After completing the takeover of Kodiak O&G, Whiting Petroleum (NYSE:WLL) is now the largest oil producer in the Bakken/Three Forks shale play. That may not be much of a consolation prize for investors who have seen the value of Whiting's stock drop more than 50% since the Kodiak deal was announced back in July when WTI was trading at $104/bbl. While the timing of the deal was somewhat reminiscent of Exxon's purchase of XTO (that is, at the top of the commodity price cycle), the fact that Whiting structured the deal as an all-stock transaction means that it took advantage of its inflated stock price as well. That said, the deal did require assumption of $2.2 billion in Kodiak debt. But at the end of the day, the sell-off of the US shale producer energy sector combined with end of year tax-loss selling has left Whiting in the bargain bin. Share are undervalued and could easily return 25% over the next 12 months, and still be undervalued based on its proven reserves base.
Source: December Presentation (available here).
Whiting released its 2014 year-end reserves report this week and as expected it revealed impressive growth: proved reserves were up 29% to 780 million boe, 83% oil. Of the total year-end proved reserves, 25% (194 million boe) came from the KOG acquisition. Kodiak shareholders disappointed in the transaction should consider they now own ~29% of the new company while chipping in 25% of proved reserves - and that appears to be equitable. That said, Whiting certainly did not overpay for KOG, paying just 2.2x its 2013 year-end proved reserves value.
It is important to note that Whiting itself grew proved reserves by 147 million boe yoy (33%) to 586 million boe, double the rate of KOG's proved reserves growth.
In the Q3 EPS report, Whiting continued its history of impressive production growth (+26%) and discretionary cash flow (19%). Yet unlike leading shale producer EOG Resources (NYSE:EOG), WLL also continued its history of not being able to raise bottom-line net income despite its impressive production growth:
An average realized oil price of $86.78/bbl was down 11% yoy as Whiting was already showing effects of weakness in global oil prices. On the other hand, WLL showed improvement in per boe costs, with reductions in LOE, taxes, and G&A. The result was, at least for me, still more disappointment on the bottom line: $1.32/share of net was down 23% as compared to the prior year quarter. YTD earnings per share for the first 9 months were basically flat yoy.
Going forward one has to ask the obvious question: if WLL couldn't grow earnings at $90/bbl realized prices, what's the motivation to invest in the stock going forward? It has to come from two areas: productivity & the long-term value of its reserves.
Whiting continues to improve its completion design technology. In the Seeking Alpha Q3 conference call transcript we learned that a new slickwater frack design is boosting recoveries and EURs. For example, the Sanish Brehm 13-7H well was completed using a slickwater frac design and was flowing 3,770 BOEs per day from only a 6,800-foot lateral. Adjusted for the short lateral, WLL said it is one of the most productive wells it had ever drilled in the prolific Sanish Field. Likewise, the Sundheim 21-27-1H well in the Missouri Breaks field also showed strong results with WLL's first slickwater test. The well had a 200-day cumulative production of over 71,000 BOEs, over 64% greater than an offset well completed using older technology. The Iverson well, completed with an increased number of perf clusters per stage, tested at 1,228 BOEs per day, one of the strongest rates to date on the Western edge of Whiting's acreage.
These results are in-line with other operators in the area. As I recently reported on an article on Bakken operator StatOil (NYSE:STO) - see StatOil: US Shale Overview - slickwater fracs are increasing that company's recoveries as well (see graph to the right). So this appears to be yet another technological advance that is proven to increase recoveries. In fact, Steven Kranker, Whiting VP of Reservoir Engineering, had this to say in response to an analyst question concerning the potential impact of slickwater fracs:
We're monitoring our slickwater fracs. There are several that are up 60-plus percent on initial rates the first month or 2 production. A little early to tell what it'll translate into in the EUR, but we're hopeful it'll be the similar uplift that we saw on the cemented liner, plug-and-perfs as well. And as Jim says, we'll see more of that in the year-end reserve report.
I reported on the uplift of the cemented plug-and-perf completion design in this piece: Whiting's Cemented Plug-n-Perf Technique Should Lead to Higher Valuation. That technique led to ~40% higher IP rates. A similar uplift using slickwater fracs would be very impressive and a significant catalyst moving forward. Note WLL was at $60 when the plug-n-perf article came out, and ran up to over $90. While that was obviously during a time of higher oil prices, they were stable higher oil prices, so the increased productivity of plug-n-perf did help boost the stock. Slickwater fracs can do the same.
