When senior executive pay becomes parody: Transocean edition

Transocean awards bonuses to senior management at least in part based on safety.  That looks honorable to me.

But as the WSJ reports:

Transocean Ltd. had its "best year in safety performance" despite the explosion of its Deepwater Horizon rig that left 11 dead and oil gushing into the Gulf of Mexico, the world's largest offshore-rig company said in a securities filing Friday.  

Accordingly, Transocean's executives received two-thirds of their target safety bonus. Safety accounts for 25% of the equation that determines the yearly cash bonuses, along with financial factors including new rig contracts. 

The payout contrasts with that for 2009, when the company withheld all executive bonuses after incurring four fatalities that year "to underscore the company's commitment to safety."

I want to express my view about the obligation of shareholders to hold management accountable and the problems in corporate law and practice that make that difficult (eg staggered boards) but sometimes you need to just look in wonder at where we have got to.



John

Northern Oil's expanding share count

I had to double-take when I wrote this.  Over the past two years Northern Oil has had about 60 million dollars of revenue.  It has issued roughly three quarters of a billion dollars worth of stock at current prices.

Think about that for a while - then read the detail.

Details details details...

Here is the share count for Northern Oil for the last 8 quarters

2009 Q4     34,120,103
2009 Q1     34,392,103
2009 Q2     36,691,195
2009 Q3     36,769,195
2009 Q4     43,911,044
2010 Q1     44,932,331
2010 Q2     51,079,143
2010  Q3    51,596,849
2010 Q4     62,129,424

Shares outstanding have risen by 28 million which at current market prices is about three quarters of a billion dollars.  Share count has risen every quarter.

Regular issuance is dilutive of the interests Northern Oil shareholders.  It is hard to justify the current stock price if this issuance keeps up.

Many of these shares were sold to the market for cash.  However shares were also issued for lots of other purposes.

Warren Buffett observes that when a company issues shares it is selling a little bit of itself.  If it sells shares for acreage it is selling a little bit of the company in exchange for that acreage.  If the acreage is better-than-average it might be worth it.  But when a company is issuing shares at this rate the quality of assets acquired for those shares should be subject to scrutiny.

As noted - this company often buys acreage for shares.  The land manager (presumably someone important in making that decision) is a 23 year old.  He is probably on top of it.

However shareholders should keep abreast of the reasons management issue stock.  To help I have  (without further comment) reproduced below the section on stock issuance in the 10K.



John






NOTE 6     PREFERRED AND COMMON STOCK


The Company’s Articles of Incorporation authorize the issuance of up to 100,000,000 shares.  The shares are classified in two classes, consisting of 95,000,000 shares of common stock, par value $.001 per share, and 5,000,000 shares of preferred stock, par value $.001 per share. The Board of Directors is authorized to establish one or more series of preferred stock, setting forth the designation of each such series, and fixing the relative rights and preferences of each such series.  The Company has neither designated nor issued any shares of preferred stock.


In 2008 optionees exercised 260,000 stock options granted in 2006 and 2007, resulting in cash proceeds to the Company of $933,800.  A tax benefit of $425,000 related to fully vested stock option awards exercised was recorded as an increase to additional paid-in capital


In February 2009, the Company agreed to issue 92,000 shares of Common Stock to three employees of the company as compensation for their services.  The employees were fully vested in the shares on the date of the grant.  The fair value of the stock to be issued was $261,280 or $2.84 per share, the market value of a share of common stock on the date the stock was obligated to be issued.  The entire amount of this stock award was expensed in the year ended December 31, 2009.


On February 27, 2009, the Company closed on a revolving credit facility with CIT Capital USA, Inc. (“CIT”).  As part of obtaining this credit facility agreement the Company entered into an engagement with Cynergy Advisors, LLC (Cynergy).  As part of the compensation for the work performed on obtaining the financing, Cynergy received 180,000 shares of restricted Common Stock of the Company.  The fair value of the restricted stock was $475,200 or $2.64 per share, the market value of a share of Common Stock on the date the financing closed.  The fair value of this stock was capitalized as Debt Issuance Costs and is being amortized over the amended term of the financing.


On April 3, 2009, the Company acquired leasehold interests in North Dakota. The total consideration paid for this acreage was 49,092 shares of restricted common stock.  The fair value of the restricted stock was $224,879, or $4.58 per share, the market value of a share of Common Stock on the date the leasehold interests were acquired.


In June 2009, the Company completed a registered direct offering of 2,250,000 shares of common stock at a price of $6.00 per share for total gross proceeds of $13,500,000.  The Company incurred costs of $813,237 related to this offering.  These costs were netted against the proceeds of the offering through Additional Paid-In Capital.


