Northern Oil and Gas: Stronger Positioning, But Commodity Prices Could Drag

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Northern Oil and Gas, Inc. uses a unique, less risky business model by owning minority interests in wells, resulting in higher margins and higher cash flow than peers.The company's stock price closely...

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(NYSE:NOG) is an upstream oil and gas exploration and production that primarily operates by taking minority interests in operating oil and gas wells, as well as royalty interests. These are throughout the Bakken Shale, Marcellus Shale, and Permian Basins in the United States. The company's investor relations webpage includes a great description of its overall business model: NOG is the largest, publicly traded, non-operated, upstream energy asset owner in the United States. We engage in the acquisition, exploration, development and production of oil and natural gas properties, primarily in the Williston, Permian and Appalachian Basins. Our primary focus is investing in non-operated minority working and mineral interests in oil and gas properties in the United States. This is a different business model than most upstream oil and gas producers. Northern Oil and Gas does not typically operate the wells that extract the oil and natural gas from the ground. Rather, all that the company does is to own land with oil and gas reserves (or simply the mineral rights to the reserves on the land) and then leases these rights to other companies that actually extract the resources from the ground. Alternatively, the company might invest in a well that is already producing resources, essentially becoming a partner of the well's operator. The company takes a percentage of the resources produced on the property as payment, which results in its cash flow exhibiting a significant correlation with oil and natural gas prices. This also extends to the company's stock price, which also exhibits a substantial correlation with oil and natural gas prices. We can see that in this chart: Barchart This chart shows the spot prices of West Texas Intermediate crude oil (black line), the spot price of natural gas at Henry Hub (blue line), and the share price of Northern Oil and Gas (orange line) over the past year. As we can see, Northern Oil and Gas's stock price exhibits a very close correlation to West Texas Intermediate crude oil, although it is slightly less volatile. This has been particularly true since mid-August, as the company's share price did not decline nearly as much as crude oil did since that time. This might be partially due to natural gas staging a rebound and providing a small amount of support to the stock price. Overall, this suggests that investors can purchase Northern Oil and Gas if they are looking to get exposure to West Texas Intermediate crude oil prices. The company's share price is slightly more stable than crude oil, and the stock currently pays a 4.94% dividend yield. Thus, this could be an interesting play for an investor who wants less risk than would be taken on by buying oil futures or an exchange-traded fund that tracks oil futures. Unfortunately, it is very difficult to be an oil bull right now. As I have pointed out in a few recent articles, there are plenty of concerns surrounding the American economy. A rising unemployment rate has created some fears of a recession that could result in job losses. In addition, the still high inflation rate suggests that we could be looking at a stagflation scenario. In such a situation, households might cut back on their discretionary travel and simply only drive when necessary (such as to purchase food). This could reduce the demand for crude oil that, when combined with economic weakness in China, makes it difficult to see supply demand pressure to the upside. That is a short-term scenario, though, and the long-term bull case for crude appears to remain intact. That may be a few years away, though, and shareholders in this company might be in for some disappointment over the coming months. About Northern Oil & Gas As stated in the introduction, Northern Oil and Gas is an upstream energy company that primarily collects royalty payments from oil and natural gas extracted on land that it owns. It also invests in wells that are operated by other companies. This is a very similar business model to the one used by Viper Energy, Inc. (VNOM) or PHX Minerals Inc. (PHX). The company is quite a bit larger than most of its peers, though, as it currently controls approximately 272,000 net acres containing approximately 10,000 active oil wells: Northern Oil & Gas The company reports an average daily production of 123,300 barrels of oil equivalent per day, 69,650 barrels of which is in the form of crude oil. That puts the company's production weighting at 56.49% crude oil, which is reasonable. After all, as we discussed recently, the fundamentals for natural gas are much better today than they were a decade ago when natural gas was basically considered a waste product that was not even worth trying to sell. The company's acreage is fairly well split between the three basins in which it operates: Northern Oil and Gas This also suggests that it might be trying to split its royalties between crude oil and natural gas. The Appalachian position in particular is almost entirely natural gas, as very little crude oil is produced in the Marcellus Shale (the company's acreage is mostly in Southwestern Pennsylvania). As we can see here, the Williston Basin (Bakken Shale) is very oil-heavy, although it does produce some natural gas: U.S. Energy Information Administration The Permian Basin is likewise oil-heavy, but it also produces substantial amounts of natural gas. Thus, it appears that Northern Oil and Gas has been trying to construct its royalty portfolio in a way that gives it somewhat equal exposure to both crude oil and natural gas. This could be a good thing for the company going forward, especially if the expected growth in natural gas demand eventually pressures supply sufficiently to push up prices. That would require that the current glut be reduced, which does not appear to be likely in the near term, but