Friday, December 5, 2014

One from the archives: The guy in charge of purchasing acreage at Northern Oil and Gas

Northern Oil and Gas has been a minor obsession of mine for some years and we have remained continuously short.

This is a blog post first published in March 2011 discusses - for the benefit of shareholders - who has been making the major capital decisions for them.


Northern Oil is not a traditional oil exploration and production company. It has a simple model. It buys part shares in acreage in the Bakken shale. It waits until the major holder develops the acreage and it pays a proportion of the development costs and receives a proportion of the revenue.

That allows it to be a 1.6 billion dollar company with only 11 staff.

The only expertise it brings to the table is buying acreage. And they buy it at a wide scatter of prices.  They have paid $2500 or more an acre for some small (and presumably productive) lots. For example they paid $2500 an acre for 1748 net acres in Williams and McKenzie County of North Dakota during 4q 2010. They have paid less than 250 an acre for some very large lots. In the last quarter they purchased a 50% working interest in approximately 14,538 net acres in Richland County Montana for less than $250 an acre in the same quarter. In that case the acreage was purchased from the operator (Slawson) and presumably the operator had better-than-average intelligence as to the quality of that acreage.

The supporters of the stock value the stock based on acreage owned. This is obvious enough because you most certainly would not want to value it against current earnings or current revenue.

Given that acreage purchase is the whole reason for owning Northern Oil and believing the Northern Oil story it is worth following the people who manage acreage purchase. Betting on Northern Oil is above all betting on those people.  Northern Oil after all buys acreage in a scatter of prices almost all below $3000 an acre with large purchases below $250 an acre but is valued by the market at about $8600 per acre.  The acreage buying is the driver of incredible (market) value.

So without further ado I will tell you that the Land Manager of Northern Oil is Mr Kruise Kemp. Kruise Kemp has been hanging around the courthouses of Montana swooping on land where leases have expired without ever being drilled. An old article in the Billings Gazette describes the process and says how lease holders in Montana look in envy on the lease holders of North Dakota because in North Dakota the land often gets drilled whereas in Montana leases expire without ever seeing the drill bit. To quote:

Kruise Kemp is no stranger to the courthouses of northeastern Montana. The land manager for Minnesota-based Northern Oil & Gas said there are several buzzing with the land men just like Richland County's. 
Many of those speculators are looking to "top lease," meaning their sniffing out existing oil leases that are just about to expire in hopes of swooping in to strike up a new deal just as the clock runs out. 
In these parts, Montanans, some with leases that went untapped, have looked in envy toward North Dakota where drilling rigs have cropped up like knapweed the last couple years. There are 138 rigs punching holes through the shale in North Dakota. Here, there is only a handful. 
Kemp said the state of North Dakota had provided oil companies with a wealth of services including online field data that made it easy to setup. And drilling rigs attract other drilling rigs. It's a safe assumption when you see other rigs active in your area that you're going to hit something. Having so many rigs drilling in one area puts pressure on companies to permit as many wells as possible before moving on. 
But now companies are turning to Montana to further define the productive area of the Bakken. Working with two other companies, Northern launched a new 3,000-acre project in Richland County this month and has two others nearby.

You see Northern is buying the land where the drills aren't. Of course this makes it cheap. It could be cheap for a reason - the drills not being there because it is not really all that good land. Or it could be that Northern Oil is really great at finding cheap acreage that really is super-prospective.

Well as investors we can't directly know. We don't see the seismic and we are not there with the drill bit.  

All we have to go on in the people. And so I present to you a picture - a couple of years old - of Mr Kruise Kemp.

He played golf for Montana State and was a business school graduate (no particular honors) in the spring of 2010.  A nexus search identifies him as 23 years old.

So what qualifies Kruise Kemp for such a senior role in a 1.6 billion dollar company? Well it is not his finance degree. But Kruise is steeped in the oil industry in Montana. His father owns or controls a couple of oil companies. (I can find their names but not much detail about them.) His late grandfather was also an oilman.

Northern Oil has also done many related party transactions to buy acreage.  If the company is buying acreage from directors then I guess it is incumbent on the land manager to vet those purchases. Kemp is the man with that job.

We view Kemp's age and business degree (rather than say a major in geology or reservoir engineering) with skepticism. Then again we own Google. That is one of the greatest companies in history and it was started by (very bright) people in their 20s. Steve Jobs was 16 when he was introduced to Steve Wozniak and Apple was the result.

It could be that Montana State University business school has produced one of the world's great 23 year old oil-industry entrepreneurs. Might be. As a Northern Oil shareholder that is one of the things you are betting on.



Anonymous said...

Billings gazette link is broken - here is fix

Anonymous said...

" most certainly would not want to value it against current earnings or current revenue."

If this statement applies to NOG, then it applies to every producer in the Bakken. In fact, every E&P. NOG is trading at an EV/EBITDA of < 4x. That multiple is either the same or lower than Bakken peers.

Cash flow will fall as hedges roll off, but that applies to every single E&P in the U.S. of A.

As far as NOG, I think you are missing the forest for the trees. Like them or hate them, the management team has effectively rode the tailwind of an explosion in the Bakken. NOG's margins are in line with their operating partners. Their assets are no better, and no worse, than the companies I named above.

Now, they have some leverage and they are a small cap. That puts them in a more challenged position than large cap E&Ps with better balance sheets. There's no denying that.

