Petroleum's new well completion technique).
  2. Greater-than-expected retrievable oil quantity in the Bakken and Three Forks formations.

Acquisition Potential

In a report on Whiting Petroleum Corp., Suntrust analyst Ryan Oatman reported that Whiting Petroleum's new well completion techniques "looks revolutionary" and continued to say it would benefit other Bakken companies. Whiting Petroleum is an operator that works with NOG (among others). Since NOG is a non-operator, it is extremely likely that this will work to their benefit (six- to 12-month range).

In 2008, a U.S. geological survey reported that there was between 3 and 4.3 billion barrels of recoverable oil in the Bakken formation. A U.S. geological survey released in April 2013 held a new figure, indicating that there is approximately 7.4 billion barrels of recoverable oil. As new technology surfaces and more oil is discovered, properties in the Bakken become more and more valuable (one- to 12-month-plus range).

NOG could see an acquisition of the whole company or strictly its leaseholds, as its high Bakken acre ownership can be viewed as attractive to a variety of larger companies. Last year, QEP Resources (NYSE:QEP) acquired 27,600 net acres for $1.38 billion from a variety of companies, including non-operators. As of June 30, 2013, NOG leased approximately 182,400 net acres, about half of which are undeveloped. This would mean that if QEP or a similar company bought out just NOG's undeveloped acres, it would pay approximately four times the enterprise value of NOG. This is evidence of not only the possibility of an acquisition, but also that NOG may be severely undervalued. (unclear time frame).

Risks

Although NOG is undervalued and is a strong, growing company, it has several key risks, such as:

1. Default/Insufficient Cash Flow

NOG has a high debt/equity ratio (81.85). As of June 30, 2013, NOG had a total long-term debt of $510,283,000, and only $18,095,000 of cash in hand. The company's current assets are also lower than its current liabilities. While this is cause for concern, it is mitigated by several factors. First, the fact that NOG has tripled its operational cash flow over the past three years indicates that it will likely have sufficient funds to cover its payments. Second, NOG has about $400 million of borrowing power (revolving credit facility) at its disposal should it run into a situation where it desperately needs to pay off debt.

Hedge: Since this affects all aspects of NOG's business, and is its largest risk, it would make sense to use NOG's put options as a hedge. The table below shows a range of put options available (not limited to, however), expiring January 17th, 2015. In bold is my suggested option. A put option with a $15.00 strike price trading at $2.10 would give a maximum loss of 8%, at an expense of 12.8%% of original investment (per 100 shares/$16.37).

10.00

NOG150117P00010000

0.66

0.00

0.55

0.75

3

118

12.00

NOG150117P00012000

1.08

0.00

0.95

1.15

30

434

15.00

NOG150117P00015000

2.10

0.00

1.90

2.20

5

487

17.00

NOG150117P00017000

2.85

0.00

2.75

3.10

40

175

20.00

NOG150117P00020000

7.20

0.00

4.50

4.90

3

6

2. Oil/Gas Market Fluctuations

The oil and natural gas markets are volatile and can negatively (and positively) affect the company's oil sales. While the company does hedge against the commodity market risk, these hedges may not always be effective and may present another problem: unrealized gain/loss on derivative instruments. The company reports unrealized gain/loss on its derivative instruments as revenue, which in turn effects its earnings. The company's past income statements show that this has both increased and decreased revenues. Therefore, it is important to perform due diligence on the company's source of revenues each quarter.

Hedge: If a concern is only over lower oil prices (and thus lower sales), shorting oil futures or shorting another oil company -- such as Triangle Petroleum Corporation (NYSEMKT:TPLM) -- could be an effective hedge.

3. Environmental Regulations

The growing concern over climate change and greenhouse gases presents a regulatory risk to NOG. Movements are in effect to limit oil consumption and production, both of which may negatively affect NOG's business. It is unclear as to what extent these regulations will affect the business, if at all. However, it is still within the range of possibilities.

Hedge: If an investor was looking to hedge only against regulations, the most effective hedge would be the short sale of a similar company, such as Triangle Petroleum Corp.

Recommended Risk Control

While NOG offers huge upside, like all investments it contains a degree of risk. My personal suggestion for hedging would be solely Jan. 17, 2015, put options with a strike price of $15. These put options would cap losses for all risks, and are reasonably inexpensive as compared to the per share market price of the company.

Conclusion

NOG is a growth play at a good value. The company has grown exponentially in the past several years and is in the position to continue growing at high rates in the future. As a non-operator, NOG is a highly attractive company due its low overhead and high returns. Since NOG's biggest risks are its high debt and the possibility of regulation, I would recommend buying one Jan. 17 put option at a $15 strike for every 100 shares bought. This creates an absolute maximum downside, with minimal cost to upside. Ultimately, if hedged properly, NOG is a safe investment with huge potential for gains in the near and long term.

Disclaimer: This is solely my opinion. It should not be considered investment advice by any means.

Source: Northern Oil & Gas: Growth At A Good Value