Northern Oil and Gas

Moat: 2/5

Understandability: 2/5

Balance Sheet Health: 3/5

NOG is an oil and natural gas company primarily focused on non-operated investments in the Bakken and Three Forks formations in the Williston Basin of North Dakota and Montana and also in the Permian Basin in Texas and New Mexico.

Investor Relations Previous Earnings Calls

The moat, understandability, and balance sheet health scores reflect a conservative evaluation to ensure a margin of safety in any assessment.

Northern Oil and Gas, Inc. (NOG) operates through a non-operated working interest in a vast network of oil and natural gas wells. This business model entails a less direct involvement in day-to-day operations, focusing instead on contributing capital to the development and production of wells managed by other companies, called operators. These operators are established businesses with a history of consistent execution and expertise.

Business Overview:

Revenue Distribution: NOG’s revenue streams are predominantly derived from crude oil and natural gas sales. They also utilize a complex system of derivative instruments to hedge price risk. Sales revenue is dependent on the market prices for oil and gas, which are subject to volatility, as well as on production volumes. As per the latest 10Q report, the company’s revenue streams were as follows:
- Oil sales - $376 million in Q3 2023, up from $258.5 million in Q3 2022
- Natural gas and natural gas liquids sales - $285 million in Q3 2023, up from $202.9 million in Q3 2022.
Industry Trends: The oil and gas industry is currently experiencing volatility due to the global political situations and economy. Demand for energy sources are high and have continued due to geopolitical tensions and the lack of production capacity. In the near-term, oil price fluctuations are expected to cause significant variation in profits. Furthermore, recent industry trends have shown the growth in exploration in the Permian Basin which has created competition and increased valuations for acquisitions in the region. Additionally, government regulations on oil and gas companies have been seen as a risk factor to production, which is seen by investors as a high liability.
Margins: Net income for the 9 months ended Sept 30th was 832.1m on revenues of 1.8 billion. The operating margin is affected by the volatility of oil and gas prices. In the latest earnings call, management said that even while reducing production, they were able to bring down operating costs and improve margins.

They have also stated that current price realizations are approximately 80% of NYMEX price. They have reduced their opex costs and are on target to reduce them to below $13 per barrel for full year 2023.

Competitive Landscape: NOG operates in a competitive environment with numerous oil and gas producers, large and small. NOG competes on capital deployment efficiency (acquiring quality assets at reasonable prices), the ability to choose top tier operators with lower costs and better execution, and access to finance to fund its activities. In addition to these factors, they face commodity market risk.
What Makes NOG Different? NOG’s distinctive approach is a focus on non-operated working interests that allows them to scale their production and operations at a higher rate of efficiency with a lower cost than their competitors. They invest in production areas where they believe well operated operators have already established sustainable and repeatable processes. This means NOG is more dependent on the operational performance of their operators and thus face a unique kind of risk. They are also expanding quickly in the Permian, and that is also a point of differentiation. NOG has a proven ability to generate free cash flow and deploy that cash strategically.

Moat Analysis: 2/5

NOG’s moat, or competitive advantage, is rated as a 2 out of 5 due to the following points:

Limited Economic Moat: NOG doesn’t have a wide economic moat because it is primarily exposed to commodity prices. The biggest threat they face is from prices falling and demand changing. They are also reliant on other companies to operate the assets which decreases its degree of influence on profitability.

Their growth strategy also has a heavy reliance on acquisitions, but at current valuations of producers the deals are not as attractive anymore, especially with a lower growth profile compared to other industries, and that makes their future return less certain.

Intangible Assets: NOG does not have any significant intangible assets like brands, patents, or licenses that create a competitive advantage. Their products are fungible commodities that are traded in the market.
Switching Costs: NOG faces very low switching costs, as they are mostly a capital provider to other operators.
Network Effects: No network effects are present as NOG’s business operations are not affected by the size of its user network.
Cost Advantages: NOG does not possess inherent cost advantages stemming from a proprietary process, unique location, or privileged asset access, although they benefit from cost savings by their non-operational business model.
Size: NOG doesn’t have the size advantage to have economies of scale, as it is still growing and has considerable competition. Although it can have a relatively large footprint in a specific area, such as the Williston basin.

Moat Risks:

Several risks could negatively impact the moat, as the nature of the business model is based on a strategy that hinges on factors it can not directly control. These risks can be categorized as:

Commodity Price Volatility: NOG’s profits are directly linked to oil and natural gas prices, which are notoriously volatile. Sudden price drops can severely impact revenue and profitability.

Management has noted that there is a trend of lower oil price expectations, although their hedges help with this volatility and protect them.

Geopolitical & Economic Instability: Global events can influence oil and gas prices and supply chains. Any economic downturn will depress demand for oil and gas.

Management acknowledged the presence of higher volatility than usual in the energy market, but they expect that high demand and production caps will continue to keep oil and gas prices at a profitable level for NOG.