If oil prices didn't move from where they are today for the next 3 years and NOG's cost structure didn't budge, they'd have issues. Many others would have issues before them.

Allow me to propose an alternative scenario. I believe NOG will survive and the stock will be meaningfully higher than its current price in a couple years.

1) I don't believe oil will stay at its current level for long. Among reporters, its a race to the bottom to see who can quote the newest, lowest breakeven price. It used to be $85, then then $70, $60, $50, and now $25? C'mon, $25 barely covers DD&A for a lot of E&Ps. A fruitful investment in NOG and every other E&P today assumes a higher long-term price than spot. I believe such an assumption is highly probable. At $80 oil or higher, I believe NOG is a great investment here.

2) Can they make it until oil gets to $80? Yes, I think so. They are extremely well-hedged for 2015 at $90. Their balance sheet is not good, but it's not terrible. They have Debt to EBITDA of 2.5x. The industry average is a little over 2x. Sure, their leverage multiple (and peers) is likely to grow as cash flow weakens when hedges roll off, but it's not even much of a concern until 2016 or later.

3) What do they do in 2016, if oil hasn't rebounded? Chances are, if oil prices haven't improved, NOG's costs have re-rated too. Day rates fall. Production taxes fall. To an extent, falling costs help perpetuate weak oil prices, because it lowers breakeven levels. Yet, most operators will not be reducing costs and growing production simultaneously. They will be retrenching, conserving capital. This should ameliorate industry oversupply.

4) Asset sales remain an option for all parties, including NOG. Obviously, selling producing acreage will hurt cash flow, but the company has undeveloped acreage as well. Asset sales can buy them time as they wait for higher oil prices. Maybe they sell some working interests back to operators. Do you think OPEC wants $70 Brent for 3 years?

5) Differentials in the Bakken should improve as pipelines come online. NOG and others will not permanently suffer a $10+ discount on their production.

6) NOG is trading at the same EV it was in 2010, when it had essentially no revenue and no EBITDA. Times have changed. Even adjusting revenue and EBITDA for current strip prices, the company's multiples would be on the low end of where it has ever traded. Admittedly, NOG has more leverage today (reflected in the EV), but far more cash flow to support it.

The negative views expressed in the blog center on the quality of the management team and ignore that there's a real company here with working interests in 25% of the wells in the biggest oil producing region in the U.S. NOG is well hedged and can be selective about which wells to drill without losing acreage. With the stock down 2/3 in a few months, is now the right time to be piling into a NOG short trade?

I have decided to take the other side of the NOG trade.

Anonymous said...

While the short thesis on NOG is probably valid, the logic behind this post in particular seems to be nonsensical. Perhaps readers have misconstrued, but it would seem that Mr Kemp's abilities are being doubted entirely because 1) he is young and 2) he graduated from Montana State University (without honors no less!).

I daresay that a very large number of people outside of, well, Adelaide, might thumb their nose at a graduate of the University of Adelaide, or wonder how spending a meaningful chunk of one's youth in tax and accounting qualifies one to evaluate investments in sectors such as media, energy and consumer products.

By the logic in this post, one should only invest alongside older graduates of Ivy League schools and nobody else. Ironically, this would have been a sound strategy with regards to Herbalife and Bill Ackman....

John Hempton said...

Ah, there are certain things that it is hard to do at age 23. And certain things that it is hard to do at age 70.

Youth has advantages - but second tier business schools and youth is not an advantage for dealing with powerful executives selling you oil on insider-terms.

Nor is it I think a fairly good way of being an intuitive judge of field geology.

Your call - but I do not think my view is unsound.


But What Do I Know? said...

Nice trade--assuming you stuck with it :>)

Anonymous said...

John, do you intend to write any more monthly commentaries under the Australian fund? I've always enjoyed reading them in the past. (At least update your performance numbers!)

John Hempton said...

As long as you do not fall into the categories we are not allowed to market to (some European, US retail for example) we are happy to put you on circulation lists for our letters (just ask via email).

Alas I do not make the decision whether you can get them. Simon does. Compliance with that stuff is his job.


Anonymous said...

Your comment ... "Youth has advantages - but second tier business schools and youth is not an advantage for dealing with powerful executives selling you oil on insider-terms.", may well be valid, but you are ignoring the real world dynamics that you yourself stated in your blog. The guy comes from an oil family.

He may well be a puppet, controlled by dad, but does that make it a "new" reason to dislike the current price and valuation of the company?

Anonymous said...

As for NOG- just another GSX- they bet big, and costs are going to kill them.

A long slow death march has just been kicked off in oil. And now they start on the pathway to piles of rusting pipe and busted dreams.

Gasco lived until the hedges rolled off, then they died a long bitter death.

Welcome to the petro bust, big time. It will break entire countries this time, and folks are expecting a quick rebound- nope.

Russia, pffft. Chavezistan, pfft. Iran, begging for peace and quiet to sell some dang oil.

This is a problem with high oil prices, everyone finds more of the stuff that would make huge dollars at those high prices, but at the bottom the Saudi's control the prices with a big ability to open the taps.

And they are clearing out the competition, which they will buy on the cheap.

bjdubbs said...

The value of the rpt is small. Someone steeped in MT oil industry is well suited to precisely this job (I had no idea such a thing existed). This is grasping at straws.

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