it could be a possibility in the future. As evidence of this, we can look at current natural gas demand forecasts. McKinsey's latest natural gas outlook states that global consumption of natural gas will increase by 10% to 15% through 2035: McKinsey & Company It is difficult to project past 2035 as it depends on the speed at which new technologies are deployed to offset the intermittent and unreliable nature of solar and wind generation. There are some scenarios in which McKinsey sees demand growing through 2040 and even 2050. However, even just assuming demand growth through 2035 gives us another ten years of consumption, and that is not bad for a long-term investment. The Appalachian Basin in particular is one of the few areas left in the world where substantial natural gas can be found and where production can be easily and cheaply increased. As such, it seems likely that the region will see growing production over the next decade. Northern Oil and Gas has acreage there to take advantage of this opportunity, which is nice to see. Northern Oil and Gas does not actually operate the oil and gas rigs or wells that produce the hydrocarbon resources that it sells: Northern Oil and Gas This gives it several advantages over an ordinary upstream exploration and production company. Perhaps the most important of these is that the company does not have to take on the risks or costs involved in actually drilling a well. There are times, for example, when a company drills a well only to find that it does not contain any resources. There are other times when it does find resources, but there are insufficient resources in the well to cover the costs of drilling it. Northern Oil and Gas does not have to worry about any of these costs or risks. Rather, it simply acts as an outside partner that buys into the producing well once someone else has already incurred the costs of drilling it. The operator gets an inflow of cash from selling the minority interest to Northern Oil and Gas, which the operator can then use to help finance more oil and gas drilling operations elsewhere. Northern Oil and Gas gets a portion of the well's output as its investment return. As the company does not need to have staff on-site to operate the well, it can make do with a much smaller number of employees than an ordinary oil and gas company of its size. That saves money on employee salaries, benefits, and similar things. High Relative Margins As the company does not have the expenses, financial risks, and overhead of drilling wells and maintaining a large staff, it should be able to enjoy higher margins than other exploration and production companies. In the most recent trailing twelve-month period, Northern Oil and Gas had a total revenue of $1.9709 billion, a gross profit of $1.5800 billion, and a net income of $565.1 million. This gives the company some fairly attractive margins:   Gross Margin 80.17%   Net Margin 28.67%   Operating Cash Flow Margin 67.93%   Click to enlarge * Operating Cash Flow Margin is defined as operating cash flow divided into total revenue. Here is how that compares to an ordinary upstream exploration and production company. For this comparison, we will use Diamondback Energy, Inc. (FANG).   Gross Margin 79.36%   Net Margin 39.34%   Operating Cash Flow Margin 66.07%   Click to enlarge Admittedly, Diamondback Energy did better than I actually expected, which could be a sign of how efficiently some shale producers have been able to structure their business operations over the past few years. However, we can still see that Northern Oil and Gas has an advantage in terms of both gross margin and operating cash flow margin. In theory, we should expect that Northern Oil and Gas would have a substantial advantage in free cash flow margin. However, the company has spent a substantial amount of money on capital expenditures over the past year, so it actually has a negative free cash flow. If we compare Northern Oil and Gas's margins to another upstream exploration and production company, Devon Energy Corporation (DVN), we can immediately see that Northern Oil and Gas has a substantial advantage:   Gross Margin 54.30%   Net Margin 23.74%   Operating Cash Flow Margin 45.66%   Click to enlarge As was the case for all of the above peer comparisons, the above figures for Devon Energy were calculated using the trailing twelve-month period. Thus, all three companies have been represented by the same Q2 2023 to Q2 2024 period, ensuring that the macroeconomic factors are all the same. We can clearly see that Northern Oil and Gas's business model enjoys some margin advantages over that of a traditional upstream exploration and production company. This is something that stockholders should generally appreciate, as it results in Northern Oil and Gas having more cash available to invest in expansion (in this case, buying mineral royalty interests and minority well stakes) or to return to the stockholders. As income investors, one of our top interests is having money returned to us, so Northern Oil and Gas appears to have some things to like here. Growth Opportunities Northern Oil and Gas has a long history of growing its production over time. As can be clearly seen here, the company has managed to increase its full-year production during most of the 2017-2023 period: Northern Oil and Gas The only real exception to this production growth was in 2020, which is understandable. That year saw a collapse in energy demand, particularly for crude oil. The reduction in demand collapsed oil prices and many companies sought to conserve cash, and one of the easiest ways to do this is reducing their investment in new wells. Northern Oil and Gas was no exception to this, as its capital expenditure totaled $283.9 million for that year (a 50.11% reduction over the full-year 2019 level). The company resumed its investment into well minority interests the following year. We saw its capital expenditures increase substantially in 2022 and 2023 from 2021 levels: Seeking Alpha This has been the single largest driver of the company's production growth since 2020. After all, the only real way for the company to grow, given its business model, is to buy up interests in ever