In Part I of this note, I compared Kodiak Oil & Gas's (KOG) and Denbury Resources' (DNR) Bakken portfolios from an operating perspective in order to understand how the metrics implied by last week's Exxon Mobil's (XOM) acquisition of Denbury's assets can be applied to Kodiak. The comparative property review suggests that the two portfolios are very similar and the Exxon/Denbury data point is therefore very relevant and directly comparable to Kodiak, at least in the M&A context.
The analysis also indicates that on average Kodiak has been able to achieve a higher well productivity than Denbury for the wells the two companies completed during the last twelve months. While the question remains open whether the higher flow rates are a function of a better rock quality or more effective completion practices, I use the assumption that Kodiak's core acreage will continue to yield wells with 15%-20% higher EURs than Denbury's.
Exxon/Denbury Transaction Metrics
The first step in understanding the "read-through" to Kodiak is to correctly interpret the Exxon/Denbury transaction metrics. The complex nature of the deal, which included a swap of difficult to value assets, appears to have caused confusion even among seasoned Wall Street analysts with regard to the valuation.
In this transaction, Denbury will receive the following consideration:
- $1.6 billion in cash.
- Interests in two large mature oil fields, Webster and Hartzog Draw, that are candidates for tertiary oil recovery (CO2 floods), which I value at $570-$735 million using comparable transaction analysis.
- Effectively, a reduction in tax liability, which I estimate at $330-$420 million, due to the like-kind treatment for the acquired assets (I include the likely purchase by Denbury of the CO2 reserves from Exxon).
Therefore, total "cash equivalent" value that Denbury will receive in this transaction is potentially as high as $2.5-$2.755 billion. Without taking into account the very significant non-cash component of the consideration, it is impossible to rationalize why Denbury has accepted the offer.
My estimate for the value of Webster and Hartzog Draw fields is higher than the "just under" $400 million indicated by Denbury's management during their analyst call. In my understanding, Denbury was referring to a measure calculated under GAAP Fair Value guidelines for valuing acquired assets, which is different from the M&A market valuation I am using.
It is also important to keep in mind that Denbury sees very attractive (high-20% to low-30%) rates of return on its investment in EOR projects as the company owns a very large source of natural carbon dioxide (Jackson Dome field). The return is particularly high on "bolt-on" EUR projects that capitalize on the infrastructure already developed. The fields Denbury is acquiring from Exxon as part of the asset swap are such bolt-on projects. As a result, the value that Denbury effectively "sees" in the opportunity to acquire two very large fields is substantially higher than my estimate for the M&A market value. Therefore, Exxon's offer may compare favorably against a hypothetical all-cash offer even at the high end of my $2.5-$2.75 billion transaction valuation range.
My last week's note "Exxon Mobil: Bakken Acquisition Analysis" provides a detailed discussion of various aspects of the Exxon/Denbury transaction, which I strongly recommend as an integral part of this discussion.
Value Comparison of Denbury's and Kodiak's Bakken Portfolios
Coincidentally, the amount of proved developed producing reserves at the end of Q2 for Kodiak and Denbury is essentially equal. Kodiak has disclosed PDP reserves in the amount of 28 MMBoe. Denbury has stated that they had 107 MMBoe of total proved reserves in the Bakken, of which I assume 26% were developed producing (using the same percentage as at 2011 year end). This yields 28 MMBoe of PDP reserves for Denbury. Therefore, the value attributable to flowing reserves for the two portfolios should not be materially different. In the M&A context, I estimate it in the range of $750-$900 million (not including wells in progress).
The difference in value between Kodiak's and Denbury's Bakken assets therefore stems mostly from undeveloped acreage (which in both portfolios is the largest value component). For purposes of this analysis, I attribute value only to "core" portions of the two companies' total leaseholds.
