Kodiak Oil & Gas (KOG) is one of the smallest oil and gas companies trading, with a market cap of just $2.2 billion. The company shows strong prospects for future growth, spurred by its acquisition spree in the final months of 2011 and its focus on assets on the Bakken Shale as it develops the experience and knowledge needed to expand further. The U.S. Geological Survey estimates that up to 4.3 bboe could be recoverable from the Bakken across North Dakota and Montana, which is substantially more than the upper estimate of 3 bboe recoverable remaining in the best plays of the Permian Basin.
At the moment, Kodiak is hampered from fully exploiting the Bakken by a lack of manpower and equipment, like many of its competitors. As of its latest investor presentation, the company had thirteen wells in the Williston Basin that were waiting on completion tools in order to move towards production. I suspect that as the company moves forward with its drilling pads Kodiak's growth will look meteoric in hindsight, especially given a current regulatory environment that threatens to change the way energy companies do business. Kodiak's active hedging strategy indicates that despite the company's current small size, it may be unduly impacted by these changes.
CFTC Action against Arcadia Is the Beginning
A major part of Kodiak's financial strategy is active participation in commodity hedging, where it aims to hedge between 85 and 95% of its production. It also plans to increase its hedges regularly as its PDP increases. Though a common and accepted strategy, an increased federal focus on market manipulation through speculation may soon require re-analysis of this strategy by Kodiak and others.
Last year, the Commodity Futures Trading Association (CFTC) enacted a rule that caps the number of contracts a single derivatives trader can have, and enforcement of this rule will begin later this summer, on August 5. Though currently the rule only affects members of the CFTC, Kodiak's annual report makes reference to the fact that this regulation and new restrictions imposed by the Dodd-Frank Act could adversely impact its hedging strategy through increased costs and limitations on participation.
The CFTC is taking speculation seriously, moving forward with a lawsuit against Arcadia Petroleum and Parnon Energy alleging manipulation of oil futures prices in 2008. The CFTC is asking for trading and registration bans on those responsible, civil penalties, restitution, and a permanent injunction against the parties. The defense's main argument is that the companies "never held enough oil to influence global prices." The problem with this argument, which is also the problem with the CFTC's argument that the defense was able to move the markets, is that no one knows how much oil has to be cornered or otherwise manipulated to have a global impact. According to the complaint, the Arcadia consortium began with a purchase of 4.1 million barrels of February WTI crude in January. At the time, there were between 15 and 17 mboe at Cushing, meaning that the group purchased between one-quarter and one-third of the supply there.
Common sense would assume that this significant percentage would be enough to move the market, but no exchange always operates according to common sense. It will be very interesting to see where this case ends up, especially as it relies heavily on the 2007 case brought by the CFTC against Marathon Oil (NYSE: MRO), in which Marathon paid a $1 million civil penalty for allegedly manipulating futures prices in 2003.
A Framework of Increased Futures Regulation
I think that this CFTC case, which shows signs of becoming much larger than the Marathon case, will combine with President Obama's current calls for greater futures restrictions and regulations to potentially usher in a new framework for futures trading. There are arguments for and against greater regulation, but I think the main point on which most would agree is that it would have a disproportionate impact on smaller players like Kodiak, SandRidge Energy (SD), Continental Resources (CLR) and Chesapeake Energy (CHK).
First, hedging activities allow these smaller producers to protect against wide swings in the market which larger companies can better sustain. Second, increased regulation almost always has a larger adverse impact on small players, as small players are working with fewer resources - not just production, but revenue, budget, and crucially, political influence. Supermajors like Exxon Mobil (XOM) may be able to influence regulation through carefully chosen wording, but even a consortium of small and mid cap energy companies would have trouble bringing enough pressure to bear to achieve the same results at a national level, especially on an issue like futures regulation.
Of course, the supermajors are just as unlikely to prefer increased commodities restrictions, since these companies' positions in the markets can be enormous - for example, as of the end of the first quarter 2012 Chevron (CVX) realized a $10 million gain on its derivatives trading, and held $431 million in derivatives assets against $128 million in derivatives liabilities. Compare this to Kodiak's derivatives positions as of the end of the first quarter, when Kodiak reported $688,000 in current derivatives assets against $2 million in current derivatives liabilities. Kodiak's activities are extremely small compared to Chevron's, but if new rules were enacted Kodiak would potentially face the same regulatory and accounting burdens as a larger competitor better able to absorb the cost and increased staff hours related to such a change.
I anticipate that regulatory changes are on the horizon for the futures market, especially if the CFTC proves that those involved in the Arcadia trades were able to move the market on their activities alone. The burden of proof, however, is on the CFTC. I believe that Kodiak and its peers large and small will also be watching the case closely.
Though Kodiak reported first quarter earnings per share of just $0.01, there were several other factors on its balance sheets that must be taken into account to receive a better idea of this small cap's growth potential. What stands out to me is that Kodiak accumulated acreage in 2012 that contributed to higher than average depreciation and amortization costs in the first quarter. Though the balancing is correct, it does not take into account growth prospects. For a better picture, consider that in the first quarter of 2011 Kodiak reported a $0.04 loss, and Kodiak's most recent quarterly total revenues were a stunning 84% above its revenues for the year-ago quarter. I think this points to a fast-growth track for Kodiak.
I am also encouraged by the company's commitment to keep its long-term debt at two times or less of EBITDA, which shows an awareness of the prospect of over-leveraging that is recently lacking in small, expanding energy companies. Current trading around $8 per share gives Kodiak a price to book of 2.5 and a forward price to earnings of 8.3, which is a little on the high side until its 158% revenue growth in just the last three years is remembered. Overall, I think Kodiak is an excellent opportunity, and I expect to see the stock respond positively to the company's strong growth throughout the rest of 2012.