On October 26, 2009, the Company deposited 41,989 shares of common stock in a specially-designated shareholder account that had been previously-created to hold shares of our common stock represented by certificates that appear in our stock transfer records but were known to have been cancelled and their underlying shares transferred between July of 1987 and August of 1999.  An aggregate of 58,268 shares of our common stock are held in the specially-designated shareholder account, which, following a substantial review of all available historical stock transfer records, the Company concluded represents the maximum number of shares of our common stock that could potentially be released to shareholders who may be able to establish a valid claim to such shares due to previously unrecognized issues with the Company’s stock transfer records.  These shares are considered issued and outstanding and are included in the total number of shares outstanding disclosed on the cover page of this report.


On November 4, 2009, the Company completed a registered direct offering of 6,500,000 shares of common stock at a price of $9.12 per share for total gross proceeds of $59,280,000.  The Company incurred costs of $2,972,027 related to the offering.  These costs were netted against the proceeds of the offering through Additional Paid-in Capital.


In November and December 2009, the issued 79,005 shares of common stock related to the purchase of leasehold interests in North Dakota. The fair value of the stock was $890,859, the market value of the Common Stock on the date the leasehold interests were acquired.


In November 2009, the Company issued 50,000 shares of Common Stock to two employees of the company as compensation for their services.  The employees were fully vested in the shares on the date of the grant.  The fair value of the stock issued was $457,500 or $9.15 per share, the market value of a share of common stock on the date the stock was issued.  The entire amount of this stock award was expensed in the year ended December 31, 2009.


In December 2009, the Company issued 100,000 shares of Common Stock to two executives of the company as compensation for their services.  The executives were fully vested in the shares on the date of the grant.  The fair value of the stock issued was $970,000 or $9.70 per share, the market value of a share of common stock on the date the stock was issued.  The entire amount of this stock award was expensed in the year ended December 31, 2009.


In December 2009, the Company issued 41,670 shares of Common Stock to the Company’s outside Directors as compensation for their services.  The Directors were fully vested in the shares on the date of the grant.  The fair value of the stock issued was $404,199 or $9.70 per share, the market value of a share of common stock on the date the stock was issued.  The entire amount of this stock award was expensed in the year ended December 31, 2009.


In December 2009, a Director of the Company exercised 100,000 stock options granted to him in 2007.  The exercise of these options was completed through a cashless exercise whereas the company repurchased 52,061 of common shares to issue the common shares related to this option exercise.


In January 2010, the Company agreed to issue an aggregate of 4,000 shares of Common Stock to two employees of the Company.  The shares were fully vested on the date of the grant.  The fair value of the stock issued was $50,280 or $12.57 per share, based upon the market value of one share of the Company’s common stock on the date the stock was obligated to be issued.  The entire amount of this stock award was expensed in the year ended December 31, 2010.


In January 2010, the Company agreed to issue 1,000 shares of Common Stock to a consultant of the Company.  The shares were fully vested on the date of the grant.  The fair value of the stock issued was $12,320 or $12.32 per share, based upon the market value of one share of common stock on the date the stock was obligated to be issued.  The entire amount of this stock award was expensed in the year ended December 31, 2010.


In March 2010, the Company issued 10,287 shares of Common Stock as part of an acquisition of leasehold interests in North Dakota. The fair value of the stock issued was $99,475 or $9.67 per share, based upon the market value of one share of common stock on the date the leasehold interests were acquired.


In March 2010, pursuant to employment agreements the Company issued an aggregate of 50,000 shares of Common Stock to executives of the Company.  The shares were fully vested on the date of the grant.  The fair value of the stock issued was $664,500 or $13.29 per share, based upon the market value of one share of common stock on the date the stock was obligated to be issued.  The Company expensed $307,331 in share-based compensation related to the issuance for the year ended December 31, 2010.  The remainder of the fair value was capitalized into the full cost pool.


In April 2010, the Company entered into an underwriting agreement to sell 5,750,000 shares of common stock at a price of $15.00 less an underwriting discount of $0.60 per share for total net proceeds of approximately $82.8 million, after deducting underwriters’ discounts.  The Company incurred costs of $300,000 related to this offering.  These costs were netted against the proceeds of the offering through Additional Paid-In Capital.


On June 14, 2010, the Company issued 382,645 shares of Common Stock as part of an acquisition of leasehold interests in North Dakota.  The fair value of the stock issued was $5,360,856 or $14.01 per share, based upon the market value of one share of common stock on the date the shares were registered with the SEC for resale, which is the date the leasehold interests were acquired.


On June 18, 2010, the Company granted 14,167 shares of Common Stock related to acquisitions of leasehold interests in North Dakota.  The fair value of the stock granted was $238,006 or $16.80 per share, based upon the market value of one share of common stock on the date the leasehold interests were acquired.


 On July 13, 2010, the Company granted 31,206 shares of Common Stock related to acquisitions of leasehold interests in North Dakota.  The fair value of the stock granted was $451,551 or $14.47 per share, based upon the market value of one share of common stock on the date the leasehold acquisitions were agreed upon.


