Northern Oil and Gas: A Perfect Storm

Business Overview

Northern Oil & Gas’s business model is simple – participate in owning the interests of the wells but let some one else operate it. Here are the listed benefits.

Naturally, this translates to operator risk – if someone incompetent or bankrupt operates your wells, you’re shit out of luck. Thankfully, that’s not the case here w most of their wells operating in the top 4 oil producer active counties.

Thesis

  1. Extensive Hedge Book + Flexible Capital Expenditures
  2. Debt has no significant maturities due
  3. Company has cut dividends and slashed capital expenditures
  4. Bought back debt at discounts
  5. Opportunities to buy great assets at distressed prices
  6. High insider ownership + Large insider buying

First, Valuation & Survival Analysis

  1. Enterprise Value -> Mkt Cap ($429.91m) + Preferred Stock ( + Debt ($1.047b) – cash ($8.5m) = $1.468b enterprise value.
  2. EV/Share-> $1.468b/497m = $2.95 per share
  3. EV/TTM Ebit -> 1.95

I’ll be the first to admit I’m not E&P valuation expert. I also acknowledge that Ebit isn’t exactly a fair number to be using when you’re looking at the cash flow from assets. But I’ve chosen to use that number simply because (a) NOG’s capex numbers are highly flexible and (b) to not account for that flexibility would be just as ludicrous. You can choose the number you want to work with but bear in mind that capex for 2020 was slashed to $200m by $NOG.

All that’s needed for these guys is to stop putting out intensive capex exceeding net income every year. Bahram Akradi (who recently bought a lot more shares) has also stressed, and I quote,

Q419’s transcript

As evidenced, they’ve dropped capex to $200M for 2020. This is rather indicative to me.

In addition, the company currently possesses $375-$400m of hedge book value. That is nearly entire market cap of the company.

And of course, if oil prices plunge further, leading to greater curtailment, that leads to greater hedge gains. On a fcf basis alone, $NOG will be reading as a stock with over 20% FCF Yield.

On a macro level, my personal stance is that oil is range bound. OPEC+ cannot keep oil prices high without US shale oil industry stepping in to curtail additional profits. between a range of $40-$60 is going to be the norm for quite awhile until demand finally stretches oil supply beyond breaking point for perhaps 1-2 quarters before excess supply coming online knocks prices back down.

This is why we want a low cost, high operating margin oil producer with low debt capable of making money in low price oil environments with excess strength to take on increased productions and make gains from temporary oil price increases.

Let’s dive into hedging.

Hedging provides solid value + Flexible Capex Allows Greater Maneuverability

When an oil producer drops capex, the indicative thought process is that even though short term cash flow improves (due to reduced capex), long term cash flow suffocates (since production -> revenue -> cash flow) is reduced as you have less oil to sell.

Whilst that is true of MOST natural resource plays, I don’t look at $NOG in a similar light. Remember, $NOG is entirely a non-operator model. They don’t control the production. They just hedge it.

$NOG has hedged 75% of production in 2020 and 50% in 2021 at extremely reasonable prices.

Here’s the fun part.

Image

In case you need help understanding what I’m getting at, I will make it clear.

1 – if NOG didn’t actually sell any oil for the remainder of 2020, they actually earn more money than they would if they DID sell oil since the hedges would become like market trades and become pure profits.

2 – these hedges naturally INCREASE in value as the price of oil decreases. Based on reports of increasing covid19 cases in US post-protests and riots, I’d bet on oil prices no recovering in the short term, which is perfect for $NOG.

3 – this cash value of hedges afford $NOG the ability to do two extremely cash generative things, 1st, buy back debt at huge discounts, 2nd, buy up assets at huge discounts. As of this writing, channel checks w owners of small energy producers who are also analysts in the field reveal that there is a sweeping wave of banking redeterminations reducing overall loans and adding pressure to the oil production companies. As of June 10th, $NOG also took the opportunity to swipe up some assets in the Williston Basin at rather decent prices (1.5 year payback period at June 5, 2020 strip prices). Company has also bought back debt on discounts previously. Reference conference calls and debt reduction releases.

4 – The extent and duration of the hedges extends till mid 2021, where I believe oil prices should bounce back above $50 due to a confluence of rising demand to pre-covid levels matching a period of low production due to reduced capex at current. This means that $NOG is set up for some seriously big cashflows at almost all points in time. If (a) oil stays low, they have sufficient hedges to last longer than everyone else. If oil (b) comes back up, but stays below target, they make some profits. If (c) oil comes roaring back up by 2021, they might lose some money on 50% of their oil swaps, but they’ll more than cover the bigger gains with the rest of their production. If (d) oil is not produced/sold, they absorb maximum profit from hedges and have effectively “increased” their reserves, though of course they’re paying for storage if they produced the oil.

