Norther Oil & Gas (NOG)

Action:  Buy
Target 1: $4.50
Target 2: $7

Northern Oil and Gas, Inc. is a non-operated exploration and production company focused on the Bakken and Three-Forks plays in the Williston Basin. The company takes positions in land acreage about to be drilled where it thinks it can generate a high rate of return.

Investment Thesis

Northern Oil and Gas is the largest non-operator in the Williston Basin and has been benefiting from improved economics in the Bakken. Northern's operating partners in the Basin are the most efficient operators allowing Northern to benefit from record well results. Adding to this is a tailwind from substantial Bakken differentials¹.

Strength in Scale

As operators in the region tap into producing wells, they often look to bring in limited partners who can offer a lump sum cash payment thereby allowing the operator to reduce their total capital outlay in the project. Since these operators use debt vehicles to finance their E&P activities, generating upfront cash flow improves their balance sheet by reducing their risk. Northern is positioned as the primary non-operator able to write the biggest checks, giving them the advantage of having first-look on most of the deal flow. As result, the company is the leading consolidator in the Bakken with an aggressive ground strategy targeting the largest transactions that immediately add to the company’s EPS.

In this business, it’s all about free cash flow (FCF) and debt covenants.  Northern has achieved material FCF of $100MM+ much quicker than industry peers because of fat margins from non-operated activity, extremely lean cost structure, enviable price hedging and absurdly favorable differentials.

Northern beat Q4 earnings estimates owing to production results much better than what they expected. At the same time, spreads between natural gas liquids (NGL) and natural gas have been extremely favorable. Combined with very low costs for maintaining and operating producing oil and gas leases (LOE) and perhaps an overly conservative budget based on WTI of $50 ($59.87 as of this writing), the company has stacked the deck in such a way as to generate substantial free cash flow which will likely be returned to shareholders in the form of a dividend. What if crude prices drop, you ask?  Northern has ~63% of 2019 crude production hedged at ~$63/bbl, and ~51% of 2020 crude production hedged at ~$59/bbl, leaving the balance to benefit from prices likely to go above $63 soon.  In fact, as  prices approach the $63 handle, you will see a rapid winding down of existing short positions in the stock and the initiation of long positions. We’re already seeing these footprints as large blocks continue to cross the tape in greater frequency.

Surprisingly, Northern is one of only a few E&P’s generating positive free cash flow and they will have no problem maintaining this position even if oil prices drop below $50 given a hedge portfolio that would make even the best commodity trading funds envious.  This gives Northern substantial flexibility in their capital program as banks line up to do business.

When a company gets everything to line up in their favor, the result is a tsunami of cash which becomes a self-perpetuating cycle. The cash flows back to shareholders through bond redemptions and a dividend, thereby increasing their investor base, which gives them additional powder to make accretive acquisitions, generating more cash, and so on... Case in point:  Northern made several transactions last year which were accretive resulting in an accelerated timeline to reach FCF+.  2019 and 2020 are poised to be transformational for the company’s shareholders as a result. Moreover, temporary drop in crude prices during Q4’18 tee’d up several juicy purchases from highly motivated sellers that will show up in their May 6 earnings report.

Footnotes:

1- In the energy sector, a basis-differential represents the difference in prices between locations