On July 14, 2010, the Company granted 444,186 shares of Common Stock related to acquisitions of leasehold interests in North Dakota.  The fair value of the stock granted was $6,529,534 or $14.70 per share, based upon the market value of one share of common stock on the date the leasehold interests were acquired.


In July 2010, pursuant to an employment agreement the Company issued 5,000 shares of Common Stock to an employee of the Company.  The shares were fully vested on the date of the grant.  The fair value of the stock issued was $69,250 or $13.85 per share, based upon the market value of one share of common stock on the date the stock was obligated to be issued.  The entire amount of this stock award was expensed in the year ended December 31, 2010.


In November 2010, the Company entered into an underwriting agreement to sell 10,292,500 shares of common stock at a price of $20.25 less an underwriting discount of $0.81 per share for total net proceeds of approximately $200.1 million, after deducting underwriters’ discounts.  The Company incurred costs of $392,795 related to this offering.  These costs were netted against the proceeds of the offering through Additional Paid-In Capital.


In November 2010, the Company issued 153,075 fully vested shares of Common Stock to the executives and employees of the Company as compensation for their services.  The fair value of the stock issued was $3,497,764 or $22.85 per share, the market value of a share of common stock on the date the stock was issued.  The Company expensed $1,235,429 in share-based compensation related to the issuance for the year ended December 31, 2010.  The remainder of the fair value was capitalized into the full cost pool.


Restricted Stock Awards


During the years ended December 31, 2010, 2009, and 2008,the Company issued 1,058,000, 361,330 and 20,000, respectively, restricted shares of common stock as compensation to officers, employees, and directors of the Company. The restricted shares vest over various terms with all restricted shares vesting no later than December 31, 2013. As of December 31, 2010, there was approximately $13.2 million of total unrecognized compensation expense related to unvested restricted stock. This compensation expense will be recognized over the remaining vesting period of the grants. The Company has assumed a zero percent forfeiture rate for restricted stock. 

The guy in charge of purchasing acreage at Northern Oil

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.

John

Northern Oil related party statements

From the 10K - presented without comment

NOTE 7 RELATED PARTY TRANSACTIONS 

The Company has purchased leasehold interests from South Fork Exploration, LLC (“SFE”) pursuant to a continuous lease program that covers specific agreed upon sections of townships and ranges in Burke, Divide, and Mountrail Counties of North Dakota where SFE previously acquired leasehold interests on the Company’s behalf and is authorized to continue to acquire additional acreage within the proximity of the originally-acquired leases. This program differs from other arrangements where the Company may purchase specific leases in one-time, single closing transactions. In 2008, the Company paid a total of $815,100 related to previously acquired leasehold interests. In 2009, the Company paid a total of $501,603 related to previously acquired leasehold interests. In 2010, the Company paid a total of $5,000 related to previously acquired leasehold interests. Because each lessor separately negotiates its own desired royalty, SFE’s over-riding royalty interest varies from lease to lease. The Company is receiving a net revenue interest ranging from 80.25% to 82.5% net revenue interest in the acquired leases, which is net of royalties and overriding royalties. SFE’s president is J.R. Reger, the brother of the Company’s CEO, Michael Reger. J.R. Reger is also a shareholder in the Company. 

The Company has also purchased leasehold interests from Montana Oil Properties (“MOP”). In 2008, the Company purchased leasehold interests from MOP for a total consideration of approximately $5,160,824. In 2009, the Company paid MOP a total of $63,234 related to previously acquired leasehold interests. In July 2010, the Company paid MOP a total of $269,821 for leases and reimbursement costs pertaining to two separate wells in Mountrail County, North Dakota. MOP is controlled by Mr. Tom Ryan and Mr. Steven Reger, both are relatives of the Company’s Chief Executive Officer, Michael Reger. 

The Company has also purchased leasehold interests from Gallatin Resources, LLC (“Gallatin”). In 2008, the Company purchased leasehold interests from Gallatin for a total consideration of approximately $22,109. In 2009, the Company paid Gallatin a total of $22,223 related to previously acquired leasehold interests. In 2010, the Company paid Gallatin a total of $15,822 related to a previously acquired leasehold interests. Carter Stewart, one of the Company’s directors, owns a 25% interest in Gallatin. Legal counsel for Gallatin informed the Company that Mr. Stewart does not have the power to control Gallatin Resources because each member of Gallatin has the right to vote on matters in proportion to their respective membership interest in the company and company matters are determined by a vote of the holders of a majority of membership interests. Further, Mr. Stewart is neither an officer nor a director of Gallatin. As such, Mr. Stewart does not have the ability to individually control company decisions for Gallatin. 

The Company has a securities account with Morgan Stanley Smith Barney that is managed by Kathleen Gilbertson, a financial advisor with that firm who is the sister of the Company’s president and Director, Ryan Gilbertson.

All transactions involving related parties were approved by the Company’s Board of Directors or Audit Committee.

