Kodiak: Avoid This Speculative Stock

| About: Kodiak Oil (KOG)

In January, a number of people said that Kodiak Oil & Gas Corp. (NYSE:KOG), which is a Bakken Shale oil and gas company, could have promising investment potential. Jim Cramer announced that it was a screaming buy while it hit Zacks Rank Buy as a "1". The recent pullback in price is good reason for us to look at Kodiak once again.

The United States has made it a priority to reduce dependence on foreign oil and there are a number of promising projects with this purpose. The Bakken Shale, which is spread over Montana, North Dakota and parts of Canada, is believed to have oil reserves that are richer than some of the oil producing countries in the Middle East. The US Geological Survey estimates that the Bakken Shale holds undiscovered reserves that could total 3.65 billion barrels of oil, 1.85 trillion cubic feet of dissolved natural gas and 148 million barrels of natural gas liquids. Since Kodiak has exclusivity in crude oil, it stands to benefit from high prices of crude oil, as well as any recovery in natural gas prices.

Recently, analyst Daniel Katzenberg of Oppenheimer revised his earnings estimate for Kodiak after the updated company guidance and reiterated the "Outperform" rating and $12 price target on shares of KOG. The company expects to hit its year-end exit rate of 27,000 boe/d. Eight wells have been completed in May and another 12 are planned for completion in the second quarter.

Katzenberg believes that average second-quarter production volumes would be 15,000 boe/d. The first quarter had a slow start because of a shortage of rigs and average production was only 10,500 boe/d but in March 2012, production was 12,500 boe/d. However, the availability of more rigs and fracking crew means that the company's year-end target should be achievable. The brokerage increased its 2012 EPS estimate to $0.83 from $0.71 and its 2013 estimate to $1.05 from $0.81.

Kodiak is one of the smallest oil and gas producers with a market capitalization of around $2 billion. It is highly leveraged because it has been aggressive in building its oil and gas assets and is therefore vulnerable to the downside of oil price fluctuations. Because it is involved only in crude oil, the present lows of the natural gas market do not have an impact.

At the moment, West Texas Intermediate spot crude prices are at a nine-month low and developments in Europe mean that oil prices will continue to be volatile. Lacking the financial resources of the larger players, Kodiak relies heavily on hedging and a large part of its 2012 production and a smaller part of its 2013 production are hedged at higher West Texas Intermediate spot prices. If oil prices decline further, it could be pushed liquidity-wise to keep its operations going. The capital expenditure budget for 2012 is $585 million of which the company claims to have $400 million in available liquidity.

For Kodiak as well as the other Bakken shale oil producers, such as EOG Resources, Inc. (NYSE:EOG) or Oasis Petroleum Inc. (NYSE:OAS), the potential for investors critically depends on oil prices and the production costs of shale oil. The cost considerations of shale oil production complicated because you have to take the cost over the lifetime of the assets into your calculation. Oil can be extracted very cheaply from oil fields in places like Saudi Arabia and profitable even at very low crude oil prices.

Shale oil is an entirely different ball game because fracking, which involves the use of chemicals and lots of water, is much more expensive. High labor costs in places like North Dakota add to the expense. In fact, one of the largest oil companies in the world, Occidental Petroleum Corporation (NYSE:OXY) has recently announced that it is drawing its rigs from the Bakken shale because of the high costs of production.

The outlook on global crude oil prices is uncertain because the European crisis has caused the dollar to strengthen and the prices of crude oil to fall. Developments in places such as Iran have caused speculators to bid up oil prices in the expectation of global shortages. The more fundamental reason for the weakness in oil prices is simply the demand supply equation.

Production in both the OPEC countries and North America has risen over the last year, while the economic uncertainties have actually reduced demand for oil from around 90 million barrels a day in December 2011 to just over 80 million barrels a day in April 2012. At the same time, prices of natural gas are showing signs of recovery because of the heavy promotion of natural gas transportation by investors such as T. Boone Pickens, the major investor behind Clean Energy Fuels Corp. (NASDAQ:CLNE) which is building a coast to coast chain of natural gas fuel stations.

Hedging is not as straightforward a strategy as it may seem. The Commodity Futures Trading Association (CFTC) is leaning towards more regulation. There are arguments both for and against but, clearly, more regulation would have a disproportionate effect on smaller companies such as Kodiak, SandRidge Energy, Inc. (NYSE:SD) and Chesapeake Energy Corporation (NYSE:CHK). The smaller producers will find it more difficult to protect themselves against market price volatility, and lack the resources and financial or political strength to be able to lobby effectively. Moreover, increased regulation will inevitably lead to increased cost.

There is no doubt that Kodiak has potential as an investment, but I find myself unable to give you a buy recommendation at this point in time. There are still too many uncertainties, which mean that an investment would be a speculative play rather than a decision based on fundamentals. I would recommend that you wait and watch and buy when the future outlook appears to be more favorable. Hold onto any existing investments in the expectation of an upside in due course.

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