The bottom line here is that WLL continues to increase well productivity via improvements in drilling technology. Drilling costs are going to decline with the decline in rig count and well permits. Now (after the KOG takeover) the company has 844,000 net acres and a current inventory of ~3,500 drilling locations in which to exploit the new technology. That means higher EURs, higher IRRs, and higher reserves growth.
As with any US shale producer, the risk of lower oil prices for a protracted period of time is a real and valid concern. Bakken producers like WLL are also facing additional head winds including new flaring and rail car regulations. The Wall Street Journal reports that new railcar regulations could very well lead to a retrofit compliance bottleneck. Greenbrier (NYSE:GBX), a smaller builder of new tank cars, is expecting retrofit about 2,000 cars a year - up from about 600 now. And of course there is always the discount to WTI that Bakken producers face due to the extra transport expense. However, take a look at WLL's latest Williston Basin average well production profile, and note the chart is based on a $9/bbl price differential to WTI.
I recently reported (see Bakken Crude At $41.75 Is Continental Resources Quandary) that Bakken Crude was recently trading closer to $40/bbl than the $61/bbl (and 43% IRR) implied by the curve above. So hedging is important and Whiting's Q3 report included some oil hedging information as well as natural gas hedges and contracted oil sales.
While I would prefer to see straight collared hedges with a floor, at least WLL did not enter Q4 and 2015 completely un-hedged like its peer Continental Resources (NYSE:CLR).
Debt may be another concern. At the end of Q3, WLL had long-term debt of $2.7 billion and picked up an addition $2.2 billion of KOG debt for a total (estimated) debt load of ~$4.9 billion. This is likely why Whiting took advantage of the reserves press release to also update its liquidity position. President and CEO James Volker:
..., on December 19, 2014 our bank syndicate increased our credit commitments to $4.5 billion reflecting our reserves and current market conditions. At year-end 2014, we estimate we will have approximately $1.4 billion drawn, leaving us $3.1 billion of liquidity.
In addition, Volker mentioned WLL is pursuing monetization of select assets that would reduce debt and create up to $1 billion in additional liquidity. As opposed to creating trusts as the company has done in the past, perhaps WLL will now consider simply selling assets outright. This could include non-core assets such as enhanced oil recovery acreage in North Ward Estes (Texas), marginal Redtail Niobrara acreage (Colorado), or perhaps even interests in WLL's highly valued gas processing plant capacity in North Dakota.
Whiting has a 50% interest in two valuable Bakken gas processing plants: Robinson Lake (Sanish field) and Belfield (Pronghorn field). Considering WLL sold a 50% interest in Belfield for $66.2 million (35 MMcf/d) and Robinson Lake has a capacity of 110 MMcf/d, the combined value of WLL's interest in these two plants is likely in the neighborhood of ~$300 million. Both plants have fractionation capability to convert NGLs to higher margin butane and propane. Whiting also owns two gas processing plants in Michigan and is constructing a new plant in Weld County for the Redtail field (Niobrara).
As I have reported in the past, Whiting's corporate governance could use some improvement. As an example, I have highlighted the company's "Production Participation Program" that rewarded employees simply for growing production, whether it was profitable production growth or not. That program no longer exists. Today, I am not a big fan of Volker being Chairman, CEO, and President of the company. It's time to diversify leadership roles and shareholders should press the company on this issue. Shareholders should also press the company to remove the poison pill structure which will not expire until 2016. It's time Whiting Petroleum acts like a grown up with respect to corporate governance. Shareholders need to push it to do so.
The oil current oil crisis and end-of-year tax loss selling has driven Whiting Petroleum stock into bargain basement territory. Morningstar currently has a 5-star rating on the stock and its December 2, 2014 report has a fair value of $84/share. That price was determined (in part) by a five-year cash flow model and longer-term resource potential.
