Despite the fact that Kodiak Oil & Gas (NYSE: KOG) has decided to be acquired by Whiting Petroleum (WLL) for slightly less than market value for similar deals recently, Wall Street seems to love the transaction. Both Kodiak and Whiting have seen shares climb by 10.1% and 10.4%, respectively, following the announcement, which suggests there might have been something bigger to the deal. Let's take a look at what has changed recently for Kodiak and how that could impact other smaller players in the Bakken such as Oasis Petroleum (OAS) and Triangle Petroleum (NYSEMKT: TPLM).
Source: Chesapeake Energy Media Relations.
Exposing Kodiak's flaw
The first thing that stands out to investors for Kodiak Oil & Gas is its incredible growth story over the past few years. Since the first quarter of 2012 to today, the company has seen production and revenue grow by 7.41 and 7.5 times, respectively. This makes it one of the fastest growing oil producers in the country:
| Company | Production Growth 2011-2013 |
| Kodiak Oil & Gas | 741% |
| Whiting Petroleum | 138% |
| Oasis Petroleum | 317% |
Not only that, but the company has a prime acreage position in the Bakken formation, which is becoming a more prolific oil reserve by the day. Thanks to better drilling technology and more experience in drilling tight oil wells, the total recoverable amount of oil in the region has more than doubled to 7.38 billion barrels of oil since the U.S. Geological Survey's first assessment of the shale play, and top companies in the region even consider that to be a conservative estimate. This means that the 2,100 or so potential drilling locations Kodiak has on its books may only be scratching the surface of this company.
This huge surge in production and Kodiak's push to tap that potential has come at a cost -- its financial health. Along with that revenue growth, its total debt has tripled to $2.25 billion because the company's capital expenditures have been outpacing its cash flow. The theory is that its increased production and revenue would catch up to its debt load, and it would start to generate free cash flow.
In most cases, this theory was starting to work, but one recent change for producers in the Bakken region has changed that dynamic, and that is North Dakota Industrial Commission's decision to limit natural gas flaring at wells. According to the commission, any well that cannot reduce flaring at the well by 74% by October will not be allowed to produce more than 200 barrels per day at each well. Not only will this involve preparing new wells to capture gas, but companies will also need to go back to previous wells. Kodiak doesn't really have the financial flexibility to go back and make those installations at previous wells, nor could it risk having its wells' production be so constrained. By combining forces with Whiting, the combined company will have a bit more financial flexibility to make the necessary fixes at its new and existing wells.
Who's next?
Kodiak Oil & Gas isn't the only one that has employed this growth strategy in the Bakken, and several other companies that are either Bakken-centric or have smaller assets in the region will also struggle with these new regulations. The companies that immediately come to mind are Oasis Petroleum and Triangle Petroleum because they are pure plays, but two other companies that could be at risk here are Halcon Resources (HK) and Magnum Hunter Resources (NYSE: MHR). While Magnum Hunter and Halcon do have assets elsewhere, they have both been using the Bakken as a production base to generate revenue while they explore less established shale formations. Based on the cash flow at these companies, they can ill afford to see production limited in the Bakken.
| Company | % Production From Bakken (on Boe basis) | Total Wells in Bakken (net) | % of Capital Expenditures Covered by Operational Cash Flow (LTM) |
| Oasis Petroleum | 100% | 406.2 | 29.2% |
|
Triangle Petroleum |
100% | 39.6 | 19.5% |
| Magnum Hunter Resouces | 31% | 98 | 7.2% |
| Halcon Resources | 71% | 188 | 23.8% |
Source: Company 10-ks and S&P capital IQ, authors calculations.
Magnum Hunter has already been in the process of linking its current and upcoming wells to a natural gas gathering system to reduce flaring, so it may be in a better position than the others on this list in that regard. However, if these companies are already struggling to finance operations before these flaring regulations start to take hold, then don't be surprised if they follow a similar path to Kodiak Oil & Gas and sell either its Bakken operations or sell out entirely.
What a Fool believes
The next several months will be very interesting regarding the future of the Bakken. These new regulations will put immense pressure on companies that have not been dealing with natural gas, especially the smaller ones that are already financially stressed. When you add this little wrinkle to the mix, it's a little easier to understand why Kodiak has decided to be acquired by a bigger fish in the Bakken pond for a less than premium price. Investors with a stake in the region should really keep an ear to the ground, because it's very likely that we will see another similar deal soon.