more wells. The company's capital expenditures and acquisition spending year-to-date is lower than what it had in the first half of 2023, though. The fact that the company's capital expenditures and acquisition spending year-to-date are lower than in the first half of 2023 does not mean that it is going to stop growing its production. This is because well productivity in some regions is actually up compared to prior years: Northern Oil and Gas This chart shows the total output of a well from the time that it was brought online in the Bakken Shale. As we can see, the 2024 figures are a bit higher than in either 2022 or 2023. This tells us that after 210 days of being online, a well drilled in the Bakken Shale around the start of this year has produced more oil and natural gas than a well drilled last year or in 2022 at the same point in its life. If we extend this out across numerous wells, we can see that the total production can actually be the same or higher even if the number of new wells drilled declines. This is important because drilling and completions activity has been falling since the start of this year: Northern Oil and Gas However, as we saw earlier in this article, production of crude oil and natural gas is actually up compared to the same period of last year in both the Permian Basin and the Bakken Shale (production is flat year-over-year in the Marcellus). This suggests that Northern Oil and Gas might be able to continue to deliver production growth, even if the number of new wells coming online that it can purchase an interest in declines. We might see such a decline if energy prices continue to fall over the rest of this year (which is possible in a recession). Financial Considerations As I stated in my last article on Northern Oil and Gas: One thing that we always want to investigate prior to making an investment in a firm is the way that the company finances itself. This is important because debt is a riskier way to finance a company than equity. This is because debt must be repaid at maturity, which may be difficult if the market is not welcoming to a refinancing. In addition, the company must make regular payments on its debt if it is to remain solvent. As such, an event that causes a decline in cash flows could push the company into financial trouble if it has too much debt. This is one reason why we sometimes see bankruptcies when energy prices collapse. As of June 30, 2024, Northern Oil and Gas has a net debt of $1.8671 billion compared to shareholders' equity of $2.0683 billion. This gives the company a net debt-to-equity ratio of 0.90 today. This is a substantial improvement compared to what the company had the last time that we discussed it. As you may recall, at the time, Northern Oil and Gas had negative shareholders' equity. Clearly, the company has managed to strengthen its balance sheet significantly since late 2021, and this is something that any investor should appreciate. After all, as we saw throughout much of the latter half of the 2010s, debt can be dangerous for any fossil fuel company. A net debt-to-equity ratio below 1.0 is now the minimum required for any company that I am personally willing to invest in, and many companies have managed to get their ratios well below that. Let us take a look at how Northern Oil and Gas's financial structure compares to its peers:   Company Name Net Debt-to-Equity   Northern Oil and Gas 0.90   PHX Minerals 0.22   Viper Energy 0.34   Diamondback Energy 0.28   Devon Energy 0.42   Click to enlarge Admittedly, neither Diamondback Energy nor Devon Energy are perfect comparisons to Northern Oil and Gas because both of those companies actually operate the wells themselves. However, they do still have exposure to oil and natural gas prices, and commodity prices are one of the biggest risks to consider when evaluating an energy company's financial structure. After all, it is a decline in commodity prices that most reduces an exploration and production company's ability to pay its debt. As we can see, all the companies here have significantly lower levels of leverage than Northern Oil and Gas. This might be an indicator that Northern Oil and Gas is employing too much debt in its financial structure than is really safe. Northern Oil and Gas has certainly made great strides here since 2021, but this peer comparison suggests that the company might have more work to do. Valuation According to Zacks Investment Research, Northern Oil and Gas currently trades at an incredibly low 6.29 forward price-to-earnings ratio. The major domestic American indices have substantially higher forward earnings multiples: Wall Street Journal Thus, Northern Oil and Gas, Inc. stock appears to be tremendously cheap compared to the market as a whole. However, this is not unusual for an energy stock, as most of the oil and gas industry has traded at very low relative multiples for several years now. It may be better to compare Northern Oil and Gas with its peers. Here are the figures:   Company Name Forward P/E Ratio   Northern Oil and Gas 6.29   PHX Minerals 33.60   Viper Energy 21.51   Diamondback Energy 8.80   Devon Energy 7.45   Click to enlarge (All figures from Zacks Investment Research.) PHX Minerals and Viper Energy are the closest two companies in the list to Northern Oil and Gas in terms of business model. As we can clearly see, both of these companies trade at substantially higher earnings multiples. This could imply that Northern Oil and Gas is undervalued right now. However, the company's higher debt load could mean that it is a bit riskier than those two companies. Conclusion In conclusion, Northern Oil and Gas is an interesting upstream company with a rather unique business model. The company does not operate any wells itself, but it simply takes a minority interest in wells that someone else has managed to get operating. This is a much less expensive and risky model than that possessed by most upstream companies, and it has resulted in Northern Oil and Gas having higher margins than many other companies in the sector.  The company appears to be in a much better place than it was at the time of our last discussion. 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