Kodiak: New Reasons To Buy This Undervalued Stock Now

Jun.21.12 | About: Kodiak Oil (KOG)

Kodiak Oil & Gas (NYSE:KOG) released an interim corporate update in early June, reporting strong results from the Bakken. For three of its high working interest (94% and above) wells in McKenzie County, North Dakota, Kodiak recorded initial production rates of 3,117, 2,971, and 2,709 boe. Kodiak indicated in its update that it expects to place three wells in the Dunn County area into production within "the coming days".

These wells are using extended laterals from 9,177 to 9,697 feet, which also extends the time that it takes to reach completion. Fortunately for Kodiak, its seventh operated drilling rig was recently delivered, and will be sent to McKenzie County to assist in Kodiak's escalating Bakken production for its first project, drilling a four-well pad. Kodiak is reporting higher rates of return from 10,000 foot laterals compared to laterals closer to 5,000 feet, so its recent results are in line with its past predictions - a sign of a strong management team and a realistic outlook. Both of these strengths will help Kodiak further along its growth trajectory, which I believe could be exponential.

According to its May 2012 investor presentation, Kodiak anticipates producing between 17,000 and 21,000 boe per day in 2012. Its results on the Bakken show that Kodiak will be able to meet this goal and then some by the end of this year. According to its first quarter earnings report, Kodiak had interests in 157,000 net acres in the Williston Basin, which it is using to target the middle Bakken specifically.

Refining Hydraulic Fracturing for Better Margins

As the practice of fracking develops, producers are learning to exploit multiple new strategies for greater extraction. Perhaps the most cost-effective of these measures is downspacing. EOG Resources (NYSE:EOG) took the lead with downspacing on the Bakken, moving to a 320-acre spacing that saw its recovery rate raised by 4%. On the Eagle Ford, EOG is spacing at as little as 65 acres, which increased its potential inventory to 3,200 locations - important in a field that gives EOG an 80% post-tax rate of return. Picking up on this cue, Kodiak completed five sets of wells on the middle Bakken with 1,300 feet or less of separation, and the results were strong enough that Kodiak believes it can support up to four middle Bakken wells per drilling unit.

This downspacing also reduces operating costs for Bakken producers. As the play heats up, demand for share in the infrastructure is rising past the point that the existing infrastructure can support. Though Kodiak's recent acquisition of 50,000 net leasehold acres on the Bakken included some infrastructure (three water disposal wells and a gas pipeline connection to a regional gathering system), other support infrastructure is lacking. Mark Williams, Whiting Petroleum (NYSE:WLL) Senior Vice President of Exploration and Development recently called the infrastructure on this play "stressed", noting that road problems are a major barrier on the play.

A 700% growth rate in wells drilled is placing more demand on the roads, rigs, and pumping units in the area, leading to outside-the-box solutions such as increased rail takeaway capacity. According to Continental Resources (NYSE:CLR) President Jeff Hume, now that production is escalating the infrastructure problems are "being cured very quickly", though major new pipeline starts are not scheduled until 2014 to 2015.

Another major sign that the mid-continent is heating up is the cost of housing in production hot spots. Recent reports indicate that in southern Kansas, a shortage of housing for rig workers and support staff is leading to as much as $2,100 a month rental rates for double-wide trailers. Taken together, the lack of support facilities has an immoderate impact on companies like Kodiak, since small-growth firms are not as easily able to compete on costs. With just $249,050 cash on hand at the end of the first quarter, I don't expect Kodiak to be making any major moves to build its own infrastructure like competitor Whiting, which has a planned oil and gas gathering system including lines, a terminal, and a gas plant that would come in at a cost of $200 million. Since Kodiak cannot afford this class of investment, I think it is likely that Kodiak will innovate its way to the capacity it needs to make a good showing, given its strong start with limited resources already.

Outlook

Oil and Gas Investor magazine recently awarded Kodiak its "Financing of the Year" award for its issuance of common stock and senior notes last year, which combined with a bridge loan from a consortium of servicers gave the small company the leverage it needed to make the 50,000 net leasehold acre acquisition noted above from a private seller, which effectively doubled Kodiak in size. This deal stood out as one of the major energy independent accomplishments in the past 12 months, and it is actions like these combined with a strong balance sheet that helped Kodiak earn a "buy" rating from Canaccord Genuity and a "B-" affirmation on its senior unsecured notes from Standard & Poor s Ratings Services.

Given its assets on the middle Bakken, its foresight, its strong balance sheet, and its demonstrated willingness to compete, I think Kodiak is on its way up. Over 95% of Kodiak s revenues are from oil sales, helping cushion it from low natural gas prices. As is the case with many small growth stocks, Kodiak is volatile with a 52-week range between $2.43 and $7.70, which is similar in percentage terms to the ranges of SandRidge (NYSE:SD) and Continental. In fact, since late 2007 these three stocks have responded similarly to the markets with a closer correlation than other energy independents like Anadarko (NYSE:APC) or Devon (NYSE:DVN).

Looking at the similar peaks and troughs between Kodiak, Continental, and SandRidge, I do think all three of these stocks are poised for an upswing. Currently trading around $7.50, Kodiak looks to be a very strong buy, and as oil prices rise with summer temperatures in the U.S. and elsewhere, I believe shares in Kodiak will rise in step.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.