- For Denbury, I include in the "core" portfolio Charlson, Murphy Creek, Bear Creek, Cherry and Lone Butte operating areas. I exclude Camp/Indian Hills area (where well results have been mixed), as well as Northeast Foothills, Old Shale Play, Montana and other areas. Total "core" net acres: 118,000, including estimated 100,000 undeveloped (assumed 85% of total). Assuming 7 wells per 1,280-acre unit, this yields approximately 550 potential drilling locations.
- For Kodiak, I include in the "core" portfolio Koala, Polar, Smokey, and Dunn County operating areas. In Dunn County, I exclude 6,000 net acres in the potentially less prospective Southeastern most part of the lease block (detailed analysis of Kodiak's properties is provided in the earlier notes). Total "core" net acres: 97,000, including estimated 85,000 undeveloped (assumed 88% of total). Assuming 7 wells per 1,280-acre unit, this yields 470 potential drilling locations.
The location math may appear somewhat simplistic. However, given the similarity of the two companies' acreage, the method is effective as long as it is applied consistently to both sides of the equation.
The total Exxon/Denbury transaction value range of $2.5-$2.75 billion implies an average price of $2.8-$3.5 million per undeveloped location. Acreage productivity is very important from a valuation perspective as NPV of a well depends on the EUR in a non-linear fashion. Assuming an average EUR on Denbury's acreage of 700 MBoe per well and using the discussed above 15%-20% EUR differential for Kodiak, I estimate that average Kodiak's drilling location is $1.75-$2.5 million more valuable than Denbury's on a net present value basis. The incremental value to Kodiak from greater acreage productivity is $0.8-$1.2 billion (470 location times $1.75-$2.5 million per location). The lower location count (80 locations less than Denbury) translates in a $0.2-$0.3 billion lower value. Adding together, Kodiak's acreage comes out more valuable than Denbury's by $0.6-$0.9 billion.
Since there are no other major value differentials between the two portfolios within this framework, I arrive at the total implied M&A value of Kodiak's assets of $3.1-$3.65 billion using the Exxon/Denbury transaction as the basis. This compares to $3.3 billion current firm value.
The analysis is clearly sensitive to the assumed relative well productivity between the two portfolios. Given the location proximity, it is difficult to believe that the differential can be very wide on average across all properties.
- While on the surface the Exxon/Denbury transaction may seem to be valued substantially lower than other recent Bakken acquisitions, a closer examination leads to a very different result: the deal is priced "in line" based on the expected return and taking into account Denbury's drilling results.
- In my opinion, current Kodiak's stock price does not leave much room for a meaningful M&A premium (using XOM/DNR transaction as a guide). A compelling premium would imply that the buyer either is willing to accept an expected rate of return in the mid teens (below comparable transactions), or believes in a very strong well productivity on a substantial portion of Kodiak's acreage (remains to be proven, as discussed in the earlier article).
- Given Kodiak's very strong and consistent recent well results, it is possible that the company's completion techniques are contributing significantly to the drilling success. It would be incorrect to attribute all the value in the company to its acreage, as skillful operatorship adds significant value to the assets. This component of the value would potentially be lost in an M&A transaction.
- Kodiak may be more valuable as a public stock than as a take-over target, given the very high required rate of return (20%+) implied by M&A comparables. If the assets in the Bakken are as terrific as the recent M&A transactions suggest, the "develop it yourself" strategy may prove, over time, to be the most profitable of all.
While the primary focus of the note is on Kodiak, the discussion is also highly relevant to other small- and mid-cap Bakken-focused stocks, including Continental Resources (CLR), Whiting Petroleum (WLL), WPX Energy (WPX), QEP Resources (QEP), Enerplus (ERF), Newfield Exploration (NFX), Triangle Petroleum (TPLM), and others.
Disclaimer: This article is not an investment recommendation and does not provide a view on the value or price direction of any security. Any analysis presented in this article is illustrative in nature, is based on an incomplete set of information and has limitations to its accuracy, and is not meant to be relied upon for investment decisions. Please consult a qualified investment advisor.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.