The marvellous Wall Street capitalization machine: Northern Oil edition

Northern Oil has its defenders and the defenders tend to point to one thing only – the value of Northern Oil's acreage.  After all you would never buy Northern Oil based on its current revenue or its current profit.  Here are the quarterly numbers (you will need to click for full detail):

(The company notes the 3c per share loss in the fourth quarter was after oil hedging losses.  The loss was also after an extra depletion charge.)

Anyway its pretty hard to justify Northern Oils $1.6 billion market cap based on these quarterly numbers.  We are talking approximately 35 times revenue – and well over 100 times earnings (on their numbers – numbers which I believe are inflated).

To justify the market cap you need to assume that soon-to-be-developed acreage is worth a fortune.  And the defenders do just that.  For example Canacord Genuity (a major promoter) in its daily note (23 March 2011) led with this:

Investment recommendation 

We are reiterating our BUY rating and thesis based on Northern Oil’s acreage quality and relative growth potential. The company's core competency is lease acquisition, and we remain encouraged by its ability to accelerate acreage acquisition and development activities. In our view, the recent bearish sentiment and associated sell-off are overdone. We remain very comfortable with our assessment of the Bakken, oil and gas accounting and Northern Oil’s valuation. We view this weakness as a buying opportunity given precedent transactions and the company’s proven ability to organically acquire acreage at accretive levels.

Investment highlights

 From our constructive stance, we believe the bulls would argue that Northern Oil trades at a ~17% discount (EV/EBITDAX) to its closest peers (BEXP and OAS) and that the recent Linn Energy transaction (CXO/LINE valued at +$12,700 per acre, NOG valued at ~$8,600 per acre) more than underpins its fundamental valuation. The LINE and NOG metrics are adjusted for production at $100,000 per boepd. The bears point to depletion accounting and corporate governance concerns.  While oil and gas accounting is complex, we are very comfortable with our assessment of Northern’s business model, reserve accounting and oversight controls and balances.

The key here – which I highlighted – is that the company is only valued at $8,600 per acre compared to some recent transactions at $12.600 per acre.

That would be good if we were comparing apples with apples (or acres of identical quality).  We can however find a good scatter of acreage prices.  The Feburary 25 edition of Rocky Mountain Oil Journal gives a Bakken state of play.  This is what they said about North Dakota auctions by the State in 2011:

Aside from the oil and gas numbers, North Dakota also set numerous lease records for 2010. The state held four land sales during the year, selling 164,848.38 acres for a total of $311,238,786.60. This translates into an eye-popping per-acre average of $1,888.03. The Mar. 10, 2010 sale was particularly memorable, with 53,274.97 acres being sold for $158,099,211.75, representing an unbelievable per-acre average of $2,967.60.

Note that a $1,888 average is “eye popping” in a trade magazine.  The March auction was “ unbelievable” at $2,967.

I run out of adjectives for Northern Oil's market cap at $8,600 an acre.  But that is Wall Street – buy it at sub $3000 an acre, put it in a company and have pension funds buy it from you (when you sell your stock) at $8,600 an acre.  Everyone is happy!

But hey – why use average auctions when we have Northern's own numbers?  When you read these numbers remember that well spacing is typically about 1 per 600 acres to 1 per thousand acres with the lesser spacing being more common.  Quoted from the 10K:

The following describes some of our larger acquisitions during the fourth quarter of 2010: 

Williams and McKenzie Acreage Acquisition 

In December of 2010 we acquired approximately 1,748 net acres for $2,500 per net acre in Williams and McKenzie Counties of North Dakota. All of the acreage consists of non-operated tracts that are not subject to specific exploration or development agreements. Several operators have been permitting and drilling wells in close proximity to the acreage, and we expect development of our acreage will commence in 2011. 

Slawson Exploration Lambert Prospect 

In December of 2010 we acquired a 50% working interest in approximately 14,538 net acres for total consideration of $1,737,483 in Richland County, Montana. Slawson will be operating the prospect and all drilling and future acquisition costs will be shared pro-rata with Slawson based upon our proportionate working interest in the prospect. This prospect is in close vicinity of Elm Coulee, and considered an extension of the Southwest Big Sky project, which is also operated by Slawson. 

BLM Sale

In December of 2010 we purchased 720 net acres from the Bureau of Land Management for $875 per net acre in Richland County, Montana. The acreage lies within a selected township that recently experienced a successful test well targeting the Bakken formation, but is not subject to specific exploration or development agreements. 

Miscellaneous Acreage Acquisitions 

In November 2010 we purchased 506 net acres for $2,000 per net acre in a single spacing unit in McKenzie County, North Dakota. In December 2010 we purchased 506 net acres for $1,500 per net acre in a separate spacing unit in Richland County, Montana. As of December 31, 2010, the McKenzie County, North Dakota well was awaiting completion and the Richland County, Montana well was spud. In December of 2010 we purchased 322 net acres for $1,775 per net acre in Mountrail County, North Dakota, of which 235 net acres is estimated to spud during the first quarter of 2011.

