Kodiak Oil and Gas is a small Rocky Mountains E&P developing NG in the Green River Basin of CO/WY border, specifically, ~30,000 net acres in the Vermillion Basin’s gas-rich overpressured Baxter shale, and oil, ~15,000 net acres, in the Williston Basin of MT and ND, including the Bakken Shale, two hot areas of development.  Kodiak has very little production and has not achieved their goals in their most recent VB drilling efforts resulting in the stock being cut in half from it’s STR-success-induced highs. And, that’s the bull story.

 

“No meaningful production, variable results on drilling efforts, and a chopped stock price are reasons to buy?”, you quite reasonably ask.  Yes, when taken in context of the story.

 

First, to the Vermillion Basin, since this is the source of most of the value. Kodiak has lands contiguous to Questar’s, whose stock price had soared on their exceptional Vermilion basin results. (IP’s as high as 9mmcf/d). The VB was considered a mature legacy region that had been thoroughly exploited until new seismic and completion techniques opened up large volumes of tight gas sands and shales. The Baxter Shale has been compared to the Barnett Shale in the Fort Worth basin. The play also has deeper, less overpressured targets in the Frontier and Dakota formations, as well as shallower, normally pressured plays.

 

So, STR has phenomenal well results and KOG is still getting there. So what? Well, STR drilled around 28 wells on the road to finally cracking the Vermillion code. They claim to have discovered a way, using 3-D seismic, to locate clusters of natural fractures such that horizontal wells have massive IP’s.  KOG, on the other hand, has only drilled 3 wells resulting in one completion.  But, what KOG has gotten out of this effort is validation that the Vermillion play extends into their lands, and, given that STR has managed to figure out how to make successful wells, odds are KOG will too. Additionally, KOG will likely drill a well (Whiskey) with STR, and will thus share information at that time. KOG is concentrating on the deeper Baxter and Frontier levels.

 

Even tho they’ve likely proved the geology, who says KOG can replicate STR’s success? How about a roster of shareholders that includes the likes of S.A.C. Capital Advisors and a technical team from companies like UPL and WGR with a history of success.

 

A quick review of the Vermillion basin and Kodiak’s drilling is in order. The VB is a sub-basin within the Greater Green River Basin and is productive from depths of 2,000 feet to 18,000 feet. The Baxter is highly overpressured, with a pressure gradient of around 0.72 psi vs a normal gradient of .47 psi. The Baxter is the stratigraphic equivalent of the Hilliard Shale which is the hydrocarbon source for the Jonah and Pinedale and the Mancos Shale of the Sand Wash and Uinta Basins. Kodiak’s first two wells, vertical wells, in the North Trail region, 3-4 miles north of STR’s most prolific well, were the North Trail State 4-36 and North Trail Federal 1-33. NT 4-36 encountered mechanical problems, possibly bad casing; NT 1-33 crossed a fault that brought in a prolific amount of water. KOG had relied on 2D seismic on this hole and thus learned that 3D is necessary. Due to poor Rockies gas prices, both wells are currently shut in, tho they can produce small amounts of gas from the upper Baxter. NT Federal 4-35, KOG’s first horizontal well, and sited in between the first two wells, did not intersect natural fractures as hoped. KOG had to stop drilling before reaching it’s target length, the same difficulty STR has encountered. On a positive note, KOG drilled a longer Hz well than STR. KOG is using it to further the science of the play. They have extended the drilling down to the Frontier level. The company is using 3D seismic to pinpoint overpressuring.

 

To the West in the Horseshoe Basin, KOG drilled HB Unit 5-3, which encountered a gas charged overpressured window in the Baxter, confirming that the play extends West. KOG is multi-stage fraccing the play. They’ve fracced the Frontier and are fraccing the Baxter in segments. One analyst I spoke with compared KOG’s current situation and valuation to UPL before the Pinedale ramp, except that STR has proved that the play can be made to work. Kodiak has shifted from geologic risk, to execution risk. What it comes down to is that Kodiak must make a well, and analysts and industry actors I’ve talked to have every confidence that KOG will succeed in climbing the steep learning curve and make wells.

 

In the Williston, KOG has assembled the Four Bears acreage, which is on-trend with significant Bakken producers. The Bakken is a very hot region. A recent Jefferies report on Shale plays opened its section on the ND Bakken with “They’ve got our attention” and goes on to detail EOG’s spectacular success in Mountrail county, and posits the question of whether the Bakken could be better than the Barnett.

 

Regarding valuation, various analyses I’ve seen have price targets/NAV’s for KOG ranging from a $6 NAV from BMO (which was 80% risked, ie, assumes only 20% of the acreage is productive.) to $12 from Southcoast. Canaccord has a $7.38 “breakup value” for KOG. Pickering Energy models a total valuation of $10.72, which includes a $50M equity issuance at $3.50/shr, and a 50% risking. Analysts model a higher Rockies price than current firesale pricing, but still model persistent discounts to HH or NYMEX. (Stage One of REX comes online in early 2008). I have vetted the models’ inputs, things like NG price, risking, avg well size, etc. to make sure they were reasonable or even conservative. KOG will need to raise money for 2008 CapEx. In lieu of an equity raise, they are also looking at debt funding (they have a clean balance sheet), or joint venturing some wells with other companies, like DVN or EOG.

 

Lastly, Kodiak appeared to have a persistent seller, who seemed like a distressed seller. A large print finally went up at $3.10 the other day, and I sense the seller is gone. KOG will likely be for sale as we come into tax loss selling season, and this will provide the liquidity to establish positions. Also, some sort of financing will get done. Once both these weights are lifted from the stock, the market can focus on the that should be made in the interim. Lastly, given STR’s success in the region, they would be a logical buyer of KOG, in the unlikely event that KOG can’t figure out what STR has. Kodiak has established the value of the properties they own, which, for now, gives a cushion to the value of the stock. Thus, the risk/reward is very favorable.