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Even though Kodiak Oil and Gas Corp. (NYSE:KOG) is a high-growth company, we have a neutral stance on the stock in the near term given its cash flow situation and considerable unrealized gain on derivatives that are not likely to continue in the future.

Introduction

Kodiak Oil & Gas Corp. is an independent energy company involved in the exploration and production of oil and associated gas in the Rocky Mountain region of the United States. The oil and natural gas reserves of KOG are mostly in the Williston Basin of North Dakota and the Green River Basin in Wyoming and Colorado. The primary target of the company in the Williston Basin is the Bakken and the three fork formation. KOG has a market cap of $2.49 billion and is headquartered in Denver, Colorado.

Industry

The increased application of hydraulic fracturing and horizontal drilling for unconventional production has led to the shale gas boom in the U.S. This excess supply reduced the prices of natural gas, which bottomed at $1.94/mmbtu in April 2012, and has shifted the production from gas to oil plays due to higher prices and margins prevalent in the U.S. and international markets.

A few of the important shale oil plays in the U.S. include Bakken shale North Dakota, Eagle Ford Texas, Avalon and Bone Springs Basin Texas and Las Angeles, and San Joaquin Basin California.

The most promising play is the Bakken shale in North Dakota, which has expected reserves of 3.59 billion barrels (Bbbl) of recoverable oil.

Financial Review

KOG has recorded revenues of about $85.8 million for the second quarter of 2012, showing an increase of 287.9% as compared to $22.1 million in the same period last year. The drastic increase in revenue was contributed by increased production of oil and gas, as the company increased its drilling activity.

The increased production of oil and gas increased operating expenses by 352.6%, and the company's operating margin witnessed a decrease of about 100bps to reach 30.6% for the outgoing quarter. The operating margins decreased due to higher oil and gas production expenses and the higher depletion and depreciation charges.

KOG reported diluted EPS of $0.35 for the second quarter of 2012, showing an increase of 338% as compared to the same period last year. This increase in profitability was due to a gain of $95.6 million from the derivatives exposure of the company, up from $4.9 million in the same period last year.

Production Mix and Revenue Contribution

Revenue generated through the sale of crude oil contributes about 96% of the revenue generated for KOG, and the remainder is from natural gas sales. The table below compares the sales and production volumes for the two commodities.

2Q2012

2Q2011

% change

Total Sales Volume

Oil (Bbls)

1,043,854

223,755

367%

Gas (NYSEMKT:MCF)

669,101

87,122

668%

Sale Volume (NYSE:BOE)

1,155,370

238,275

385%

Natural Gas flared

687,880

143,495

379%

Total Production Volume

Oil (Bbls)

1,047,682

222,907

370%

Gas

1,356,981

230,617

488%

Production Volumes

1,273,846

261,343

387%

Source: 10Q

Cash flow from Operation and Capital Expenditures

The cash flow from operations witnessed a similar trend and increased by 281% YoY to reach $85.5 million for the second quarter of 2012.

The company's capital expenditures jumped significantly to reach $896.8 million for the first half of 2012, as compared to $135 million in the same period last year. The capital expenditure for the first half of 2012 included the acquisition of acreage in North Dakota worth $588 million, undertaken by the company in January. The acquisition was funded by the cash held in escrow, which was generated through the issuance of senior bonds issued by the company in November 2011. The cash held at the end of the first half of 2012 was $13.5 million.

Outstanding Debt and Credit Facility

KOG has total long term debt of $805.9 million, which has increased by 7.5% as compared to the outstanding debt at the end of 2011. The company issued senior denominated bonds at par value of $650 million in November 2011 to fund its acquisitions and expansion. In May 2012, the company issued additional bonds at par value worth $150 million to repay the borrowings under the credit facility and fund its capital expenditures.

The company has a credit facility of $750 million with a borrowing base of $375 million, due to expire in 2016. The credit facility has a number of covenants and requires KOG to enter into hedging agreements to support the borrowing base.

Hedging through Derivatives

KOG has extensive positions in derivatives utilizing swaps and no premium collars to hedge the price of its oil production in the future. These hedging activities led to a total realized and unrealized gain of $95.6 million in the outgoing quarter, as average crude oil prices witnessed a decline. The realized gain for the quarter was $3.9 million.

2Q2012

2Q2011

% change

Sales Price

Oil ($/Bbls)

78.93

95.72

-18%

Gas ($/Mcf)

5.05

7.99

-37%

Commodity Price Risk Management Activities ($/Sales BOE):

Realized Gain (loss)

3.35

-4.17

-180%

Since prices of crude oil have reversed since the beginning of 3Q2012, we are of the opinion that the unrealized gains on derivatives will reverse, as oil prices are hovering around the same level witnessed during the second quarter of 2011.

Outlook

With most of its oil and gas producing properties located in the highly-lucrative oil rich Williston basin North Dakota, KOG is poised for high growth in the future, as can be seen in its low PEG of 0.4.

However, the aggressive capital expenditure incurred by the company to increase its oil and gas producing acreage in the Williston Basin, and to develop its existing properties, has reduced the cash held by the company to $13.5 million at the end of the first half of 2012. Even though the company has a credit facility of $750 million available, it has covenants, and as witnessed previously, the company avoids relying on this credit facility. KOG's debt/equity ratio is 81.4%, so the company can raise additional debt to finance its operations.

Another key factor going against KOG is the extensive derivative positions held by the company to hedge the prices of its oil production. The huge unrealized gain witnessed due to low crude oil prices may reverse as oil prices have reversed since the beginning of 3Q2012, and may increase beyond the hedged level. Even if oil prices do not increase beyond the hedged prices for the gain to reverse, the trend is not likely to continue.

KOG is trading at premium P/E, EV/EBITDA, P/B and P/S multiple of 12.3x, 13.1x, 2.5x and 10x, and does not offer a dividend as compared to its peers mentioned below. Therefore, we have a neutral stance on the stock in the near term.

Name

P/E

EV/EBITDA

Dividend Yield

PEG

P/B

P/S

Kodiak Oil and Gas Corp

12.3x

13.1x

N/A

0.4

2.5x

10x

Anadarko Petroleum Corp (NYSE:APC)

16.7x

6x

0.5%

3.5

1.8x

2.7x

Marathon Oil Corp (NYSE:MRO)

8.9x

3.4x

2.4%

108

1.1x

1.4x

Note: Most of the information used in the article is from the company's 10Q filling.

Source: Kodiak Oil Is A High Growth Stock But Cash Is A Problem