Operational Risks: NOG relies on its operators for day-to-day production. Any mismanagement or operational problems with those operators will directly reduce NOG’s production and profits.

Management has reported that their operators had increased activity during Q3. They’re seeing a higher rate of returns from wells that were brought online this quarter, and also better efficiency from higher production levels.

Regulatory Risks: The oil and gas industry is subject to significant governmental regulations and tax changes, which can impact a company’s profitability and development.

Increased regulations on production and exports in the oil and gas sector remain a concern, although the US is a net exporter of crude oil, they still do not know how their export restrictions will affect the sector.

Limited Control Over Operations: As a non-operator, NOG’s control over operations and their costs is limited. They are reliant on operators for consistent performance, which they are unable to directly influence.

Management has said that the key driver for them is that the operational activity and success rests on the producers whom they select and that has continued to serve them well. However, if the operators fail or change, NOG’s returns are directly affected.

Business Resilience:

Despite the above risks, NOG has demonstrated good resilience by building a track record of consistent profits and low operating costs. Key strategies that have been put into place for resilience include:

Hedging: NOG actively hedges future production and revenues to reduce the risk of price fluctuations.
Financial Flexibility: NOG has worked on reducing long term debt in the past and has a credit facility available that can be used when needed. Also with their low cost of operations, they are well positioned to withstand the impact of decreased oil and gas prices.
Prudent Acquisitions: They strategically acquire properties that offer the opportunity for immediate free cash generation and are also managed by proven operators.

The focus going forward for the company, according to management, is to find assets that add more incremental revenues and free cash flow and do not have a long development cycle. They also added that the production is weighted more towards crude oil, and the prices are expected to remain strong.

Financial Analysis:

Revenues: NOG’s revenues are primarily driven by the price of oil and gas, and therefore revenue varies significantly quarter-to-quarter.
Profitability: Net income for 9 months ended September 2023 increased significantly to $832.1 million, compared to 484.5 million in same period 2022. The main reasons for this are higher production and prices.

Their EBITDA has seen consistent growth over the past three years and this trend is also expected to continue.

Cash Flows: The company generates considerable free cash flow, most of which is used for reducing debt and further acquisitions, along with shareholder returns (mostly in the form of dividends).

A dividend increase of 15% in the base dividend was announced in the latest earnings call. Also, $300m in stock buybacks has been announced. Management noted that this increase in return to shareholders stems from confidence in free cash flow generation.

Debt: NOG has worked on bringing down debt levels over the years. They have around 1.3 billion in debt but are working towards a debt target.
Capital Allocation: Management allocates capital towards acquisitions, deleveraging, and returning capital to shareholders. They have maintained a level of balance between these different categories. They also noted they are more focused on deleveraging and improving cash generation.
Shareholder Returns: NOG provides returns to shareholders through a dividend and repurchase program.

Understandability Rating: 2/5

NOG’s business is rated a 2 out of 5 for understandability due to the following reasons:

Complex Business Model: While it may sound easy to understand a commodity producer, in practice, the complexity of NOG comes from the fact that it is a non-operator. They are not involved in day-to-day operations and instead focus on capital deployment to high-performing operators, a model that can be difficult to comprehend for those not well versed in the intricacies of the Oil and Gas sector.
Financial Intricacies: The use of derivatives for price hedging, and the numerous accounting items that may or may not come out of operations is hard to understand. A very detailed look into the financial statements and the footnotes is needed to fully understand the business.
Reliance on Operators: Much of NOG’s profitability depends on external actors whom they have little control over, which makes it hard to forecast, especially the operations portion of the business.
Industry Specifics: To properly analyze the business, you need an understanding of the commodity markets, and of the processes used to extract crude oil and natural gas.

Balance Sheet Health: 3/5

The health of the balance sheet is a 3 out of 5, although they are on a very strong improving trend:

High Debt: While the debt levels are declining and the company is on a track to reduce it, its total level remains concerning at around $1.3 billion. A company with such a heavy debt load does face high risk in times of financial stress.
Cash: They have almost $2 billion in cash and have been generating good free cash flows that allows them to service the debt. They have said they intend to reduce debt, and have recently used cash to retire debt.
Limited Assets: Being an explorer, NOG doesn’t have a heavy asset base, but does have a growing portfolio of producing properties.

Management has been highlighting the expansion of their assets in the Permian, while also noting that their acreage is spread across many regions in North America. This diversification helps in risk management.

Recent Concerns, Controversies and Problems

The company has had a few problems over the past few years, namely

COVID-19: Production was impacted due to reduced demand during COVID.
Volatility in the sector: Fluctuating crude oil and natural gas prices have affected profitability. They are able to manage this with hedges and diversified production, but price instability remains a threat.

Management has addressed these issues by noting that their company is strong and is set up in an appropriate way to withstand the volatility in the sector. Moreover, they believe that the current global situation is favorable to their operations, due to continued demand and limited supply capacity in the oil and gas sector. They also expect their cost cutting and financial discipline to continue to yield positive results.