Now the first acquisition (William McKenzie) is 1748 acres (two or three wells at standard spacing) at $2500 per acre.  These will be drilled this year - and they were purchased at about the mid-price for Bureau of Lands sales in 2010.  You would expect them to be ordinary acres. It is a bit adventurous the the stock market to value this at $8600 per acre but it is at least in line with industry norms.

But the second acquisition (Slawson Exploration Lambert Prospect) was very different.  It was a 50 percent interest in net 14,538 acres (call it 7269 acres net for Northern) for $1,737,483.  That is $239 an acre.  And they did not buy it from a dupe part - they bought it from Slawson who operates and will continue to operate those acres.  The operator was willing to sell these acres for $237.  It looks awful rich to value them at $8,600 per acre for these acres.

The BLM sale was at about a third the cost of the average BLM sale during the year - and that was at a competitive auction.  $875 per acre in a competitive auction is not chump-change but it is about 10 percent of the market-cap per acre the company trades at.

Wall Street - the capitalization machine

Wall Street capitalizes future earnings.  The price of a stock now is the market estimate of what cash it can generate for investors in the future.  Sometimes Wall Street is really dismal and the price of stocks is much lower than the value of the same businesses would sell for in a private transaction.  (That is when Warren Buffett likes to buy stocks.)  Sometimes Wall Street values stocks far more than independent industry transactions.  At that time businesses wanting to sell rush go to public.

Boone Pickens when he purchased oil stocks famously said that it was cheaper then to "drill for oil on the floor of the New York Stock Exchange" than it was to drill out in the field.

Northern Oil stock is the anti-Boone-Pickens transaction.  The company buys acreage at as low as $237 an acre and have the AMEX value it it at $8600 and have lots of Wall Street's Finest Analysts tell you that is cheap compared to comparable transactions.

Thanks - but I am still short.



John

Northern Oil and Gas – the source of the strange auditor

There are lots of things that I do not know about Northern Oil and Gas.  The thing I would most like to know are the flow rates on their wells at initial, six month, twelve months, eighteen months and twenty four months.  The decline rates of the wells are the key to the economics of the Bakken and will tell you whether any or all the stocks are buys or even shorts.  The decline data I have suggests a decline rate of over 2 percent per day but only includes the front-end of the decline curve.

My first post had one question that left me pondering.  The question was how did Northern Oil and later Voyager Oil choose an auditor that nobody has ever heard of in Salt Lake City over twelve hundred miles from their office?

Moreover it wasn't any ordinary auditor – it was Mantyla McReynolds, an auditor with an almost unblemished record of auditing penny stocks that later collapsed.

Well I have the answer – at least in the case of Northern Oil.  The auditor came with the initial shell company into which Northern Oil was merged.  Mantyla McReynolds was the auditor both before and after the reverse take over.

The initial shell company was called Kentex Petroleum and it was controlled by Duane S Jensen.  The initial shareholders received 6 percent of Northern Oil for just a listing.

Duane (and his children) have a long record with penny-stocks using the same Salt Lake City auditor.  Indeed a few Jensen (sometimes Jenson) specials were mentioned in the first Northern Oil blog post.  However Bikini Team International Inc stands out.  This is their business description:

Our initial operations consisted of a "bikini team" comprised of women clad in bikinis who were engaged through us to appear for a fee. Some of the events that the bikini team appeared at were: an NFL super bowl party at the Roadhouse Grill in Evanston, Wyoming; as "ring" girls from May 2001 to September 2002 for the Wendover Boxing Series; the 24th of July Rodeo at the Delta Center Salt Lake City, Utah in 2001 and 2002; and the 2002 Winter Olympics, which were held in Salt Lake City, Utah, where they worked for Budweiser as the snow angels and hosted several pre-Olympic parties with Budweiser. They also appeared at several charity events, primarily in held in the State of Utah, like the X-Mas box foundation, the Cancer foundation, Christmas toy drive, Ron Boone golf classic at Thanksgiving Point, Downs Charity, Make a Wish foundation and the Ride for Hope With Harley Davidson in May 2001 and 2002. They also hosted bands at concerts, such as Lifehouse and 3 Doors Down and appeared on the Salt Lake City Fox 13 television morning show and sports segment "Rungee Time" for 15 months.

I really wanted to find photos of the Swedish Bikini Team – but all I found is Duane's (sometime Dwayne's)  more colourful record going back to the 1970s including SEC sanction and rougher...

If readers want to dig they will find plenty that is amusing.  I still chortling at a listed superbowl party.



John

The Street Sweeper on Northern and Voyager: Part 2

The Street Sweeper has published Part II on Northern Oil and Voyager Oil.

Linked without comment.

