4 Areas Kodiak Oil & Gas Investors Must Watch


With the end of the era of "easy oil," energy companies like Kodiak Oil & Gas have increasingly turned toward locations that are harder to reach and harder to drill in its quest for the black gold. North American shale reservoirs have been especially popular.

While these unconventional plays offer unparalleled rates of production, they often carry high - sometimes prohibitively high - operating costs. Take North Dakota's Bakken Shale, for instance.

While the vast and expansive play is responsible for one of the biggest oil booms in decades, the costs to drill and complete a Bakken well routinely exceed $10 million. In addition to equipment costs, labor costs in North Dakota have risen dramatically over the years, adding further pressure on companies to find ways to reduce expenses.

Bakken operators like Enerplus , Oasis Petroleum , Northern Oil and Gas , Whiting Petroleum , and many others are constantly experimenting with ways to cut their costs. Some commonly employed methods include switching between long and short laterals, varying the number of fracturing stages, using a technique called "down-spacing," which reduces the spacing between wells, and various other techniques.

Kodiak is no stranger to these methods and has made substantial progress in reducing its operating expenses, especially this year. In fact, in order to explore Kodiak's cost-cutting measures, as well as numerous other crucial factors affecting its future, I created a premium research report on the company. Hopefully, the report should help investors get a better picture of the company's future. It includes opportunities, major risks, crucial areas to watch, and a closer look at the company's management.

The following is an excerpt from the report that addresses four key areas investors should watch. It's just a sample of one section, but I hope you find it useful.

Four Key Areas You MUST Watch
Following Kodiak's operational and financial progress is easier than with most energy companies, many of which tend to have diversified holdings across North America. By contrast, Kodiak's producing portfolio is exclusively in the Bakken. With that said, be sure to keep an eye on the company's progress in terms of four major indicators of operational and financial health: production rates, cost-cutting measures, cash balance and credit facility situation, and hedge situation.

Kodiak is shooting for 27,000 barrels of oil per day by the end of 2012, so be sure to follow the company's updates on new wells, especially in McKenzie, Williams, and Dunn counties in North Dakota.

Judging by initial production rates, Kodiak is one of the best oil producers in the Bakken. And with the company aiming for a higher number of fracking stages for the remainder of the year, initial production rates and estimated ultimate recoveries should continue to move higher. Kodiak may also have some of the most desirable acreage in the Williston. For instance, its results from the Koala well in McKenzie County were some of the best seen in the entire basin.

Cost-cutting measures
One aspect that Kodiak continues to focus on is reducing operational expenses. The cost of drilling and completing wells in the Bakken is extremely high, often twice the cost in other up-and-coming plays like the Mississippi Lime. Therefore, minimizing costs and maximizing efficiency is crucial for Kodiak, as the company seeks to fund itself primarily through its operating cash flow.

From an operational perspective, significant progress has been made in both drilling and completion. The company currently has an eight-rig count, up from three just a year ago. Drilling days per well have also been reduced to five days, representing a meaningful three-day reduction. As the new drilling crews continue to become more familiarized with the idiosyncrasies of each well, such improvements are likely to continue.

In terms of completion, the company is making solid progress by using innovative techniques, such as cemented liners. This is a completion technique that involves cementing the liner throughout the horizontal wellbore, which has the benefits of greater wellbore stability, greater control of fracture initiation, as well as improved well serviceability.

Kodiak is also seeing meaningful reductions in the time taken to complete a well. Drilling crews have managed to complete two well pads in eight to 10 days by using "zipper fracs," a hydraulic fracturing technique made possible by microseismic fracture mapping. This allows adjacent wells to be fractured in sequence and maximizes the area of exposed reservoir rock.

The company has made significant progress, especially since the third quarter of 2011, in lowering its lease operating expenses, which are the costs incurred maintaining and operating property and equipment on a producing oil and gas lease.

Through efficiency improvements in water handling, Kodiak has managed to bring these costs down to the $5-$6 range per barrel, and management expects further reductions in lease operating expenses going forward. Also, the company's shortened drilling times are a major cost-saver considering that rig burn rates are as high as $100,000 per day.

The block of acreage in Williams county is not nearly as productive as Kodiak's other acreage, yet the company still expects an internal rate of return of 20%, assuming completed well costs of $7 million-$7.5 million and ultimate estimated recovery of roughly 300,000 barrels. This is a good sign because it shows that even its worst-performing wells are easily economical at current oil prices, thanks in part to significant reductions in well completion costs.

Overall, Kodiak continues to see improving efficiencies in its drilling projects, which has led to a meaningful decline in spud-to-rig-release drilling times. Through a combination of operational efficiencies and cost-cutting initiatives, Kodiak's completed well costs for operated wells are now between $10 million and $10.5 million. If the trend of recent cost reductions continues, the company expects to reduce well costs by an additional 5%-10% over the second half of the year and early 2013.

Cash balance and credit facility situation
Production has grown rapidly and so has Kodiak's capital budget. In 2009, the company's capex was just $27 million. By 2011, it grew to just over $260 million. For 2012, the company estimates it will have to shell out around $650 million to achieve its production goals.

The bulk of 2012's capex, around $640 million, will go toward drilling, completion, and related facilities, while the remaining $10 million will go toward additional acquisitions of land. Over the past couple of years, the company's capex budget has exceeded its operating cash flow by quite a lot. In the past, it has turned to equity issuances to raise capital, but it may no longer have to resort to such dilutive measures.

One recent development that bodes well for the company is the significant expansion of its borrowing base. After expanding its syndicate by adding seven new banks, the company now has a $750 million revolving line of credit, which improves both balance sheet flexibility and its liquidity position.

This expansion in its line of credit and the resultant improved liquidity should allow the company to maintain its low cash balance. Normally, such a thin cash margin would raise some red flags, but the expanded borrowing base should allow the company to sustain itself until it meets its target production rates and can fund itself through operating cash flow.

Hedge situation
The company is ramping up production rapidly, which means that as new wells come online, production from those wells will need to be hedged accordingly. So far, the company has done a good job of hedging production as soon as it comes online.

In line with most energy producers, Kodiak uses various derivatives to minimize the effect of commodity price fluctuations. Currently, the company is utilizing swaps and "no premium" collars. The hedging strategy is important for investors to keep track of because it affects the company's liquidity, since the company must either receive cash from, or pay cash to, its counterparties in the transaction.

Hedging through derivative instruments is a commonly employed strategy among oil and gas producers. While it does limit the downside risk of adverse price movements, it also limits the upside potential from favorable movements in price. In general though, given the tremendous macroeconomic uncertainty in today's environment and the high volatility in oil prices, I prefer seeing well-hedged companies.

Interested in other opportunities and risks facing Kodiak?
That was just a sample of our new premium report on Kodiak Oil & Gas. If you're debating whether the company is a buy or sell, the report may prove to be a crucial resource. In addition to an analysis of Kodiak's risks, areas to watch, and management, the report comes with complementary updates and delves into upside and downside catalysts looming on the horizon. To get started, simply click here now.

The article 4 Areas Kodiak Oil & Gas Investors Must Watch originally appeared on Fool.com.

Fool contributor Arjun Sreekumar has no positions in the stocks mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.

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