Did Kodiak Oil & Gas Shareholders Just Get Robbed?

In an unexpected deal announced on Sunday, Whiting Petroleum (NYSE: WLL  ) agreed to acquire Kodiak Oil & Gas (NYSE: KOG  ) in an all-stock transaction valued at $6 billion, including the assumption of $2.2 billion in debt.

While the deal appears to make good sense from an operational perspective, the price paid by Whiting appears to undervalue Kodiak, which has prompted some Kodiak shareholders to cry foul. Did they really get robbed or will the move pay off in the long run?

Photo credit: Enerplus

Why the deal makes sense
The transaction will create the biggest Bakken producer with a combined acreage position of 855,000 net acres, nearly 3,500 future drilling locations, and first-quarter production totaling 107,000 barrels of oil equivalent per day (boe/d), surpassing the current Bakken leader, Continental Resources.

At an operational level, the transaction looks sound since both companies' portfolios are very similar in terms of the location and quality of their assets, although Whiting maintains a significant position in Colorado's Niobrara shale whereas Kodiak's assets are concentrated entirely in North Dakota.

According to Whiting's CEO, James Volker, combining the two companies' complementary asset portfolios will result in significant production and operational synergies through sharing of technological expertise and improved access to capital.

The deal is also expected to result in significant cost savings as synergies from the two companies' complementary acreage positions materialize over time. "The savings can be a billion dollars to us over time, most of that over the next five years," said James Volker, Whiting's CEO, in an interview.

Did Kodiak get robbed?
But from a valuation standpoint, it certainly appears that Whiting got the better end of the deal. Under the terms of the transaction, Kodiak shareholders will get 0.177 of a Whiting share for each Kodiak share they own in an offer that values Kodiak at $13.90 a share, a 2.3% discount to its average price over the 20 days prior to the announcement.

That's especially surprising since the vast majority of oil and gas acquisitions command premiums. According to data compiled by Bloomberg, the last time a North American oil and gas producer was acquired at a discount was 2008. Indeed, a number of law firms are investigating claims that the acquisition may not be in the best interest of Kodiak shareholders because it undervalues the company.

But what they may fail to properly consider is that Kodiak needs Whiting's capital to accelerate drilling across its acreage, the majority of which is undeveloped. Though Kodiak has rapidly grown its production in recent years, its capital spending budget has consistently exceeded its cash flow from operations. This has resulted in elevated levels of debt relative to EBITDA, jeopardizing the company's ability to fund its drilling program and limiting its production growth potential.

But by agreeing to be acquired, the combined company should have much greater financing flexibility, with an estimated debt-to-EBITDA ratio of roughly 1.6 times. That's significantly lower than Kodiak's debt-to-EBITDA ratio of nearly three times, albeit much higher than Whiting's ratio of 1.05 times. Combining the two companies should also meaningfully increase Whiting's earnings and cash flow per share, as well as improve its credit metrics.

Investor takeaway
All told, while the deal looks better for Whiting shareholders than it does for Kodiak shareholders in the short term, it should benefit shareholders of both companies over the long run assuming Whiting can deliver on its targets of cutting costs, growing production, and the like.

The two companies each need what the other one has; Whiting wants Kodiak's high-quality acreage to sustain strong production growth, while Kodiak needs Whiting's relative financial strength to fund future drilling costs. Combining their respective advantages should result in a better company capable of delivering stronger, more profitable growth.

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