Northern Oil and Gas: It's only a Northern Song

I have been sitting on this post for while pending the publication of an article by Mellisa Davis (of The Street Sweeper).  She has now gone public quoting me - so here is something I have been working on.

High growth subprime companies - a brief stylized history

Until the crisis one of the staples of my life was financial institutions which under provided for inevitable losses and grew really fast.  Examples include Metris and Americredit - both of which collapsed, partially recovered and were eventually taken over.

Before the collapse they had less-than-prime lending businesses in credit cards and auto loans respectively.  Metris was the more pure example.  Another example was the credit card business of Circuit City.

These companies understated losses.  That made them seem profitable.  That profitability is only temporary because eventually it becomes obvious to even the most stubborn and blinkered management that the loans are not going to pay.  When that happens a charge is inevitable - and future profitability winds up at a lower level (more akin to economic reality).

However the companies in question deferred the day of reckoning.  They did this a couple of ways.  First when someone could not pay their loan they tended to extend them more credit.  Metris’s average balance outstanding went above $4000 (or more than double average balances at similar companies).  That meant that when the losses (inevitably) came they were bigger.

The second way that they deferred the day of reckoning was just to grow really really fast.  After all, if you don’t recognize any losses on new loans, then filling your portfolio with new loans meant your aggregate credit looked OK, even if the old loans were toxic.  The denial solution de jour was hypergrowth.  The hypergrowth hid problems and also (incidentally) drove stocks to the moon giving management ample opportunity to cash out.  In other words the path that made management rich was to make the problem bigger and bigger.

Sometimes before they blew up (and they inevitably blew up) you would get a signal: a quarter with an unexpected “reserve adjustment”.  Reserve adjustment being a (belated) admission that the reserves were not adequate.  Sometimes there was no signal except insider selling.  Mostly even the insider selling was not a good signal because the insiders were always selling.

Lesson from this

There is a lesson I drew from this.  Be very wary of fast-growing hyper profitable companies (especially companies in competitive industries) where the earnings are critically dependent on a reserve or variable that has to be estimated and on which the estimate is really a guess.  This could be lending or insurance or large contract construction with contract warranties or in this case an oil company.  The company in question is Northern Oil and Gas (Northern): a member of the S&P mid-cap index.

The Bakken shale oil plays

Northern Oil and Gas (and its little sister company Voyager Oil) own acreage and part shares in oil wells in the Bakken Shale.  The Bakken Shale is one of the hotter properties in North America and is the subject of much promotion including several (sometimes anonymous) stock promotion blogs dedicated entirely to investing in the Bakken (see here, and here).  Some have go-go names like “Million Dollar Way” appealing to relatively unsophisticated investors.

That said - the Bakken is a real oil field and it has real players and is producing a lot of oil.

The Bakken is a large (200 thousand square miles) mid depth (typically about 10 thousand feet) and not very wide (typically about 40 feet wide) oil bearing shale deposit.  The area overlaps two American States (North Dakota and Montana) and one Canadian Province (Saskatchewan).

The field has been known about for many years because traditional oil fields underlie the Bakken and as the wells have been drilled, small quantities of light sweet crude have been logged.  However the technology to extract oil in quantity from the Bakken is relatively recent and involves drilling down 10 thousand feet, kicking a horizontal well down 5-8 thousand feet, putting explosives down the well to crack the rock and then chemicals and water at very high pressure to extensively fracture the rock.  And then the oil flows.

This has driven North Dakota oil production extremely well:

If you extrapolate graphs of production (something I don’t think you should do) then North Dakota overtakes Alaska in 2017 to be the major US oil producing state.

The problem with Bakken shale oil

The problem with Bakken shale oil is that the pores in the rock are tight and the rock needs to be fractured to extract it.  It is a stylized fact of oil production that the tighter the rock the faster the oil well declines to a trickle - especially after the reservoir has been forcedly fractured.

This makes sense.  If the rock is homogenous, quite porous and extends over a large area you would expect an oil well to flow for a very long time (multiple decades).  However if the rock flows only a small amount of oil without fracturing (the small amount being the amount near the well bore) then when you fracture it it will flow many small amounts (the small amounts being amounts near the fracture system).  And when you have exhausted the oil that happens to be near the fracture system then the flow should flow to a trickle as the rock is not very conducive to flow.

The risk with the Bakken is that the wells decline much faster than anticipated when the well is drilled and faster than anticipated in the accounts.

If this happens the company will have to take a “depletion adjustment” - the analog of my subprime company taking a “reserve adjustment”.

Now, also as an analog of the subprime company if the company, is drilling a whole lot of wells that are declining faster than anticipated, it can hide this through growth.  After all, new wells don’t just stop flowing: they need to be old wells before that happens.  And you can hide an aggregate decline problem by drilling like crazy.  It just winds up being a bigger decline problem when you stop drilling.

