Bakken Update: Kodiak Has Great Quarter And A Production Ramp Into High Crude Pricing

Kodiak (KOG) crushed EPS estimates in Q2, reporting $.22 versus the Street's estimate of $.13. It had revenues of $178 million missing by $8 million. These results couldn't have come at a better time, with many analysts wary with its most recent purchase of Liberty. The EPS beat is important, as no one questions its abilities as an operator. It continues to outperform in the Bakken, using all the best stuff which continues to drive IP rates. Kodiak's issues have been around cost, and some believe management has increased its total acreage too quickly. This quarter is hopefully a sign of things to come.

Kodiak is an intriguing play based on excellent production growth. It increased oil and gas sales 102% year over year and 5% from Q1. Adjusted EBITDA grew 94% year over year and 5% sequentially. Average daily sales volumes increased to 23200 from 21700 in the first quarter. Kodiak continues to spend money to reduce costs. Its drilling of SWD wells and related infrastructure is very important, as water continues to dog bottom lines of Bakken operators. Current well costs without equipping runs between $9 and $9.2 million. On July 12th, it closed on the Liberty purchase, increasing its total Bakken acreage to almost 200000. Kodiak has 7 operated rigs running and plans to stick with this number through year end. It recently added a second completion crew, with a third crew to help complete some wells in the Liberty purchase. Those two crews are on an as needed basis. The production ramp continues as it completed 24 net wells compared to 18 in Q1. It estimates completing 29 Q3 wells. Differentials were excellent in Q1, with a slight drop off in Q2. Differentials averaged $5.50/Bbl, but with oil above $100/Bbl margins are approximately $60/Boe. This compares to $3.50/Bbl in Q1. Currently those differentials are in the $7 to $8 range.

Kodiak's pilot projects could be the biggest catalyst in 2013. There are a few reasons for this, but the biggest has to do with where its acreage is located. Almost all of its acreage is in very good Three Forks areas. When investors speak about the Sanish and Parshall fields, these are thought of as the best middle Bakken areas, but the Three Forks is not nearly as good. In Kodiak's acreage along the river, and also in its Smokey Prospect we have found the Three Forks to be 200 to 250 feet thick. The majority of this acreage is prospective three benches. Because its acreage is on some of the best stacked play areas, it success is measured more on its Three Forks source rock than the middle Bakken. It currently has one pilot in the Polar Prospect and another in Smokey. The Polar pad is a total of 12 wells all of which are completed. The Smokey pad has 8 completed with 4 left. Kodiak provided the release below from the Polar pilot.

The above table was modified to simplify the results. It's interesting that the best IP rate was a Three Forks well. The middle Bakken wells had an average IP rate of 2738 Boe/d. The Three Forks average was 2360 Boe/d. Keep in mind that one of the IP rates in the Three Forks was low due to restricted surface facilities. If I remove that well the Three Forks average increases to 2592 Boe/d. These strong results makes me optimistic, but remember these are only 24-Hour IPs, and we will need at least 90 days of production to see how these wells model. If the Polar and Smokey pads produce within 10% of earlier wells, production goals will easily be met. Kodiak's 2013 production guidance of 30000 to 34000 Boe/d looks achievable. Currently, I have them at the top end of guidance, but if its pilot projects have problems Kodiak will come in at the low end or miss. Current production is 34000 Boe/d. Cap ex is revised up to $1 billion, as Kodiak is trying to get production on line while WTI pricing remains strong. This also increases risk, as a falling oil price would be tough on the operator, but remember it is well hedged. The reason I like Kodiak's move here to take advantage of high oil prices has to do with why WTI continues above $100/Bbl. Currently domestic feedstocks continue to U.S. refineries. Now that companies like PBF (PBF) in the northeast and Tesoro (TSO) in the southwest are able to use the rails for better oil prices, we see demand running down supply to Cushing. I do not know how long this will last, but I believe oil prices will remain strong through year end. Brent is still making its way to some of the coastal refineries, but this will slowly decrease through year end as more domestic crude hits the rails.

I still believe that Kodiak's Purchase Of Liberty Resources Could Make Or Break Its 2013. As I have studied Liberty's well results in Williams and McKenzie counties, my optimism has increased. This area's geology is different than other Kodiak prospects. These wells will not produce the very high IP rates of the Polar Prospect, but this area is still quite good. I believe Kodiak was getting a deal buying this operator for another reason. Liberty has had as good success in western Williams as any other operator. Keep in mind, EOG Resources (EOG) is active here. Liberty's results are interesting because it uses more water than any other operator. I will include a series of operator production in this area. Kodiak should easily come in at the top end of guidance for 2013, since Liberty wells model at a higher EUR than any other operator. I am not just talking about this specific area, but in all of North Dakota. First we will go over well design. Liberty is unique in its design, and this is the reason it outperforms. Below I have provided a table that provides Liberty's water and proppant volumes.

As you can see above, Liberty uses approximately 25 barrels of water per foot of lateral. Kodiak in comparison, uses 9 barrels per foot. Keep in mind, Kodiak is at the high end of this average. We rarely see an operator use more than 10 barrels per foot. Liberty, like Kodiak, uses significant amounts of proppant. It uses approximately 400 lbs./foot. Liberty was motivated to sell and this doesn't seem to have anything to do with its ability to drill and complete. This well design is expensive, and it would have taken Liberty a substantial amount of time to drill through any significant inventory. Kodiak, on the other hand, has the backing of banks and an already significantly levered company. Liberty's results have been fantastic. Below, I will provide a series of operators working Kodiak's new acreage. This will provide an idea of how much better Liberty results were before the acquisition. It will also provide an average out performance to guide production from these 42000 acres. The table below provides IP rates of some of Liberty's wells.

An average Liberty well produces 93960 barrels of oil in the first 6 months. This lower quality acreage, when compared to northeast McKenzie County, is out producing better fields by a significant amount of resource. As a comparison, I am providing data on other operators in the same general vicinity. Halcon's (HK) well results underperform Liberty wells, but it has improved on Petro-Hunt's (previous operator) well design.

Halcon is relatively new to this area, but was able to improve production immediately. Marathon (MRO) has not focused on its western Williams County acreage. It is a secondary area and not considered core. Because of this, results have lagged.

Obviously, Marathon had two wells that had early problems. The 180-Day IP would increase to just below 200 Bo/d if the two were removed from the list. In the table below, EOG performed better than all other operators except Liberty. Keep in mind, EOG has several short laterals on the list, which increases its production per foot.

The last operator is Continental (CLR). It is one of the more active operators in the area. It uses a conservative well design, and good production levels.

As you can see, Liberty may be the best operator in western Williams. Since Liberty has produced significantly more resource, the acreage becomes more valuable, but more importantly production guidance is easier to meet or beat.

When the rate is broken into total barrels produced we begin to see how good of a deal Kodiak made.

In summary, Kodiak had a great quarter. It is managing to keep costs down and produce better bottom line numbers. Kodiak continues to drill SWD wells and get infrastructure in the ground to take help with water associated costs. It is on pace to meet the very large production numbers for 2013. Its Polar Pad released very good early rates, with no real bad news. Kodiak also stated it Smokey Pad was two-thirds done and is progressing as planned. Its Liberty purchase could be a home run, as production by this operator was as good as much better acreage to the east. Kodiak is ramping production and increasing cap ex while WTI pricing remains high, with tight differentials. Kodiak is well hedged if the price of oil falls, but I estimate the current environment will continue to support WTI pricing above $100/bbl. I would be a buyer on pull backs