Kodiak Oil & Gas (KOG) is experiencing a volatile month, buffeted by uncertainty over oil prices and activities in its larger peers. Based in part on its lowered expectations and gradually falling prices, analysts at Raymond James downgraded Kodiak from "underperform" to "market perform" late last week. In my view this is pessimistic, especially as other firms are taking a bullish approach to Kodiak, with Wunderlich Securities and Canaccord Genuity setting Kodiak's rating at a "buy".
Joining Forces Against Giant Enbridge
Kodiak is joining other small producers in accusing (subscription) pipeline operator Enbridge Energy Partners LP (EEP), a subsidiary of pipeline giant Enbridge (ENB), of discrimination against U.S. producers in favor of Canadian oil sands producers. Enbridge recently rejected a request from Highline Prairie Pipeline, LLC for a connection to Enbridge's main system in Minnesota, which sets back Williston Basin producers hurting for infrastructure. Kodiak filed its complaint with the Federal Energy Regulatory Commission as part of High Prairie's complaint initiated in mid-May. Refiners Suncor Energy (SU) and Tesoro Refining and Marketing Company, a subsidiary of Tesoro (TSO), sent in documentation of support for the complaint earlier this month.
High Prairie's pipeline project, which would transport 150,000 boe per day from the Bakken if completed, depends on a connection to Enbridge's system. Before the dispute escalated, Enbridge claims (subscription) it offered High Prairie a connection point in Superior, Wisconsin, which High Prairie rejected as unreasonable as it would add $200 million to its Williston Basin project costs. The pipeline is sorely needed as production in North Dakota more than doubled in the last two years, leading North Dakota to a spot as the third largest oil and gas producing state in the U.S.
The lack of pipeline is having a serious negative impact on Kodiak and its competitors here. Producers see increased storage costs as means for outgoing shipments are restricted, which leads to increased flaring at wellheads since at current natural gas prices any increase in storage costs mitigates profit to such an extent that flaring can be a more viable alternative. Furthermore, the competition for what transport space there is drives up transportation costs for all production. The final blow to producers here is that the limited marketability of untransportable resources leads to a discount against NYMEX prices. Due to these factors, drilling costs in the Williston Basin are rising dramatically, leading state regulators to fear an independents' exodus to other states as producers seek more profitable opportunities.
Despite its volatility, Kodiak does not offer investors a dividend to offset what can be a wild ride (and it is wild: Kodiak's 52 week range is $3.59-$10.90). Given that Kodiak just passed the five year anniversary of its IPO, it may be time for the company to focus on streamlining its balance sheet so that a dividend to shareholders becomes affordable. However, with setbacks in its primary play preventing Kodiak from competing with the wider market, it looks like this will be an uphill battle for the firm.
Kodiak is trading around $7, which results in a price to book of 2.1 and a forward price to earnings of 7.0. What really stands out about Kodiak's numbers is its revenue growth: On a three year average, Kodiak returned 158.3%, compared to an industry average of -2.8%. Despite its small size, Kodiak has done this with an above average operating margin of 36.3%, though the drawback is that to continue growth it took on debt, giving it a debt to equity ratio of 0.7.
This is still lower than other of its competitors that navigated, or attempted to navigate, the switch from gas production to oil production, like SandRidge Energy (SD), which has a wider focus than Kodiak but similar infrastructure difficulties. SandRidge is currently trading around $6, with a price to book of 2.0 and a forward price to earnings of 13.8, which is on the expensive side for a company with a debt to equity ratio of 1.9. However, SandRidge is returning 6.2% revenue growth, and after accumulating its debt through acquisition looks ready to move on production.
By comparison, Chesapeake (CHK), currently trading around $16, managed to accumulate a debt to equity ratio of 1.0 while returning three year revenue growth of 0%, or in other words, zero. While Chesapeake does pay a dividend yielding 1.9%, it is poor compensation for shareholders who bought in earlier this spring only to see the stock slide as low as $11 below its six month highs.
Like Kodiak, Forest Oil (FST) is experiencing a volatile period, though Forest's numbers are not as strong. Forest is focusing on the Granite Wash and Eagle Ford shales for production, though disappointing results (pdf) from Granite Wash are led it to acquisitions in the Permian Basin and elsewhere. These acquisitions helped lead to a $13 million decrease in net earnings and an increased debt to equity ratio for Forest. Forest's CEO H. Craig Clark departed the company last week for unknown reasons, but I think these disappointing results were a factor in the departure. As Kodiak looks for ways to get its production to market, Forest is a cautionary tale.
Currently trading around $7 like Kodiak, Forest has a price to book of 0.6 and a forward price to earnings of 5.5. Its debt to equity ratio is rising to the point of no return, currently standing at 1.5, with revenue growth firmly shrinking at -24.7% over the past three years. With no dividend and a 50% drop in value since December 2011, Forest makes even Chesapeake look more attractive.
I think that over the next few years as the infrastructure build out in the Williston Basin continues, Kodiak will have the opportunity to grow and become a major player. The company is not giving any indications that it intends to expand its focus beyond the Williston and risk a Forest-like scenario, nor do its balance sheets indicate funding shortfalls such as are impacting Chesapeake. Despite its volatility, Kodiak deserves a strong look for growth and future returns.