Northern Oil & Gas (NOG) is a rare oil producer in the energy space which holds significant acreage in the Bakken shale field, but doesn't operate any of its wells. Its future outlook may appear grim since NOG's earnings and cash flows might come under pressure due to the weakness in oil prices, which could be especially bad for the Minneapolis, Minnesota-based company operating under a mountain of debt. However, I believe Northern Oil & Gas can withstand weak oil prices, deliver strong free cash flows, and may appeal to those investors who can tolerate a bit of risk.
Image: Northern Oil & Gas Investor Presentation
Northern Oil & Gas is a unique energy company. It owns non-operating, minority interest in thousands of wells in the Bakken and Three Forks shale plays in North Dakota and Montana. Northern Oil's wells are majority owned and operated by more than two dozen leading independent oil producers such as ConocoPhillips (COP), EOG Resources (EOG), Continental Resources (CLR), and Hess Corp. (HES). This means that unlike a vast majority of oil and gas producers, Northern Oil neither drills nor operates any wells. The company essentially provides financing by acquiring the minority interest in acreage that is about to be drilled, and its partners do the heavy lifting.
Northern Oil has interest in almost 152,000 net acres in the Bakken shale, primarily in North Dakota. Its share of production was 26,700 boe per day, which was mostly crude oil. The company has participated in the drilling of more than 2,800 wells so far and holds more than 135 million barrels of oil equivalent reserves. These reserves are valued at $2.18 billion at SEC pricing formula, which is based on trailing twelve-month prices ($65.56/bbl oil and $3.10/ MMbtu gas) and $1.59 billion at a flat $55 oil and $2.70 gas price. On paper, Northern Oil appears like any other small-cap oil producer, but since this is a non-operator, it has lower overhead costs than its rivals and just 20 employees.
On the flip side, Northern Oil's investments in oil and gas properties have been powered in large part by debt. As a result, the company carries one of the highest debt loads in the energy industry relative to its size. It pays significant interest expenses which were equivalent to 30% of its revenues in the trailing twelve months through 3Q18. By comparison, the interest expenses account for 6% to 7% of the revenues of its Bakken peers Continental Resources and Oasis Petroleum (OAS), data from Morningstar shows.
The dip in oil prices has raised concerns over Northern Oil's future outlook. Although oil has risen over 20% this year to $55 a barrel (WTI oil) at the time of this writing, prices are still well below $75 seen in October. The year-to-date rally has been driven by the production cuts from the Organization of Petroleum Exporting Countries and its allies as well as sanctions against Iran and Venezuela. But surging production from the US to all-time highs combined with concerns regarding global economic growth amid the US-China trade spat has kept oil under $58 since Mid-February.
The US Energy Information Administration believes the US oil will average ~$55 a barrel in 2019, down from $65 last year. On the other hand, analysts at Raymond James are more optimistic and expect an average price of $62 a barrel for 2019. The industry's consensus is that the average price of oil will be lower in 2019 as compared to last year.
This weakness can hurt Northern Oil more than other oil producers since the company also carries a mountain of debt. The dip in prices will likely push the company's earnings and cash flows lower, but not its interest expenses.
Northern Oil's total debt load was $807 million at the end of 3Q18, which is significant for a small-cap company valued at less than $1 billion with total shareholders' equity of $11.2 million. This translates into a lofty debt-to-equity ratio of over 70. The average ratio of large-cap oil producers that usually have superior balance sheets than the small and medium caps is around 0.65. A vast majority of small- to mid-cap oil producers have a debt-to-equity ratio of less than 2.
Northern Oil, however, has mitigated the bankruptcy risk by refinancing its debt and eliminating all near-term debt maturities. In the third quarter, the company closed its $350 million senior secured notes offering which matures in 2023 and used the proceeds to retire all remaining 2020 senior notes. Nearly all of the company's existing debt will now mature in 2023. Northern Oil also enhanced its liquidity by securing a five-year revolving credit facility with a borrowing base of $425 million, of which it has drawn $140 million (as per the Jan. update).
