Kodiak Oil & Gas: Small Company, Big Potential

| About: Kodiak Oil (KOG)
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In 2010, global oil consumption increased by 2.7 million barrels of oil equivalent per day (Boe/d) from 2009 to a total daily consumption rate of 87.4 million Boe/d. Meanwhile, global oil production increased by only 1.8 million Boe/d. This leaves the world with an approximate shortfall of nearly 1 million Boe/d in daily consumption.

As a result of this supply gap, the exploration and production of oil will become increasingly important as the world’s thirst for energy continues to grow. Within the United States, there are dozens of companies focused on bridging this supply gap. In fact, according to Baker Hughes (BHI), as of October 14, 2011 there are approximately 2,023 drilling rigs on U.S. land or waters, and of these 2,023 drilling rigs, about 1,080 are used specifically for oil production.

One such company that is utilizing these drilling rigs and expanding their production because of it is Kodiak Oil & Gas (NYSE:KOG).

Kodiak Oil & Gas is an independent explorer and producer of oil and natural gas with drilling properties in Colorado, Montana, North Dakota, and Wyoming. Based in Denver, Colorado, the company is focused on developing drilling sites located in the Williston Basin (Montana and North Dakota) and the Vermillion Basin which is situated within the Greater Green River Basin (Colorado and Wyoming). The Williston Basin is estimated to hold one of the nation’s largest oil reserves.

According to the U.S. Geological Survey, one of the rock formations within the Williston Basin known as the Bakken shale could hold as much as four billion barrels of recoverable oil. To recover this massive estimate of potential oil reserves, Kodiak is utilizing the drilling technique known as hydraulic fracturing.

By using hydraulic fracturing, Kodiak can drill horizontally to recover oil and natural gas that previously could not be recovered. Hydraulic fracturing brings the potential to discover vast quantities of oil or natural gas that were thought to be previously unreachable.

By the end of October 2011, Kodiak should be utilizing a total of eight drilling rigs that employ this hydraulic fracturing technique. Six of these eight drilling rigs are or will be fully operated by Kodiak by the end of October, while the other two rigs are operated by ExxonMobil (NYSE:XOM) with Kodiak having a working interest ranging from 40% to 50% in the wells produced by these two rigs.

One of these six drilling rigs that will eventually be operated by Kodiak was recently acquired with a $235 million purchase and sale agreement in which Kodiak added 13,500 net mineral acres located in Williams County, North Dakota. This $235 million acquisition is expected to be finalized by October 28, 2011, and as a result, should allow for Kodiak to add a supplementary cash flow stream in the fourth quarter of this year.

Another exciting piece of news coming from Kodiak is the new labor agreement with Halliburton Energy Services. Halliburton (NYSE:HAL) will now provide a 24-hour frac crew for 21 days of every month, instead of the previous 14 days per month. The agreement also stipulated the intent to eventually expand this frac crew to full-time at the beginning of next year.

Kodiak’s Chairman and CEO Lynn Peterson recently commented on this subject in the company’s October 18, 2011 operations and productions update, saying that

Increasing our operated rig count to six rigs should allow us to support a full-time dedicated frac crew which we will work to achieve by year-end.

If such a full-time frac crew were established before year-end, it is fair to reason that the company will certainly surpass its year-end production goal of 9,000 Boe/d as Kodiak has also mentioned that the 21 day frac crew is adequate to complete its production schedule. This 2011 year-end production goal is about a 450% increase over the 2010 year-end production of 1,983 Boe/d. Chairman and CEO Lynn Peterson also stated in the company’s latest operations and productions update that

Our current production is approximately 7,500 to 8,000 Boe/d. With the six net operated wells scheduled for completion during the fourth quarter, as well as the ongoing non-operated completion work within the Dunn County AMI area, we feel confident in our earlier 2011 exit rate guidance of 9,000 Boe/d. These volumes do not include volumes associated with our pending acquisition, which is on track to close in late October.

Therefore, because of Kodiak’s additional production volumes from the newly acquired drilling rig and the possible implementation of a full-time frac crew, Kodiak should be able to reach its production goal of 9,000 Boe/d by the end of this year.

Despite all of these positive factors, Kodiak does have several possible risks. If the U.S. or the world enters into a recession, commodity prices for oil and natural gas will likely experience severe price declines. Kodiak does, however, have derivative contracts in place with Wells Fargo (NYSE:WFC) to help manage this commodity price risk and provide a more predictable cash flow from operations.

Another risk factor facing Kodiak is debt obligations and possible liquidity issues in the future. Due to the recent $235 million acquisition, Kodiak was forced to enhance its undrawn credit facility to $235 million from $110 million. Nonetheless, as long as Kodiak continues to drill and produce oil and natural gas at current levels of production, this liquidity issue should not be a significant concern in the future. A third risk factor worth mentioning is the possibility that winter weather in North Dakota could significantly affect production levels.

Kodiak, however, does seem to be managing this risk factor quite well. Kodiak has already completed winter preparation maintenance work for two of its Koala wells and has spent a large part of this year and last year constructing pipeline infrastructure to its well locations. This should enable Kodiak to increase operating efficiency in two ways. First, it will allow Kodiak to avoid the weather delays it experienced last winter when trucking routes to its drilling sites in North Dakota and Wyoming were closed due to excessive snowfall and the subsequent flooding. Secondly, the new pipeline infrastructure should also help Kodiak by reducing freighting expenses that were formerly incurred on the delivery of its recovered oil and natural gas.

These risk factors are fairly insignificant in my opinion, and I believe the shares are undervalued at the current level. The closing price on October 21, 2011 of $6.32 is selling at a discount of 4.4% to the closing price last year of $6.60 on December 31, 2010. Furthermore, Credit Suisse and several other research firms have placed either outperform or buy ratings on Kodiak shares with price targets ranging from $7.00 at Robert W. Baird to $9.00 at both RBC Capital Markets and Morgan Keegan.

Moreover, in a May 16, 2011, research report for Credit Suisse, analysts Mark Lear and David Lee cut their 2011 EPS estimates to $.32 from $.42 but raised their longer-term 2012 and 2013 EPS estimates to $.94 and $1.00, respectively. Lear and Lee also cite in an Oil & Gas Exploration & Production research note from October 18, 2011, that they view KOG, RRC, WLL, ROSE, and SFY as “potential acquisition targets.”

Finally, both analysts also state that because of recent M & A activity such as Statoil’s (NYSE:STO) bid to purchase Brigham Exploration (BEXP) on October 17, 2011, and BHP Billiton’s (NYSE:BHP) acquisition of Petrohawk, they believe small and mid-cap exploration and production companies should be given “premium valuations.”

Ultimately, after considering all of these factors, I believe now is a great opportunity for any longer-term investor to invest in Kodiak. I do think, however, that the best time to purchase Kodiak shares might be in the next month or two after Kodiak management has declared both third quarter earnings (November 3) and future production guidance and after the overall macroeconomic outlook has hopefully improved.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.