Chesapeake Energy Corporation (CHK): Should You Be Worried about Kodiak Oil & Gas Corp (USA) (KOG)’s Debt Levels?

Lately, Kodiak Oil & Gas Corp (USA) (NYSE:KOG) has been drawing flak due to its capital expenditure program. Management had revised the original spending plan for 2013 from $775 million to $1 billion. Moreover, the independent upstream company has shored up its balance sheet debt levels to meet funding. The market has been wary of this fast-growing company despite strong quarterly results. Should investors be worried?

I don’t think so. But before delving deeper, let’s take a look at what the company’s growth plans are for the rest of the year. According to the latest guidance from management, Kodiak Oil & Gas Corp (USA) (NYSE:KOG) aims to complete 100 net wells this year and pull up average daily production to somewhere between 30,000 barrels of oil equivalent per day and 34,000 boepd for 2013.

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Source: Kodiak Oil & Gas

Ambitious indeed

With average daily sales volumes of 22,500 barrels of oil equivalent for the first six months, production for the second half of the year will have to be somewhere in the range of 37,500-45,000 boepd in order to meet that target. That means production volumes will have to be ramped up 66% to 100% for the second half of the year. Now that’s definitely ambitious.

To fund its growth plans, Kodiak Oil & Gas Corp (USA) (NYSE:KOG) has issued debt financing. But with debt to equity currently at 130%, the market hasn’t so far been enthusiastic about the company’s spending program. However, I feel the market is likely missing out on something.

Efficiency drives growth

More than growth, management’s focus seems to be on efficiency. Kodiak Oil & Gas Corp (USA) (NYSE:KOG) has been working on two pilot projects in the Polar and Smokey operating areas. In each project, the company has been drilling 12 test wells within a 1,280-acre drilling spacing unit. The idea is to increase the number of wells drilled within a unit area of spacing.

To achieve this, management has been utilizing the highly efficient method of pad drilling. In these projects, a four-well drill pad is being used. This means, each drill pad is capable of drilling four wells simultaneously without rigging up or rigging down after every single well has been drilled. The obvious result is that well costs are gradually falling. Additionally, drilling times have also fallen drastically.

Each new well is now expected to cost somewhere in the vicinity of $9.2 million. Compare that to the cost range between $9.7 million and $10.2 million per well in the fourth quarter of 2012. With about 100 net wells to be drilled for the whole of 2013, this translates to at least $75 million in cost savings. Now this might not look too big, but on a per-barrel basis, you can’t ignore it. The following chart should give a fair idea how this looks going all the way back to the first quarter of 2011. Kodiak Oil & Gas Corp (USA) (NYSE:KOG) seems to have been doing a fantastic job:

Source: Company filings, author’s calculations

The blue line traces the average price per barrel of oil equivalent that Kodiak has been receiving, while the green line traces the operating cost per barrel of oil equivalent. This is exactly the trend that an investor should be looking for. While prices received per barrel have shown a gradual increase, the very opposite is happening with operating costs per barrel. I calculated the difference between the two values for each quarter:

Source: Author’s calculations

If we look from the second quarter of 2012, margins have been increasing. It’s true that these margins were pretty high in 2011. However, from an investor perspective, I would ignore the margins of that year for two reasons: Firstly, crude oil prices skyrocketed in 2011 due to the Libyan crisis. Second, Kodiak was still relatively a new operator in the Bakken at that time.

So given these high margins, what’s the next step that any reasonable management would want to do? Obviously, it would want to increase production. The pad-drilled wells have so far yielded excellent results. Not only have production costs come down, but the initial production rates have been promising.

Am I worried about the debt levels? Not exactly.The best thing management could do right now is increase capital spending and ramp up volumes. Also at the moment, I would prefer debt financing over raising additional equity. Diluting the stock now may send a wrong signal to investors.

A fair comparison with Chesapeake Energy?

Natural gas producer Chesapeake Energy Corporation (NYSE:CHK) had been notorious for reaching alarming debt levels, and the story is all too well documented. However, as fellow Fool Tyler Crowe points out, investors should be aware that Kodiak’s debt financing has been funding direct operations, unlike Chesapeake Energy Corporation (NYSE:CHK), which was more interested in grabbing acreage without any immediate development involved. In contrast, Kodiak’s management has so far acted within rational limits.

With oil-heavy assets in the premier Bakken Shale play under its belt, Kodiak’s strategy has so far looked good. Given the fast-growing company’s performance so far, I won’t be too surprised if this upstream company is acquired soon. With crude oil above $100 per barrel, investors should keep a close watch on Kodiak.

The article Should You Be Worried about Kodiak’s Debt Levels? originally appeared on Fool.com and is written by Isac Simon.

Fool contributor Isac Simon has no position in any stocks mentioned. The Motley Fool has the following options: long January 2014 $30 calls on Chesapeake Energy.

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