In early October, on a day when the stock market hit a recent low and WTI dropped below $80/Bbl on concerns of slowing growth in China and elsewhere, shares in Kodiak Oil (KOG) plunged to $3.60 amid media reports that the company may be facing a liquidity crunch. It is important to comprehend why these concerns arose and, more importantly, to understand if they will reappear again with a vengeance.
First, to be clear, KOG does not have an immediate liquidity crunch.
What KOG does have is a balance sheet overly reliant on bank funding that contains restrictive covenants. These covenants are not a problem so long as the economy and oil prices remain firm. And this is the crucial point; an economic slowdown and oil price retrenchment could well trigger covenant breaches that in turn cause lenders to reduce KOG’s borrowing availability. Should that occur i.e. bank lines cut, at a time when KOG has already fully borrowed its credit facilities, this would be a problem. So, whilst KOG does not have an immediate liquidity problem, it does carry some risks that the ghosts of weaker economic growth and lower WTI prices will revisit and cause KOG a liquidity crunch that again will lead to a share price wobble.
To put things into a clearer perspective, here is a snapshot of KOG’s year-end 2011 liquidity:
$101 Cash, Jan 2011
$(40) Borrowings, Jan 2011
$159 Proceeds of Share issue, Q3 2011
($71) Cash cost of Acquisition, June 30
($245) Cash cost of Acquisition, October 28
($230) Capital Expenditure, full year
$90 Cash generated from Operations, full year, including acquisitions
$225 Wells Fargo facility
$100 Wells Fargo Capital facility
$89 Projected year-end 2011 facility availability
At face value, projected 2011 year-end borrowing availability of $89 million appears reasonable. But $89 million availability out of $325 million total facilities means that the company would be using 73% of its credit lines. This is a high level of utilization. Additionally, it must be kept in mind that most of the Cash from Operations of $90 million arises later in the year whilst the $230 million Capex obligation has an earlier timetable. All in all, KOG’s liquidity during the remainder of 2011 is fairly tight but, again, there is nothing to suggest KOG should experience an immediate liquidity crunch.
Longer term it is unwise and unnecessarily risky for management to continuously borrow heavily via credit lines containing restrictive performance covenants. Additionally, given that other non-relationship banks may be involved in the Wells Fargo Capital facility this introduces risks that lines may have to be modified when external market events affect those other banks.
There are two ways the liquidity risks at KOG may be solved. The more obvious solution is another large share offering. With KOG already having a history of frequent share offerings this is not a solution that existing investors would prefer.
The preferred solution is that KOG should restructure its borrowings by issuing (say) $300 million Long-term Notes, and reduce (but not eliminate) hard-core borrowings on the bank credit facilities. Preferably, this would be embellished by an accompanying smaller share offering.
Comment: Bank borrowings contain restrictive performance covenants – in absolute levels as well as relating to the P&L and Balance Sheet - with frequent and ongoing measurement points that must be adhered to at all times, in good economic times as well as in bad. Long term Notes, on the other hand contain no P&L or Balance Sheet related covenants.
Inclusive of the October acquisition, KOG’s Total Assets by year-end 2011 should be about $800 million, being Shareholders’ Funds of $500 million and Borrowings plus Payables of $300 million.
Longer dated Notes, for liquidity purposes, are not generally issued in offerings of less than $250-$300 million in size. Conveniently for KOG, this is ball-park the amount of borrowings that KOG needs. Hence, size-wise, $300 million of Notes, which would be about 37.5% of total assets, would work for KOG.
A comparison with other Bakken peers, as of June 2011, shows that Brigham (BEXP) had $600m long term Notes on a total asset base of $1.6 billion (37.5% gearing), and Whiting (WLL) had $1.0 billion on total assets of $2.5 billion (40% gearing). By comparison, KOG’s $300 million long term Notes, also being gearing of 37.5%, would be reasonable.
The more difficult question is one of market appetite and timing. Because they are covenant-light, Long dated Notes can normally only be issued successfully when investors are confident that the risk of payment default – for both interest and ultimately principal – is low. Successful issuance of Notes is facilitated (1) by doing so when overall market conditions are favorable, (2) by ensuring the Balance Sheet of the issuer is not overly leveraged and (3) by ensuring the market can place reasonable trust in the management of the issuing company.
Whilst Kodiak is a good company with an excellent growth record in its short life, it is still small and management’s recent record of delivering reliable earnings results is lacking. Furthermore, KOG’s balance sheet is stretched and management must prove that they can bed-down the latest acquisition before the company can be expected to successfully raise $300 million on the capital markets.
On the positive side, the Bakken oil patch represents a fast developing long-term picture as evidenced by the current takeover of BEXP.
After KOG reports Q3 and full-year 2011 results, both of which must satisfy market expectations, and after the company has filed a clean 10K report evidencing a stronger balance sheet than currently exists, it should be in a position to issue $300 million Long-term Notes and to follow by restructuring its restrictive bank lines to much more manageable levels. Subject to market conditions, all of this should be doable during the first half of 2012.
Most probably, prior to accessing the capital markets, KOG may also complete a small or moderately sized share offering. This would ease liquidity concerns, would lower the balance sheet gearing to a more comfortable level, would help fund the $200m+ capex budget that KOG will have in 2012 and, most of all, would facilitate easier completion of a $300 million Notes offering.
In summary, Kodiak is currently reliant on bank credit lines that contain restrictive covenants and inherent risks. The company does not have a liquidity crunch and is unlikely to do so unless we experience an economic slowdown accompanied by lower oil prices. If such an economic slowdown were to occur – prior to KOG being able to complete a Long-term Notes financing program in 2012 - it would then be possible that KOG’s banks would have to retrench some credit facilities. An event of this nature would not be terminal because it could be solved by the company issuing further shares. The accompanying share price wobble would not be welcomed by shareholders notwithstanding that investors would be advised to buy the dip. Ultimately, KOG shareholders can look forward to the company lowering its funding risk profile via the capital markets, probably within about 6 months from now.