This week's review focuses on the high, 17½% yielding, short term bonds of Northern Oil & Gas (NYSEMKT:NOG), a "non-operator" in the oil and gas rich areas of North Dakota and Montana. This company continues to position itself competitively in the "lower for longer" oil markets by reducing costs, increasing production, and posting higher adjusted EBITDA.
For Q2, the company posted adjusted EBITDA / interest expense ratio of 2.8x.
Even with a 50% year-over-year reduction in capital expenditures, Northern still posted a 3% sequential production increase.
Northern has decreased production expenses by 11% from Q2 2015.
Adjusted EBITDA in Q2 registered a sequential increase of 22% over the previous quarter.
Being a non-operator allows the company to "cherry-pick" the most lucrative wells to participate in.
Low oil prices continue to provide investment opportunities for those who can find the unique companies who are not just surviving, but those who look to build a better and leaner organization. We believe Northern Oil and Gas is one such company. These 44-month bonds, couponed at 8.0% and yielding an impressive 17.5%, can add great cash flow and increased return to a diversified bond portfolio, and we are therefore marking them for addition to our FX1 and FX2 high yield global income portfolios.
Northern Oil and Gas recently posted its results for Q2 ended June 30, 2016. These results show a company that is continuing to focus for the long-term amidst still historically-low oil prices. As with many oil and gas companies, Northern Oil and Gas has drastically reduced the amount of capital expenditures (MUTF:CAPEX) this year in the wake of oil prices at 12-year lows. However, even with its capex reduced by 50.5% year-over-year, the company still had a 3% sequential production increase. Also, the company's production expenses decreased over Q2 2015 by 11%, coming in at $11.1 million versus $13.6 million. Northern's adjusted EBITDA also showed a sequential increase in Q2 from Q1 2016, up 22% from the previous quarter.
About the Issuer
Northern Oil and Gas is an independent energy company engaged in the acquisition, exploration, exploitation, development and production of crude oil and natural gas properties. Northern's principal business is crude oil and natural gas exploration, development, and production with operations in North Dakota and Montana that primarily target the Bakken and Three Forks formations in the Williston Basin of the United States. The Company acquires leasehold interests that comprise of non-operated working interests in wells and in drilling projects within its area of operations. As of June 30, 2016, approximately 74% of Northern's 161,675 total net acres were developed.
Interest Coverage and Operating Margin
For its latest quarter (ended June 30, 2016), Northern Oil and Gas had adjusted EBITDA of $44.3 million and interest expense of $16.0 million for an adjusted EBITDA / interest expense ratio of 2.8x. For 2015, NOG had adjusted EBITDA of $277.3 million and interest expense of $58.4 million, for an adjusted EBITDA / interest expense ratio of 4.8x.
Impressively, even as oil prices have declined over the past two years, Northern Oil and Gas' operating margin has remained fairly consistent over the past five years.
Hedging a portion of oil production helps oil companies smooth out the volatility in cash flows inherent in the sale of commodities. NOG has successfully used hedges to its advantage, increasing the price received per barrel for the oil it sells. The company is continuing to use hedging for the balance of 2016, and into 2017. Currently, the company has 900,000 barrels (450,000 each in Q3 and Q4) hedged for the balance of 2016 at a weighted average price of $65 per barrel. In addition, NOG has also hedged a portion of its 2017 oil production. Currently, the company has 720,000 barrels hedged in the first half of 2017 at a weighted average price of $50 per barrel, and 240,000 barrels hedged in the second half of 2017 at a weighted average price of $52.75 per barrel. The 2017 hedges account for roughly 40% of Northern's projected production.
The Non-Operator Advantage
While most exploration and production companies are directly involved in exploration and production (they search for new places to drill and are actually responsible for the drilling and extracting of oil from new wells), NOG is a non-operator, meaning they do not drill or operate wells. Instead, they own a minority working interest in the properties where the wells are located. One of the benefits of a non-operator include the ability to pick and choose the most lucrative wells ("cherry-pick") with the highest rates of return, only allocating capital to wells with that will maximize profits. In addition, being a non-operator gives NOG the ability to control a large acreage position, substantial production profile and high quality reserves with a very small number of employees.
