NOG - Northern Oil and Gas: A Buy Until The Music Stops Again

2023-08-24 06:29:17 ET

Summary

• Northern Oil and Gas is an oil and gas company with a unique business model that is heavily reinvesting cash flows that could benefit it if oil prices trend upward.
• The company's balance sheet isn't strong, but unless oil and gas prices decrease, this is not a concern.
• The company is not a company I would want to hold through the entire boom and bust cycle, but for those who are bullish on oil, this presents some leverage.

Northern Oil and Gas (NOG) is headquartered in Minnetonka, Minnesota just outside Minneapolis and represents one of the few oil and gas companies headquartered in the north, rather than in the south. Their business model allows them to operate without having "boots on the ground" in the various plays as the company only has 32 employees, thereby operating very efficiently. Their business model makes them a sort of "financier" of oil and gas wells. Said another way, they purchase minority, non-operator interests in oil and gas wells that are about to be drilled.

Brief History of Northern Oil and Gas

Northern Oil and Gas is a relatively young company and was founded in 2006. The company arrived just around the time that horizontal drilling began to be used in the Bakken Shale.

At the same time that the company began, oil and gas prices were moving upward wildly which precipitated a crash from ~$150 per barrel to $40. The company faced a difficult test coming out of 2009 and another difficult test coming out of 2020-21. But they survived and appear to be in growth and acquisition mode at the moment.

Free Cash Flow & Cash Flow From Operations vs Market Cap

Based on these metrics, Northern Oil and Gas presents a noticeable difference in their valuation relative to these other companies. Northern Oil and Gas is valued lower relative to the Free Cash Flow as well as their Cash Flow From Operations. Why is that?

As you can see in the slide below, although they claim their Free Cash Flow is positive, it's only positive when you strip out the acquisitions that weren't previously budgeted for. They have been aggressively outspending their Cash Flow from Operations since 1Q 2022. And as we will see in the section below, this has caused their Balance Sheet to become more and more leveraged. This undoubtedly makes the company a greater risk, but also leverages them to potentially grow faster than a competitor.

Balance Sheet Ratio Comparisons

Northern Oil and Gas is a hybrid between a financial company and an oil and gas company. Therefore, they use financial leverage to a greater extent than other oil and gas companies. Here's a comparison of their debt to asset ratio across various companies.

Debt to Asset Ratio

As you can see from this comparison, Northern Oil and Gas has the highest debt-to-asset ratios. This is what you would expect from a company that operates a business model like Northern Oil and Gas and their leverage has continually grown since 2022 as they have continually outspent their cash flow. This is likely the reason that they are not valued as highly relative to their cash flow from operations as other companies.

For information on these other companies, here's an article I wrote for Devon Energy , and here is one I wrote for ConocoPhillips .

Growth Prospects

Northern Oil and Gas is mostly leveraged to the Williston Basin but they are in the process of gaining more exposure in the Permian Basin by focusing their CapEx there. See this slide below.

Here you can see that like most companies, they are trying to focus most of their capital expenditures going forward in the greater Permian Basin.

Positives and Negatives of Northern Oil and Gas

Northern Oil and Gas brings a unique business model to the industry. They are a necessary player in the oil and gas game. As their website says, they are the "go-to" company for purchasing non-operating interests. And due to their unique business model, there are advantages and there are disadvantages that come with it.

First, while it is an advantage in one respect, its also a disadvantage that they only have 32 employees. What I mean by that is that they are not going to be the ones who have boots on the ground discovering a fresh oil play for the first time and getting in on the ground floor prices. Rather they are coming into existing oil and gas plays where someone else has already done all of the groundwork, and they are contributing capital. I'm sure there are opportunities to purchase a financial interest in a well where someone is trying to spread out the risk, however, there have been enough wells drilled in these areas to understand pretty well how they can be expected to produce. I don't know this for certain but I have to assume that the prices are fairly competitive. That said, they seem to continue to find attractive opportunities.

Now, because they don't have the leverage of having employees like geologists and engineers finding and extracting the oil, they use leverage in other ways to generate returns. And that leverage comes in the form of existing relationships with oil and gas producers along with financial leverage. And financial leverage is wonderful during the good times, but if not managed for the bad times, they will experience a greater fall as well.

Conclusion

Regardless of Northern Oil and Gas' capital structure, I would rate the company a buy. Their CapEx is expanding amidst greater opportunities along with their financial leverage. NOG's level of debt doesn't concern me at this moment. I may be wrong, and this is only an educated guess, but I don't expect a swift move down in oil prices until 2028 to 2029. How far will oil prices drop? It all depends on how dramatically they rise. It's a difficult thing to predict which is what makes Northern Oil and Gas one of the more risky ways to bet on oil and gas. NOG will experience a fantastic appreciation in share price if oil and gas prices rise, but it will also experience a difficult time if there is a sustained period of lower energy prices. There are oil and gas companies that I don't mind holding throughout the up and down market cycles but NOG is not one of the companies I would hold onto throughout the down cycle. As their CapEx demonstrates, they are in the process of trying to capitalize on oil and gas projects and using higher levels of financial leverage to do so. Further evaluation of their balance sheet in 2028 would be needed to see if they were able to bring their debt-to-asset ratio back down to more reasonable levels by then.

Some might provide a rebuttal and say, "what about their hedging program?" And my response is that every oil company has a hedging program and there is no perfect way to hedge risk without sacrificing upside as well. And when oil prices experience a crash, it won't matter as the market will behave irrationally, regardless of how well a company is hedged. That's because you cannot hedge out into perpetuity. In any kind of crisis moment, fear wins the day and people will simply sell just to sell.

For these reasons, I think Northern Oil and Gas is an attractive buy at this level if you expect oil prices to increase over the next few years, but there are better companies to own throughout the oil boom and bust cycles.

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