Kodiak Oil and Gas (NYSE:KOG) can be considered a buy based on two factors: an investor's view of future Bakken oil prices and KOG's ability to continue to both increase its production and reduce its well costs as CEO Lynn Peterson has said it will do, and as the company has been doing.
KOG has achieved a hockey-stick increase in Bakken oil production from 3,953 BOE/D in the third quarter of 2011 to 15,855 BOE/D in the third quarter of 2012. Operating income increased similarly, from $11.3 million in 3rd quarter of 2011 to $36.3 million in the third quarter of 2012. Although the stock has a steep trailing price-earnings ratio of 37, its forward price-earnings ratio is 12.5. Discounted in its current share price is KOG's solid position as one of the leading drillers in a prime US oil basin. Lagniappe is its status as a potential takeover target. Owning KOG is as close as an investor can get to owning oil without possessing the physical barrels.
KOG has a robust 53% ratio of liabilities to assets, 155,000 net Bakken acres, and expects to exit 2012 producing 27,000 BOE/D. Its current production is about 20,000 BOE/D, and 86% of its reserves are oil.
Bakken/Three Forks Reserves & KOG Position
In just a year, North Dakota has grown from the fourth largest oil-producing state to the second-largest, following only Texas, ahead of Alaska and California, and larger than OPEC member Ecuador. The driver behind all this activity is a sevenfold, and growing, increase in crude oil production, to 700,000 barrels per day (August 2012). If oil prices stay strong, industry estimates are that Bakken production will grow to over a million barrels per day (BPD) and ultimately could be sustained for several years at two million BPD. Crude oil is 86% of KOG's reserve mix and was 95% of its revenue in the first nine months of 2012.
In 2008, the US Geological Service (USGS) confirmed a Bakken reserve size of four billion barrels (Middle Bakken only). It expects to release a new estimate near the end of 2013 which will also include Three Forks reserves. Lynn Helms, Director of North Dakota's Department of Mineral Resources, estimates there are 10-14 billion barrels of oil recoverable in the state, most of which is Bakken/Three Forks. Continental Resources, a major player in the Bakken, considers recoverable reserves to be 27-45 billion barrels.
Bakken and KOG Production Drilling Efficiency Up, Well Costs Down
According to the North Dakota Industrial Commission, 190 rigs are active in North Dakota, down from 200 rigs about a year ago. KOG chairman and CEO Lynn Peterson cites estimates that the Williston basin limit is 200-225 rigs. Kodiak acquired its sixth rig at the beginning of 2012, its seventh in May, and its eighth in August. It has just released the eighth rig but will continue using the remaining seven rigs in 2013. KOG has 800 net drilling locations and plans for all of its acres to be held by production by the end of 2013.
Because producing from unconventional oil shale takes on the character of manufacturing, it requires significant capital, and a grind-it-out focus on reducing well costs. KOG capital expenditures will be $750 million this year, compared to an initial expectation of $585 million. This is due to an increase in both operated and non-operated well drilling: instead of the budgeted 51 net wells, KOG will have completed or participated in 66 net wells by year-end 2012, including 26 in the fourth quarter of 2012. Many operators are achieving HBP status for their leases, and so have accelerated their drilling. In addition, according to Peterson, KOG will be evaluating additional zones, including drilling more densely in the Polar and Smokey areas. Tests will be done on the upper and middle Three Forks zones, or "benches."
In its third quarter conference call, Kodiak reported a per-well cost of $10.5 million, down from $12 million earlier in 2012. Peterson expects to get per-well cost below $10 million. KOG lease operating expense (LOE) is down 29% in the third quarter of 2012 compared to the third quarter of 2011. The largest component of LOE is water disposal.
Savings to date are due in part to the use of zipper fracs, which allow two or more well bores to be completed at the same time. Along with a second completion crew and more mobile rigs, this has improved KOG's overall rig efficiency. Spud-to-release times per well are down from 35 days last year to 20-25 days per well now. Another factor is KOG's use of cheaper sand and resin-coasted sand, and less ceramics, in its proppant mix.
Oil prices over $50/barrel coupled with North Dakota's private (rather than state or federal) land ownership and the breakthrough technologies of horizontal drilling and multistage fracturing led to development of its Bakken oil shale.
Bakken crude is sweet (low-sulfur) and light, 36-44 degrees API: almost identical to oil standards West Texas Intermediate, Light Louisiana Sweet (LLS) and Brent. Based on transportation constraints and competition with other sources of crude, Bakken crude at the Clearbridge, Minnesota terminal was trading $8/barrel below WTI on November 8. West Texas Intermediate closed near $85/barrel November 8, itself about $22/barrel below Brent. At the Gulf Coast, Bakken crude oil competes with imported sweet crude, Light Louisiana Sweet, and Eagle Ford production. There and in the Midcontinent it competes with Canadian crude, Permian Basin crude , Niobrara basin crude, and Mississippi Lime production. LLS and Brent both have traded above the price of WTI, often by as much as $20/barrel.
The average price KOG received for its oil in the third quarter of 2012 was $82.96/barrel. The company is wholly exposed - but has derivatives hedges - to Bakken oil prices. The Bakken price closed November 8 at approximately $77/barrel. Should the price of oil fall below $60-$70/barrel, Bakken/Three Forks and Canadian oil sands drilling would slow, because both are more expensive to produce than other sources, particularly Middle Eastern oil.
Another risk is increased EPA regulation of fracking, which could make Bakken crude oil costlier to produce than other sources.
Bakken Crude Oil Markets
The initial market for Bakken crude oil was the PADD 2 (Midcontinent) market of 3.6 MMBPD, a region that is already a target for much of the 2 MMBPD of the Canadian production that the US import. So that quickly overfilled. Pipeline transportation to Cushing storage and from Cushing to the Gulf Coast, home to 8.7 MMBPD of capacity was limited. However, capacity south out of Cushing increased. Since pipeline capacity has not caught up to production, the current challenge is moving oil to refineries beyond the full ones in the Midcontinent. Railroads have taken up the slack, at a cost of $12-$15/barrel to move oil to the US Gulf Coast. The movement of Bakken crude to the USGC has become a powerful force, putting downward pressure on the price of oil in other US basins with less access (Niobrara, even Permian).
Although Bakken currently rules the rails into the Gulf Coast, the USGC refining market is world-competitive. Bakken price faces downward pressure from other US and foreign oil sources, particularly Canadian crude and new production in the west Texas Permian basin, as well as from refineries that have been optimized to use cheaper heavy, sour crude oil.
Longer-term, more north-south pipeline capacity is expected to be built. There is also the possibility that Bakken crude could also move to the West Coast or, more likely, to the East Coast, where it would displace pricier light, sweet North Sea and African crude. A 330,000 BPD Sunoco refinery in Philadelphia, PA, has been resuscitated and joint-ventured with Carlyle on just this basis. Its new rail facility will be able to unload 140,000 BPD of Bakken crude.
With KOG's closing price of $9.12/share, it is at 78% of its one-year target and 84% of its 52-week high. Given the Statoil purchase of Brigham and the more recent Halcon purchase of properties from PetroHunt, a buyout of Kodiak remains a significant possibility.
Overall, KOG should be considered a buy for investors looking to increase their exposure to domestically-produced oil who believe WTI oil prices are unlikely to fall below $60/barrel for a sustained length of time.