Embracing the Challenges
Northern Oil and Gas has approached the low oil price environment by focusing on capital discipline, maintaining liquidity and improving operational efficiencies. First, Northern Oil has exercised capital discipline. The company has cut its capex spending by 56% in the first half of 2016 as compared to 2015. It has also sought to keep a healthy level of liquidity. As of June 30, 2016, the company had $221.7 million in liquidity. Lastly, NOG continues to implement operational efficiencies, with cash operating costs down by 23% in the first six months of 2016, as compared to the first half of 2015.
The default risk is Northern Oil and Gas' ability to perform. Even as the price of oil has declined sharply over the past two years, NOG has shrewdly used hedges to help insulate its cash flows against the drastic declines. The company has managed to increase its production, even as it has vastly reduced its capital expenditures over the past year. And the company has held a steady operating margin for the past five years, even as oil prices have decreased sharply. In light of these factors, we believe the current, outstanding yield of 18.5% on the company's 45-month bonds, appears to outweigh the risks identified here.
The majority of NOG's revenues are affected by the price of oil. While there has been some recovery in the price of oil since the lows reached earlier this year, a level of continued volatility should be expected within the oil markets as they recover. However, if oil prices continue to stay low or decrease even further, it could affect NOG's ongoing revenues.
NOG has indicated it continues to be interested in acquisitions. If the company can acquire distressed properties with cash (without incurring additional debt), it could add asset value as well as potential additional oil production. However, our opinion is that acquisitions at this time through the use of debt would not be prudent.
In general, bond prices rise when interest rates fall and vice versa. This effect tends to be more pronounced for lower couponed, longer-term debt instruments. Any fixed income security sold or redeemed prior to maturity may be subject to a gain or loss. Higher yielding bonds typically have lower credit ratings, if any, and therefore involve higher degrees of risk and may not be suitable for all investors.
These bonds have similar yields and durations to other bonds reviewed on the Bond-Yields.com site, such as the 18.8% Natural Resource Partners (NYSE:NRP) and 8.5% Carrizo Oil and Gas (NASDAQ:CRZO) bonds.
Summary and Conclusion
As companies continue to strategize for "lower for longer" oil prices, Northern Oil and Gas is also taking steps to stabilize cash flow and maintain liquidity, while preserving production levels. Its smart use of hedges, capital reductions as well as cost reductions have kept the company competitive even as oil prices linger in the $40 to $50 per barrel range. Being a non-operator has been advantageous as it allows the company to "cherry-pick" the most lucrative wells to participate in, thereby making wise use of its reduced capex budget. The company's June 2020 bonds, couponed at 8.00% and priced around 75, should yield an outstanding 17.5% to maturity, and are therefore targeted for addition to both our Fixed-Income1.com and Fixed-Income2.com high yield global income portfolios.
Issuer: Northern Oil and Gas
Ratings: Caa3 / CC
Yield to Maturity: ~17.58%
Disclosure: To obtain higher yields and keep costs as low as possible, we typically bundle smaller retail orders into larger institutional sized orders with many global trading firms and bond platforms. Our main priority is to provide the best opportunities for our clients. Our bond reviews are published on the Internet and distributed through our free email newsletter to thousands of prospective clients and competitive firms only after we have first served the needs of our clients. Bond selections may not be published if they have very limited availability or liquidity, or viewed as not being in the best interests of our clients. Durig Capital and certain clients may have positions in Northern Oil & Gas 2020 bonds.
Please note that all yield and price indications are shown from the time of our research. Our reports are never an offer to buy or sell any security. We are not a broker/dealer, and reports are intended for distribution to our clients. As a result of our institutional association, we frequently obtain better yield/price executions for our clients than is initially indicated in our reports. We welcome inquiries from other advisors that may also be interested in our work and the possibilities of achieving higher yields for retail clients.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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