How The U.S. Drills Gas;

How The U.S. Drills Gas;

Is There a Need for Arbitrage, to Burst a Gas Bubble?

January 20, 2012

Where to Burn Gas?

Given the recent and substantial decline of natural gas prices, one would expect such a dynamic to have an effect on producer margins and profitability. This is especially when price declines are associated with record supplies due not only to warmer weather, but more importantly, sustained increased production.

Previously, I pointed out that the Energy Information Administration reported this month that production from U.S. shale formations increased 4.5 Bcf/day in 2011, a record. Further, production is expected by the EIA to increase by 1.4 Bcf/day in 2012, with an additional increase of .07 Bcf/day in 2013. Right now, we are breaking another record with inventories at 3,472 Bcf.

With prices where they are, and record supplies, one would anticipate indicators to develop of declining production. When I last wrote, I made mention of Peyto Exploration's liquidity problems in Q4 of 2009 when it was obtaining an average gas price of $6.17/MMBtu. Yet, today with gas in the $2.60 area, U.S. rig counts aren't showing decline.

According to Baker Hughes, the January 20, 2012 U.S. Rig count stood at 2008, which is up 21 from the last count on January 13, 2012. This January 20 count stands in contrast with year ago results.  The January 21, 2011 count was at 1713, which means that today the U.S. has 295 more rigs in operation than a year ago. Looking at the U.S. Rig count when Peyto was having liquidity issues and the price of gas was much higher, we gain further perspective. The October, 2009 count was at 1,044.

Gas Seems to Burn.

Resultantly, rig counts aren't pointing to declining production. What is more, looking at the actual  performance of companies, lets look at Kodiak Oil and Gas (KOG). Kodiak's Balance sheet for Q3, 2011 shows current assets at 133,622, while current liabilities stand at 53,615. This results in a current ratio of 2.49. If we exclude from this calculation inventories, we see a quick ratio of 2.12. Very good liquidity and demonstrates a positive cash flow beyond current liabilities.

When one looks at the debt/equity ratio, Kodiak also looks good at .215. And then we have the interest coverage ratio of 150, which reflects the amount of earnings before interest and taxes (EBIT) in order to pay existing interest payments. 150 is very high comparatively, and again shows very good liquidity and in fact low debt.

Without debt, Kodiak grows, in a fine fashion. In terms of revenue (in millions), Kodiak demonstrates revenue in the 3 months ending September, 30, 2012 of $29,528 versus a 2011 amount of $8,131. In the$64, 974 versus the 2011 number of $19,973.

Against these results, we see a confirmation of growth with revenue growing at a rate of 199.8%.  They have accomplished this growth with the acquisition of real assets that you can dig your hands into. That is, oil and gas producing soil, together with production and delivery infrastructure. Kodiak's net oil and gas properties have increased by $467,169 as of September 30, 2011 versus $232,662 on December 31, 2010.  In the same period, wells in progress have increased to 71,578 versus the 2010 number of 21, 418.

But this begs the question. How did Kodiak accomplish these results of accumulating fixed assets of a capital expenditure nature without showing lots of debt, and still having strong cash flows? Bottom line answer: the stock buyer willing to bet on the future of America's petroleum industry. Let's see. According to Kodiak's 10q for Q3 2011, they had 209,331,439 shares issued. This compares to Kodiak's 10k for 2010 which put their issued shares at 178,548,205. From 2010 through 3Q 2011, Kodiak issued some 30, 783,000 and sum shares. They are increasing their position by issuing equity. Or, otherwise stated, diluting equity.

Is there Medication for a Gas Bubble.

Ultimately, it might not be a dilution of equity. Rather, it does appear that the U.S. is in a new frontier and companies are racing for U.S. shale plays. Those first to the frontier with success, are typically the best in long term money. Let’s consider.

In Q3, 2011, Kodiak issued an additional 27,600,000 shares and resultantly raised net proceeds of $159,000,000. Of this amount, Kodiak paid $60,000,000 against its debt balance on its first line of credit. This retired an equal amount of debt that had a balance of $114,808,000 leaving roughly $55,000,000 (see balance sheet, Q3 v. Q2).  Given the $159,000,000 in stock proceeds, and the $60M payment to their credit facility, a balance on the stock issuance leaves $84M. How was this used?

We see Kodiak's cash and cash equivalents in Q3, 2011 at $78.6M versus $50.4M in Q2, 2011. An increase of $28.2M after a the cash contribution of shareholder equity. If $28.2M went into cash after the payment of debt, we still have $55.6M in stock proceeds. But, at last, we have some very serious acquisitions of Bakken property by Kodiak.

First we see a property that closed on November 30, 2010, but did not “settle until April, 2011”...indicating a bankrupt property in the amount of 14,500 net acres in the Williston basin. Kodiak captured this for $108,649.00 (thousands). The cheap property was acquired in cash, and shows $32,232 in proved reserves and $77,193 in unproved reserves. Fire sale price on this property.

Kodiak then acquired some 25,000 net acres in Williston at $85,931M. This was divided between a stock contribution of $14,425M and a loan from the first credit facility of $71.506M coming to a price of $85,931M.  This property is reflected on the statement of revenue and contributed $825,000.00 for the three and nine months ending September 30, 2011.

The big transaction explains why Kodiak paid down debt and raised cash, amid their current acquisitions. The big transaction is dated October 28, 2011 and consists of 13,400 net acres, that seems  very synergistic with Kodiak's operations. And it should be. They paid some $248,213,000 for the leases....

Essentially, this property must be very special. It has proved reserves of $119,628M and unproved reserves at $108,477M, with wells in progress at $17,384M. Word is that it it could have contributed $40,025M to Kodiak's financials, but was excluded....together with asset value.

Kodiak's Gas Relief.

Let's see the change in financing to accomplish the big acquisition. Kodiak paid $60M in stock to a debt facility with a balance of some $114,808,000. After the stock payment, the balance for Q3, 2011 came to $55M owing to the long term debt facitlity. But in the course of this, Kodiak acquired some 62,900 net acres of the hottest real estate that exists in this country. All for a price of some $334, 252,649 for the year, as it would appear.

Kodiak ran a debt balance of some $114,808,000M in debt in Q2, but paid it down to $55M in Q3. To acquire the special October 28, 2011 Williston property, Kodiak first barrowed $185M off their first line facility, which has a ceiling of $225M. This leaves Kodiak with $39M of remaining credit on this facility. All at 3%, which means the $55M went to their second line of credit. Let's look.

 On September 30, 2011, Kodiak had $55M outstanding in debt on the second facility at 10%. On October 28, 2011, Kodiak borrowed another $45M to fund the October 28 acquisition. This topped out  Kodiak's second line of credit at its limit of $100M. Based on credit terms, the second line is now at 9.5%.

Gas prices, being methane, do not move such efforts of value and risk. Kodiak is and has been willing to engage in a race. A race for a new frontier in the U.S. Why and how will it pay for itself?

My next article on this topic will address value of the gas and oil brought out of the ground. Head's up, it pays beyond natural gas prices.

Author: R. McWilliams