Moreover, NOG has posted strong production growth numbers and expects to continue going this way in the future. That should partly offset the negative impact of weak oil prices. The company posted a 74% year-over-year increase in oil production to 22,436 bpd for the third quarter. It is on track to meet its annual guidance of growing oil production by 74% this year to 25,370 bpd. For next year, the company has reaffirmed its plans in a recent presentation to grow its oil production by 44% to 36,500 bpd.
Image: Northern Oil & Gas (link provided earlier)
Besides, Northern Oil is a low-cost operator that has been successful in producing a higher margin than its peers. The company has captured superior realized oil prices (hedged and unhedged), and it books lower level of operating costs due to its non-operative business model. In the third quarter, Northern Oil reported a margin of $44.36 a (unhedged) barrel, while its peers such as Oasis Petroleum, Continental Resources, and EOG Resources booked margins of $30 to $40 a barrel. Northern Oil will likely remain profitable and generate higher margins than its peers in a weak oil price environment.
What I also like about the company is that it has minimized its exposure to weak oil prices by extensively hedging its share of oil production. Around 63% of the company's estimated oil production for 2019 is hedged at an attractive average price of $63 a barrel. This allows Northern Oil to raise ample levels of cash from operations, even if the oil price environment gets worse. Northern Oil can generate cash flows well in excess of capital expenditure (or free cash flows) even at $45 oil since the company will continue to sell its output at a higher price.
Image: Northern Oil & Gas Investor Presentation (link provided earlier)
In November, when WTI averaged almost $57 a barrel, Northern Oil predicted that it can deliver between $145 million and $200 million of free cash flows in 2019. This is equivalent to $0.57 per share of free cash flows at the midpoint of the guidance (with 300.5 million shares in 3Q18) and represents an incredible free cash flow yield of 27% at the market cap. The free cash flow yield drops to 23% at the bottom end of the guidance. If, for instance, Northern Oil underperforms by a big margin due to weaker-than-expected oil prices and delivers $100 million of free cash flows, then it will still deliver FCF yield of almost 16%. This easily exceeds the 5% yield which is considered as the gold standard among oil producers that few companies have actually achieved. A double-digit FCF yield is even rarer. This means that NOG can deliver one of the strongest levels of free cash flows in the industry.
The excess cash can then be utilized on measures that improve the company's financial health. Northern Oil recently gave a glimpse of how this might play out. During the Nov-Dec period, the company used its cash flows to reduce the amount drawn on the revolver by $35 million. The company could continue going this way in the future. If Northern Oil manages to meaningfully lower its debt, then this will likely have a positive impact on its valuation.
NOG has also been returning cash to shareholders by repurchasing shares. In the first three weeks of January, the company repurchased 4.6 million shares, which indicates it is confident in its ability to deliver strong free cash flows this year.
Shares have fallen by 13% in the last three months, partly due to concerns regarding the company's ability to withstand weak oil prices. The company's shares are trading just 3.6 times this year's consensus earnings estimate, as per data from Thomson Reuters. This makes Northern Oil one of the cheapest oil stocks. For investors, I believe its low valuation also mitigates balance sheet risks.
Northern Oil's debt load does make it a high-risk play and the stock may not appeal to defensive investors. However, the company has no significant near-term maturities. Moreover, strong production growth, high-margin operations, and a solid hedge book will not only soften the blow coming from weak oil prices but also allow the company to deliver strong levels of free cash flows. The company can use excess cash for creating value for shareholders by cutting down its debt or buying back shares, which can fuel the stock's recovery. In the long-run, when oil prices eventually improve to more than $65 a barrel, the company will likely deliver superior earnings and cash flow growth than its peers as it capitalizes on its low-cost and high-margin operations. I believe investors with some risk appetite should consider buying Northern Oil.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The article is for information purposes only. It is not intended to be investment advice. The performance of Northern Oil & Gas stock is heavily influenced by movements in oil prices and other factors. Weakness in oil prices may drag Northern Oil & Gas shares. Carefully consider your investment objectives, level of experience, and risk appetite before buying the company’s shares. Always perform your own research before making any investment decisions.