Currently WLL has a market cap of $4 billion and long-term debt of ~$4.9 billion for a total EV of $8.9 billion. This is roughly half the EV of the two companies when Whiting announced its intention to takeover Kodiak. Yet operationally the deal made a tremendous amount of sense. The two company's had over-lapping acreage in the Williston Basin and the combined firms have greater financial strength. The deal addressed the prime concern the market had with each of the individual companies:
- Increased Whiting's high quality long-term drilling inventory
- Reduced Kodak's elevated debt/EBITDA level
Yet the thesis for investing in Whiting isn't a near term earnings driven outlook. Due to the big drop in oil prices, the consensus earnings estimate for 2015 amongst 32 analyst who cover WLL has been falling and is now $1.36 for the year. Considering someone has been on vacation and is still at $4.73 for next year, this estimate could come down further.
But even at a buck a share, the point is the company will be profitable over the coming year. And the thesis for Whiting isn't near-term earnings driven - it's the value of its proven reserves and the company's technological advances to leverage the long-term potential of its massive Bakken acreage.
Consider WLL's proven reserves of 780 million boe. At the Q3 rate of production of 109,760 boe/day, that's a proven reserves inventory of 20 years. So forget 2020, what will prices be in 2030? Because Whiting will still be around (unless it is taken over by a COP, CVX, or XOM) and producing a lot of oil. Do you think it will be at $55/bbl?
I would not expect Morningstar's fair value of $84 to be reached during the current low oil price environment which is likely to persist deep into 2015. However, how does 780 million barrels of proven reserves relate to the company's current EV of $8.9 billion? I'll tell you: $11/barrel. That's a steal. And remember, while the Bakken has high transport costs, Bakken oil is some of the highest quality crude on the planet and is the refiners' #1 choice.
As a result, as cooler heads prevail in 2015, I suspect WLL will begin trading closer to a $15/bbl valuation. If we assume debt stays at roughly $5 billion, that implies a market cap of ~$6.7 billion, or roughly ~1.7x the current market cap. But due to the current market outlook on oil and the energy sector, we will be conservative and accept half of Morningstar's fair value estimate, or $42/share. That's a near 25% return over the close of today ~$34.
Summary & Conclusion
Investors should look beyond the current low oil price environment and value WLL according to the long-term potential of its proved reserves and another significant uplift in well production and EURs due to a new slickwater frac completion design. With such a large inventory of drilling locations, WLL can focus on drilling its highest quality wells during this time of low prices. Lower drilling costs will be a tailwind, but will not overtake the current low-price environment. As a result, the next three or four quarters will no doubt be challenging and yoy comparisons will certainly not be favorable.
All that said, there is also no doubt WLL has the assets, production, and liquidity to weather the storm and be a survivor. That said, if you think $50/bbl oil is here to stay for good, you should pass on WLL. However, if you think there is a good chance oil will begin to trend higher in the years ahead (as I do), Whiting Petroleum will be a good stock to have in your portfolio due to its proven reserves, technology, and excellent potential of its massive Bakken acreage position (844,000 net acres).
I suppose an investor bullish on oil could buy oil futures instead, but those are timed investments and considering most investors (professional or not) got oil prices completely wrong in 2014, I seriously doubt most investors will correctly predict oil price movements in 2015. What I am much more confident about is that the current low oil price environment will prove to be transitory. History shows us that is the case. Low prices boost demand and economic growth. Meantime, the global vehicle fleet keeps growing and lower gasoline prices will likely increase the growth rate of the world's vehicle fleet. Despite a rather lackluster world economy in 2013/14, oil demand kept growing (see Saudi Arabia: Do The Math). In fact, just a 1-2% per annum growth rate in oil demand means another 7-14 million bpd will be needed by 2020. Given those fundamentals, why would you not want to own a piece of 780 million boe of high quality Bakken crude for $11/bbl? Whiting Petroleum is a BUY.
Note the technicals of the chart shown below. The stock appears to have bottomed at $25 with high volume capitulation - likely due to year-end tax loss selling. Note also the high up-volume bounce off that low for three straight trading days. While the bounce could be explained as short covering, it is likely there were value investors taking advantage of an opportunity simply too good to pass up. That is still the case with WLL @ $34.
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Disclosure: The author is long STO.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am an engineer, not a CFA. The information and data presented in this article were obtained from company documents and/or sources believed to be reliable, but have not been independently verified. Therefore, the author cannot guarantee their accuracy. Please do your own research and contact a qualified investment advisor. I am not responsible for investment decisions you make. Thanks for reading and good luck!NOTE: the author may buy shares in WLL over the next 48 trading hours.