In early June, analysts at Wunderlich Securities began covering Kodiak Oil & Gas (KOG), initiating coverage with a "buy" rating and a $10 price target. In a research note, Wunderlich analysts indicated that "the current valuation of the stock is compelling given Kodiak trades at a discount to peers despite the expected growth in 2012 and beyond." Looking ahead to the next two years, I agree with Wunderlich's price target, but over the next eight years, I think that Kodiak could break much higher.
Natural Gas Prices Still Punishing, But Kodiak Is an Oil Company
The most recent inventory release from the U.S. Energy Department shows that while U.S. natural gas inventory is still far above average, the most recent build was much lower than average for this season. Storage rose by 71 bcf, which is at the high end of the range predicted, though lower than the 89 bcf injected last year. With lower demand from a mild spring and summer across most of the U.S., it will be some time before natural gas storage begins to decline from its current high of 2.815 trillion feet.
The continued oversupply will be putting pressure on natural gas producers like Kodiak, as natural gas prices are still flirting near the break-even point for many producers, at $2.30 per mmbtu. This is far below the 2011 high point of $4.92 per mmbtu, when U.S. independents were riding high on recent shale gas successes. This dramatic slide is pushing down shares in Kodiak as well as those for other producers like Chesapeake (CHK) and Encana (ECA). However, unlike Chesapeake and Encana, Kodiak was successful in navigating the switch from natural gas to oil, so I think that the pressure on Kodiak is deriving from investors who still think of the firm as a natural gas company. In fact, 96% of Kodiak's first-quarter revenue was oil driven, with just 4% coming from natural gas sales. This higher oil revenue amounts to a 499% increase compared with the quarter a year prior, indicating that Kodiak's executive management team is leading the company in the right direction.
By contrast, Encana relies on natural gas for 95% of its revenue. Encana is therefore suffering from the depressed natural gas prices more so than its peers, as it did not make moves to begin diversifying into oil until natural gas prices were so low that its revenue could not support meaningful oil development. Over half of Encana's annual production derives from wells in the U.S., so though the company is based in Canada, it can fairly be said to be a U.S. competitor - especially as U.S.-based independents cast attention north to Canada's LNG projects (more on this below).
Encana's Vice President, Investor Relations Ryder McRitchie admits that Encana "did not see a 50-to-one oil-to-gas ratio coming," although others in the industry, such as EOG Resources (EOG) saw the price differential coming as early as 2007. In fact, Encana made opposite moves, as it spun off its now profitable oil sands division into Cenovus (CVE) in 2008, a move that in retrospect severely damaged Encana's chances at becoming an oil producer. Since Encana now has a debt-to-equity ratio of 0.9, it is unlikely that the company will be able to overcome its oil production deficit through a major acquisition, especially since RBC Capital markets is predicting that the company will have a cash shortfall over $1 billion by 2015 if it cannot come up with new sources of revenue. Compared with Encana, Kodiak's natural gas dependence seems overblown.
Position in the Williston Could Be Starting Point for Canadian LNG
Analysts at Wunderlich recently noted that Kodiak's holdings "in the Williston basin…contain some of the most productive areas of the region," and I think that the Williston is largely responsible for Kodiak's success in shifting its production toward oil. As of March 2012, production from the Williston averaged 12,500 boe per day (pdf) for Kodiak, a respectable number from a single play for a company with a market cap of $2.1 billion. Since just 41% of its acreage on the Williston Basin is developed, Kodiak still has opportunity to increase its production of both oil and natural gas.
Kodiak also has a major infrastructure advantage. Its plays are concentrated in the northern half of the U.S., where several existing and proposed pipelines cross, connected with most of the major hubs in the U.S. and Canada. As companies like Chevron (CVX), Shell (RDS.A), and even ConocoPhillips (COP) look at exporting liquid natural gas from the western coast of British Columbia, Kodiak might be approaching a major opportunity.
Prices for natural gas remain strong in the Asia Pacific region, which is why the majors are willing to spend billions on developing pipelines and processing plants for natural gas export. Kodiak's current connection locations and its acreage with natural gas potential may already mean that Kodiak is in place to participate in the next boom. If so, Kodiak is better positioned than peers like Chesapeake. Chesapeake's acreage is scattered, and in many cases, nowhere near the major pipelines without making use of additional transport, which erodes potential profit from such a long-distance move.
The joint venture led by Shell is currently winning the race to be the first to export liquid natural gas from British Columbia, though the earliest estimated date for liquid natural gas export from Kitimat is not until 2020. This gives Kodiak an eight-year horizon to continue driving revenue on oil while preparing to jump back in to natural gas production. Given its proven ability to call trends on the leading edge of industry changes, I like Kodiak's chances. As I mentioned above, I think that Kodiak stock is being punished by shareholders who still view it as a natural gas company, which is resulting in a huge discount on the value of its shares. Trading around $8 per share, Kodiak is a solid buy for future growth.