Reference capex flexibility here.

https://seekingalpha.com/article/4331615-northern-oil-and-gass-nog-ceo-nick-ogrady-on-q4-2019-results-earnings-call-transcript

I also want to highlight that NOG has come pretty far if you look back into its history. Reference this particular bit; you can also reference the presentation made here.

Northern Oil and Gas Inc at UBS Global Oil and Gas Conference Transcript

Valuable insights can often be uncovered if you’re willing to not just look at the present state of the company but also take a look at its recent history and progress.

Yes. NOG has largely managed to do all they said they would do, but share counts also exploded upwards. Dilution was inevitable if they wanted to avoid huge amounts of debt. Why I feel that’s ok is simple because of their current operating size and increased asset base. They might have increased share counts massively, but their share prices are also anchored to oil. For those in the know, banks regularly determine the reserve value of a company based on recent pricings. If oil has gone up, your reserve value goes up, which increases your reserved base lending, which indirectly increases your NAV. Sure, its never great to dilute shareholders out, but that’s a risk you take when you invest in E&Ps. In any case, I don’t believe dilution is further necessary. Their recent acquisition was an all cash transaction w no shares issued. Further transactions would likely be the same, though I wouldn’t rule it out entirely. Just be mindful of it.

Risks: Dilution, Discounted Take Private Pricing, Oil Prices Rise Significantly Faster Than Expected

Dilution

Northern currently has preferred shares available for conversion to common shares that will increase the total float by 25% if all 5m preferred stock are exercised. I don’t think this is likely since the conversion effective share price is $2.29, implying a 129% increase for us from current share price levels. If that happens, I’m happy to sell prior to that. More likely than not though, is that if oil prices materially increase from here on out in the long term (2years), I believe $NOG’s share price will re-rate significantly higher such that the $2.29 ceiling will be breached without issue.

Hedge Fund Angelo Gordon Along With TRT owns approx 30% of shares.

Angelo Gordon recently bought up $NOG debt, and together with others, control nearly 60% of the company. I expect a take private bid to be a possibility at significant discounts from fair value of around $3-4 long term. Take private bids tend to be around 15-20% market premiums, so we can expect some gains there even if this happens. The worst thing to happen is that share prices fall lower than normal, stays there, and than they exploit the opportunity to take it private at lower than normal prices. Having said that, I think you can mitigate that risk by sizing up when share prices dip. I don’t anticipate a big dip since $NOG is well-insulated from lower oil prices and actually gain from it. But short-selling algos might short it since it “produces oil”. You never know.

Oil prices rise significantly faster than expected

$NOG’s hedge book value can quickly evaporate and turn into routing losses if oil prices rise significantly while their production remains curtailed under operators. I doubt this can happen, but you never know if a shitty situation can occur to throw a money wrench in your plans

Summary

In sum, I believe that their hedge book, their lack of bankruptcy risk, their current cash flow routes, their debt maturity profile, and their ability to lever capex to required amounts in the current covid19 storm represents a call option on higher, future oil prices. I further believe that the company is well positioned to monetize hedges when oil prices trend down further from 2nd wave of covid19 which is happening now, and to use that resulting cashflow to either reduce debt significantly ($1b) or buy up assets for cheap (recent williston basic acreage).

I would size this between 5-10% of my portfolio depending on your level of risk tolerance.

Catalysts

  1. Take private bid
  2. Huge free cash flows upon monetizing of hedges
  3. Oil price increases
  4. Massive debt reduction
  5. Sale of interests in oil wells

Disclosure: I am not long shares for $NOG but may take position within 72 hours of this article. DYODD. I am not responsible for your investment losses/gains.

5 thoughts on “Northern Oil and Gas: A Perfect Storm”

  1. Thanks for the post and idea to look into.

    Enterprise Value -> Mkt Cap ($429.91m) + Debt ($1.047b) – cash ($8.5m) = $1.046b enterprise value.”

    You may want to check your TEV calc – TEV should be around $1.5bn – it seems your SUM formula is excluding mkt cap. Also if there is pref, it will need to be added too (seems there was a debt for pref exchange, so maybe that figure nets out roughly equivalently).

    I’m also not sure I understand the comparison to takeover value (assuming by that you mean TEV/share). It seems you are just assigning net debt on a per share basis, but I don’t why TEV/share is a meaningful statistic – equity holders obviously do not benefit at a takeover at current TEV. By that standard, heavily leveraged companies would look super attractive, which is usually untrue.

    Like

    1. had it in my head that angelo gordon and co might want to take the company private. somehow, that ended up muddling w my head as i was thinking my way thru the article vs writing it out.

      Like

    1. yeah their history’s a bit of a clusterfuck. honestly though, im much more interested in where they are now vs what they were years ago. the thesis is based on flexible capex spending and gigantic hedge gains. let’s hope they don’t screw the pooch on this one.

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