An Emerging Oil Shale Company With Potential

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In recent weeks, the price of oil has dropped precipitously to less than $85 per barrel. As many of us know, sharp declines in oil cause even sharper declines in many energy stocks. Oil has certainly dropped a lot and can continue to plummet, but bargains are already starting to emerge in the energy sector. Patient investors willing to wait out the volatility with cash in hand can be handsomely rewarded for their efforts.

An investor can easily obtain energy exposure through majors such as Chevron (NYS: CVX) , ConocoPhillips (NYS: COP) , or ExxonMobil (NYS: XOM) -- they each pay steady and growing dividends and have the scale to produce oil and natural gas at a low "all-in" cost per barrel.

Investors seeking potentially higher rewards can look toward smaller independent exploration and production companies, especially those that are investing heavily in drilling and development of their acreage.

Spicing it up
Northern Oil and Gas
(ASE: NOG) is a small oil and gas exploration company operating specifically in the Williston Basin, known for its Bakken shale potential. It has amassed 150,000 net acres of Bakken acreage, making it heavily leveraged to success in the Bakken. In 2010 alone, Northern capital expenditures totaled $194 million while it only brought in $73 million in operating cash flow.

Obviously, this disparity cannot last for very long. Companies must bridge this gap by burning through available cash on its balance sheet, and then issuing common stock and debt to raise more cash. If the company's assets offer projects that produce high rates of return, this is no problem -- it's likely to earn a high return on capital, making it worthwhile to raise capital in this way. Northern in particular has gone the equity issuance route -- it currently carries no debt.

After a company has spent enough money on drilling and well completion costs, it will start to raise production meaningfully. Sometimes, companies speed up the process by outspending cash flow for several years so that they can bring production to respectable levels as fast as they can. Again, it's the quality of the land (or desperateness of management) that dictates whether the capital allocation creates or destroys value.

Let's compare some other independent exploration and production companies that are also outspending cash flow in an attempt to develop their land:

Company

2010 Operating Cash Flow

2010 Capital Expenditures

2010 Sale of Property, Plant, and Equipment

Northern Oil and Gas$73($194)$0
Brigham Exploration (NAS: BEXP) $145($410)$18
Kodiak Oil & Gas (NYS: KOG) $10($200)$0
SandRidge Energy (NYS: SD) $390($1044)$215

Source: Capital IQ, a division of Standard & Poor's. All dollar amounts in millions.

Looking at the above table, Northern's ratio of capital expenditures to operating cash flow in 2010 wasn't too outlandish compared to some of its competitors' figures. One thing is clear: Each of these companies is investing heavily in order to increase production immediately. Each company's situation is different, of course -- each company may have different management, engineering personnel, and acreage locations.

What's on tap?
Management expects to start drilling on 40 net wells in 2011 while achieving average production of 6,500 to 7,100 barrels of oil equivalent, or BOE, per day. This is pretty significant, considering production in the first quarter of 2011 was just under 4,000 BOE per day. That means the ramp-up in the second quarter (and beyond) should be quite significant.

After spending $194 million in capital expenditures in 2010, Northern is planning a 30% increase to $252 million in 2011, with each well estimated at $6.3 million. With all of its efforts focused on just the Bakken, the company's drilling plan is highly repeatable and has been successful to date. So far, Northern has had a 100% success rate in the Bakken with its drilling so far, which is no small feat.

Foolish bottom line
The market likely won't assign a higher valuation on Northern until it anticipates that it can fund capital expenditures through its own operating cash flow. Northern is obviously making moves in that direction, so the question now is how quickly it can ramp up its production in order to achieve a self-sustaining level of cash generation.

At the time this article was published Paul Chi has no positions in any of the companies mentioned in this article. Motley Fool newsletter services have recommended buying shares of Chevron and ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

Copyright © 1995 - 2011 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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