And now you see my subprime oil company: it is Northern Oil and Gas and it is a doozy.  Market cap is over $1.7 billion and the stock is up from 3 and a bit dollars to almost $30 since the beginning of 2009.  It is - through partners - drilling like crazy.

It is a strange company, despite the large market cap it only has 11 staff.  It takes minority shares in other companies oil wells.  It does not drill anything itself.  Every well seems to strike oil (that is what it is like in the Bakken) but because they do not operate the wells they only have limited insight into the decline rates.  Shareholders have even less insight into the decline rates.

Searching for a benchmark for Bakken decline rates

I spent a lot of time trying to find a benchmark for oil-well decline rates in the Bakken.  It's hard because people tend to keep this information confidential especially if they are bidding for local acreage.  Also the technology to fracture Bakken wells is relatively new and so to some extent decline rates (especially over the out years) are just unknown.  Still, I have heard good stories about individual wells that are flowing well after three years.  I have heard horror stories about wells that are flowing at less than a barrel per day after one year.  The average almost certainly lies in this range.

I was getting hung up on a benchmark when one of my favorite bloggers Peter Sacha stepped in with a really useful post.  In it he picked apart the accounts of Petrobakken.  Petrobakken is the major player in the Saskatchewan Bakken.  What is more he had a decline curve.

Its only a decline curve for the first year - of production - and it is for a particularly big well (a seven stage frac).  However, the initial flow rate was almost 250 barrels of oil per day and after 12 months this had declined to 75 barrels per day.    It is a steep decline.

And it shows in Petrobakken’s accounts.  Peter Sacha deadpans that the company likes to report “cash flow” which does not include the depletion allowance for wells.  He then notes the company spent $812 million in capex most of which was to replace depleting wells.  The cash flows are enormous - but the capital expenditure needed to maintain those cash flows are enormous - and that is because the depletion is rapid.

The key analytical assumption of this blog post is that we can compare decline rates for Petrobakken and Northern Oil.  Both Petrobakken and Northern Oil are Bakken shale producers.  Petrobakken is just much bigger and a little older and a little more experienced with decline rates.  But both companies have a large spread of wells in similar areas so the average decline rate (relative to current production) should be similar.

Here are the accounts for the first nine months.  (I don’t give the annual accounts because Northern Oil had an irregular depletion charge in the last quarter.)

For Petrobakken (and sorry you will need to click)

Note that over 9 months Petrobakken had 750 million in oil and gas sales before royalties and 654 million in net revenue.  The depletion charge was 391 million.  Depletion is 52 percent of gross revenue and almost 60 percent of net revenue.  These wells deplete badly and the depletion charges are large.

Here is Northern Oil for the first nine months (and sorry again you will need to click).

Note that for Northern the gross revenue for the first nine months is 35.6 million (a very small fraction of Petrobakken).  The depletion charge plus amortisation is 8.36 million.

Depletion and depreciation is only 23.5 percent of gross revenue.

Same field.  Same geology.  Less than half the depletion rate.

Same geology, same field suggests that the right approach to compare these companies is to assume the same depletion rate for both companies.  Of course which depletion rate - Northern or Petrobakken?

We could assume that Northern is right and these fields could actually last a lot longer than Petrobakken thinks.  In which case however you should buy Petrobakken as it will generate cash flow for years and will have already expensed the associated costs.  If Northern is right don’t buy Northern - buy the company which is really earning far more than it says.

Altenatively Petrobakken is right and the right depletion rate is 52 percent of gross revenue.  In that case for nine months the depletion plus depreciation at Northern should not equal 8.36 million it should equal that times 52/23.5 or 18.5 million.  Instead of having income from operations of 14.4 million for the nine months as per stated you have income from operations of only 4.3 million.  Income after tax is just over 3 million.  That is for nine months - but hey - annualize it!

Oh, the market cap is over $1.7 billion.

If I do the depreciation as per Petrobakken (and I see no reason why I should not) then this stock is around 400 times earnings.

Obviously enough we are short.

It all swings on accounting for depletion - so who certifies the accounts?

All of this swings on accounting for depletion.  If you use Northern’s accounting then this is a high growth high PE stock.

If you use Petrobakken’s accounting this is a lower growth stock with much higher PE and less prospects.

At that point I ask who is certifying the accounts?

Well the auditor is Mantyla McReynolds.  Have you never heard of them?  Nor had I and I am a connoisseur of obscure audit firms.

First I checked whether they were a local firm.  No such luck.  They are based in Salt Lake City and Northern Oil is based in Wayzata Minnesota.  That is 1254 miles away according to Google maps.  They went out of their way to find this auditor.

So who does Mantyla McReynolds audit?  I went through the SEC database to see who else is audited by them and this is what I found:

• Northern Oil and its sister company Voyager Oil.  (Voyager is run by family members of the executive of Northern and there are some related party transactions.)
• Pacific Gold Corp - stock price 3c.
• GeNOsys Inc - stock price 4c.
• Guide Holdings Inc - which has finally gone to meet its maker (price rounds to zero).
• Northsight Capital Inc - 45c.
• Studio One Media Inc - $1.28.
• TC X Calibur Inc - 51c.
• Other penny stocks...

