Will This Oil and Gas Play Push Your Returns North?

Callum is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Producing in America, for America

Northern Oil and Gas (NYSEMKT: NOG) "is a Williston Basin Bakken and Three Forks pure play" and owns 184,000 net mineral acres in North Dakota and Montana. In its latest earnings report (Q3) Northern reported production levels of 11,282 Boe (barrels of oil equivalent) per day on average. This was a whopping 96% growth in production. Northern's booming production levels is what makes this company interesting. Also during the third quarter Northern grew its acreage position by 3,185 net acres at an average cost of $2,060 per acre. As of right now Northern has developed 62% of its interest in the Williston Basin, which leaves plenty of room for Northern to continue boosting its production.

Company Strategy

Northern's strategy is to be a non-operating partner in all of its plays, so it can burden a percentage of the costs, take that percentage of the profits, and not have as many liabilities as the operating oil and gas producers do, such as Kodiak Oil and Gas Corp (NYSE: KOG). One reason for this is to spread out risks over several different Williston and Three Forks plays, and the other is because Northern is only a $1.08 billion company, so putting up all the production costs can be expensive. Generally Northern buys a 5% nonoperational stake, but management alluded to bringing that up to 10% or more in 2013. This will allow them to increase their stake in efficient operations.

Oil Oil Oil

Oil production was 5,344 bpd in Q3 2011 and natural gas production was 2,395 Mcf (million cubic feet) per day. In 2012 oil production went up to 10,379 bpd and natural gas production was 5,422 Mcf per day (both combined equals 11,282 Boe per day). That is a big gain in production and why Northern Oil and Gas could be a good speculative North Dakota fracking play. Kodiak Oil and Gas, who drills in the same area as Northern, saw a 385% increase in oil production from Q2 2011 to Q2 2012. Kodiak expects to keep seeing 50-80% growth in production over the next few years, which is great for Northern because it means that the other players are also seeing strong production growth in the years ahead.

On the bearish side, production expenses were up 14% and the average sales price of oil was down to $82.89 per barrel versus $85.70. But Northern hedges and got an extra $1.78 per barrel. Northern needs higher oil prices to stay profitable and to see margin expansion, and it may get its wishes. Right now WTI trades at $93.56 a barrel and the US Energy Information Agency sees WTI prices averaging $90 in 2013. That is $7 more than what Northern saw as it average oil price in Q3 2012 and if it holds true will be great news for Northern.

Other Players

Everyone in the oil industry knows about the massive potential of fracking and how it can boost production tremendously. Hess Corp (NYSE: HES) saw its Bakken oil production double in its latest earnings report to 62,000 boe/d year over year and expects shale plays to make up 27% of its oil production by 2017, up from 17% today. Kodiak is investing heavily in the Bakken formation and has seen its oil production levels skyrocket, from 10,000 bpd in the beginning of the year to 18,000+ bpd by the end of the year. Further, Oasis Petroleum (NYSE: OAS) is a pure Bakken play and has seen its production more than double year over year in 2012.

Every player in the Bakken is experiencing booming production levels, which means Northern, who buys a stake in these wells, will continue to see rising oil production. Hess's production levels will continue to rise in the Bakken, and it is actively trying to reap the rewards. In 2011 Hess spent $1.8 billion on the Bakken for capital expenditures, and it bumped that up to $3 billion in 2012 and will continue to do so for the foreseeable future. Hess's management sees oil production doubling again to 120,000 bpd in 2015, which is a big increase from 30,000 bpd in 2011.

Oasis is seeing a similar (yet smaller) story, and trades at a very cheap PEG of .59. Oasis had revenues of $330 million in FY 2011, is expected to make $670 million in revenue in FY 2012. Due to rapidly rising oil production, teh company is expected to make over $1 billion in revenue in 2013. Oasis spends all of its capital on shale plays, and so far it has paid off big time. Not only is production going up, but the cost of extraction is going down. Both Kodiak and Oasis are seeing the average cost of Boe extraction go down, and if Northern uses the same tactics (using pad drilling and having only 6 instead of 7 wells, for instance) as these players, their costs will go down as well.   

Expectations and Valuation

Northern trades at a PE (TTM) of 20.8 and 7.8 of free cash flow (TTM). Some may look at a PE of 20.8 and think it is pricey, but when you add in expectations you start to see the big picture. Northern is expected to grow its EPS by 27% in 2013 and it has grown its EPS by 29.3% annually over the past 5 years. Northern is expected to have an EPS of $1 in FY 2012 and $1.28 in FY 2013. For a company growing at 27% and trading with a forward PE of 14, this stock is dirt cheap. Higher oil prices coupled with higher levels of production will allow Northern to be able to meet these expectations easily, which will push Nothern up. Oil prices have risen steadily as the fiscal cliff was kind of resolved and better import-export data from the US and better numbers from China in regards to exports and credit expansion pushed them higher. Also Europe possibly returning to growth in 2013 could further fuel investor confidence in equities overall.

Final Thoughts

Northern is a fast growing speculative fracking oil play and worth taking a look at. The macroeconomic trends are working in Northern's favor and rising production will enable Northern to rise higher. Northern's stock is way off its high of $32, which it hit as WTI prices soared over $100 a barrel due to the "Arab Spring." Northern Oil and Gas carries a cheap valuation and should see PE expansion later in the year.

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