Last year, coming back from a pilgrimage to Glacier National Park to see the glaciers before they were gone forever, I made the mistake of stopping for the night in Williston, ND. The first motel I came to had no vacancies. Neither did the second, the third, the fourth or the fifth. My wife and I spent the night in a tent in the last campsite in a campground full of recreation vehicles, most of them used as full time homes. These are boom times for Williston, with oil and natural gas being extracted from Bakken shale by fracking procedures. There are lots of jobs, but no place to live, so all the motels are filled.
Kodiak Oil & Gas (NYSE:KOG) is a shale oil producers focused on Williston; it owns the mineral rights to a 157,000 acres of Bakken shale in the Williston Basin, with proven reserves of 52 million barrels of oil equivalent (BOE). Almost all of Kodiak's production is oil rather than natural gas. Production has been ballooning; in the March 2012 it was up over 450% from the year earlier quarter, and about 500% in dollar terms.
Despite these apparently wonderful results, Kodiak's stock price has been languishing of late. This is not surprising, as the price of crude has been dropping over the last two months. West Texas intermediate hit $110 per barrel in February, but is now down to about $83 per barrel.
Whether Kodiak and other Bakken shale oil producers like EOG Resources (NYSE:EOG) or Oasis Petroleum (NYSE:OAS) are good stock plays depends upon the outlook for 1) oil prices and 2) shale oil production costs. The economics of shale oil production are not known with any certainty, because one has to average out the cost per barrel over the lifetime of the oil play, most of which are in their early stages. The cost of the first barrel of production is very high because of the input expenses; the marginal cost of the last barrel may also be very high because it is difficult to extract. It is somewhere in the middle that all the money is made.
The recent drop in oil price has coincided with a drop in the Euro, as the European monetary union has been threatening to blow apart, due to financial crises in Greek and Spain. As the dollar rises, commodities priced in dollars naturally fall. Another reason behind the drop in oil prices has been a lessening of the geopolitical risk as Iran has become more cooperative, trying to negotiate its way out of sanctions. Speculators had bid up the price of oil in anticipation of a shortage, but have been burned badly.
But according to Bloomberg, the reason for the fall in oil is even more fundamental; demand is falling even as the supply is rising. OPEC production has increased 10% over the last year, while North American production has also risen. At the same time, economic weakness around the world, along with improved energy efficiency, especially in America, has reduced the world's appetite for oil. Global oil consumption has fallen from 90.4 million barrels per day in Dec. 2011, to 88.5 million in April.
Forty years ago, a petroleum geologist, who happened to be my grandfather, was warning me about impending Peak Oil. It stands to reason that oil resources are finite and that exploitation can't go on forever. But so far oil has obeyed the laws of Econ 101; increases in price have always brought forth increases in supply. And for now, it looks like supply is exceeding demand.
While oil from big fields like those in Saudia Arabia have very cheap production costs, and were profitable when oil was $30 a barrel, shale oil is completely different. Fracking, which requires chemicals of various kinds, and tons and tons of water, is very expensive. Fracking in North Dakota, where labor costs are high, is even more expensive. When I was in Williston, I was told that entry level workers at McDonald's were making $15 an hour, and they wouldn't stay on the job because they kept leaving for the oil fields. North Dakota has the lowest unemployment rate in the country.
One of the largest oil companies in the world, Occidental Petroleum (NYSE:OXY) recently announced that it is pulling its rigs out of the Bakken shale because of the high costs of production. According to Reuters, some analysts expect that production costs are on the verge of retreating, as natural gas producers have shut in production due to the low cost of natural gas. On the other hand, natural gas prices have been recovering of late, even as oil prices drop. Long term, oil usage in North America seems to have peaked. We are getting higher gasoline mileage due to the use of hybrid and electric cars and more efficient conventional engines. In addition, the use of natural gas as a transportation fuel has been heavily promoted by T. Boone Pickens, the major investor behind Clean Energy (NASDAQ:CLNE), which is building out natural gas fueling stations from coast to coast.
In the first quarter of 2012, as oil prices were hitting their peak, and Kodiak was scoring those very impressive production gains, the company reported all of a penny a share in profits on a GAAP basis. The company likes to emphasize instead "adjusted EBITDA" which is "earnings before interest, taxes, depletion, depreciation, amortization, and accretion, amortization of deferred financing costs, impairment, gains or losses on foreign currency, gains or losses on commodity price risk management activities, and stock based compensation expense." Some of these excluded items seem material to me. Commodity price risk management activities, i.e. hedging, cost the company $23 million in the first quarter vs. total revenues of $76 million. Is it an oil company or a commodity trader?
Long-term, Kodiak might be a great play, as oil will eventually become scarce. But right now, the uncertainties are too great. I say sell it.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.