You get the idea.  We are critically dependent on an estimated accounting expense (depletion) that is low compared to the competition (the far more established Petrobakken) .  Further, these estimates are certified by an auditor most associated with penny stocks.  Moreover, that auditor was chosen despite being over a thousand miles away and having no obvious expertise in oil and gas.

And despite all this advantage the company took a small reserve adjustment in the fourth quarter.  (Isn't a depletion charge the first warning?  My guess - some well actually ran dry!)

You can imagine that all this made me uncomfortable with the stock.

Alas Melissa Davis (at the Street Sweeper) has found far more about the stock than me.  And none of it raises my comfort level.

What the Street Sweeper found

Remember my issue here is the accounting for depletion.  The whole valuation, indeed the whole story swings on the depletion numbers, and Petrobakken gives you a good reason to doubt the depletion numbers.

I recommend you read the Street Sweeper piece.  However, given that I am obsessed by the accounting, I thought you should focus on the CFO.  Here is what the Street Sweeper says:

NOG appointed a new CFO early last year, records show, promoting former Vice President of Operations Chad Winter to that important post despite his apparent lack of credentials for the job. Winter has never registered as a certified public accountant in NOG’s home state of Minnesota, records indicate, and (unlike the company’s other leaders) has in fact never even reported that he holds a college degree. Even so, filings show, Winter fills three key positions at NOG – CFO, principal financial officer and principal accounting officer – that are regularly assumed by CPAs, with established records of experience and training, at other companies.

This guy looks like the least experienced guy ever to be appointed to all the finance positions at a nearly $2 billion oil and gas company.

I think I can stay worried about the depletion numbers.  Short seems a reasonable bet to me.

John

PS.  The Street Sweeper suggests there is a Part II.  I look forward with anticipation as they found plenty of stuff I did not know about this stock.  

Starr Asia sues CCME and others

Presented without comment (antecedent post here):


Starr Asia sues CCME et al

China Agritech: How should I reply to Kevin Theiss re China Agritech?

Forgive me a brief gloat about a successful short.

China Agritech has fired its auditor after the auditor threatened to resign.  NASDAQ has suspended the stock and there is no indication of when it will trade again.

The Carlyle representative on the board (Anne Wang) has resigned and never answered any email I sent her or any questions on this blog.

The auditor firing 8K is a gem.  Ernst & Young has recommended the "initiation of an independent investigation, in order to verify certain transactions and balances recorded on the Company’s financial statements and records for the year ended December 31, 2010."

E&Y also "orally advised the Audit Committee that it may not be able to rely on management’s representations based on the issues identified."

In other words they thought management may be lying and they thought an "independent investigation" (meaning independent of the board) was warranted.

None of this should be a surprise to any reader of this blog.

I also annoyed China Agritech's management especially because of my repeated (and unsuccessful) attempts to talk to Carlyle.

This is a letter I got from their PR flack on 24 February.  How should I respond?  Note that the flack (Kevin Theiss) says we (meaning Grayling - not China Agritech) have collected evidence that my allegations were groundless.

Dear Mr. Hempton,

We are aware that you have published a series of blog articles to negatively comment on China Agritech's business operations and attack the Company's credibility. It is becoming more alarming that you have repeatedly reached out to our largest outside shareholder. Your intention and ongoing efforts to derail our well-established, long-term relationship with our largest shareholder has come to our full attention. If you have any questions, concerns or comments, we welcome you to contact China Agritech’s management directly. We will provide you with our timely answers. Lastly, we have collected evidence that your allegations are groundless. If you continue to harass our shareholder, we will take further legal action against you.

Sincerely,

Kevin Theiss
-----------------------------Kevin TheissAccount DirectorGrayling USA825 Third Avenue, 18^th FloorNew York, New York 10022
Tel       +1 (646) 284-9400Direct   +1 (646) 284-9409Fax      +1 (646) 284-9494
E-mail  kevin.theiss@grayling.comE-mail  kevin.theiss@grayling.comFollow Grayling NY:On Facebook at Grayling NYOn Twitter at www.twitter.com/GraylingNYGrayling is a global Investor Relations, Public Relations, Public Affairs and Events consultancy.  We have offices in 70 locations, in 40 countries across Europe, the US, the Middle East and Asia Pacific.  We are the second largest independent PR firm in the world.  Grayling is part of Huntsworth plc.

John

PS.  Huntsworth PLC - the company that ultimately threatened to sue me on behalf of China Agritech - is publicly listed.  Their CEO states on their website that Huntsworth "have developed a culture of rigorous focus on margin improvement throughout the Group". Is there any business not worth doing for a high margin?  Does this letter represent the quality of their work?