Diary of a Financier

Shuffling around upstream energy exposure

In Trading Desk on Fri 13 Sep 2013 at 16:40

I’ll be spending the beginning of next week doing some shuffling-around in our portfolio. There’s one swap in particular that I’d like to highlight. We’re sitting on +8% unrealized gains in our US Oil & Gas Exploration & Production ETF ($IEO), whose future now looks bleak. I expect to sell IEO, swapping it for a singlename E&P company, Northern Oil & Gas ($NOG), which looks defiantly strong. It’s unusual to get such a juxtaposition within a subsector, so I wanted to flush-out my thinking…

We bought IEO in January, when it was breaking-out of a long term symmetrical wedge. It’s been a volatile road since then, but the charts have rung true throughout our holding period. As expected from that classical wedge, IEO daily/weekly/monthlyIEO has successfully retraced 50% of the triangle’s base, and now, IEO has coiled its way into the vertex of a new, rising wedge. This week, it brushed trendline resistance of that bearish wedge. It’s overbought on its monthly fractal, and it shows 2x bear divergence on the weekly.

In aggregate it seems like I should take the gains and move on. But, while it’s overbought too, IEO’s daily fractal has attempted a bull reversal out of its own 2x bear divergence–as manifest by the spikes in indicators this week. Given that argument, I’d normally hang-on to see the route IEO would take from this juncture, but NOG has constructed an unequivocably bullish setup that provides a better home for this capital…

NOG is near a breakout. It’s reached trendline resistance (<$14) of a classic, long term falling wedge. The daily fractal exhibits an epic LT bull divergence in MACD and ST 1x bull divergence in MFI. Further, NOG has weekly 3x bull divergence and oversold monthly indicators:

NOG daily/weekly/monthly

NOG daily/weekly/monthly

Fundamentally, NOG is cheap relative to its peer group and IEO’s underlying basket. For example, NOG trades at a 10.68x FwPE vs IEO’s 26.22 and 1.37x PB vs 2.58x. That’s the potential kicker: NOG could be a takeover target, as we’ve already seen in the acquisition rumors that circulated 10/8/2012.NOG fundamentals 2013.09.13

NOG trades at a 35% premium to its own Q2 NAV ($860M market cap vs $617M Q2 NAV, $637M YE13 consensus NAV), so production will have to resume gains for this name to hit the upside over the long term. Oil accounted for ~80% of Q2 sales, with Nat Gas only 3.1%, and NOG almost completely hedges commodity price exposure using costless collars (buy puts/sell calls) and swaps (receive fixed price/pay floating).

In the short term, I had to look at its capital structure, since NOG has a low current ratio at 0.80 and a low ROA at 4.40%. The 2q13 balance sheet doesn’t show current debt at a troubling level–just $4.75M vs $18M cash. There is a large accounts payable item of $108M, basically future capital expenditures on property developments, which has remained at this level throughout past quarters. That’s no bother though, as NOG has $400M in untapped capacity in a revolving credit facility.

NOG is in a lull right now. It expects to add 36 net wells throughout this year, of which it’s already added 15.3. NOG has 12.2 wells that are being either drilled or completed right now–wells not in production yet and will therefore come online shortly. (Multi-well pad drilling is a new, cost effective strategy that’s becoming the industry norm, but that means latency will sometimes yield a decoupling between well counts and average production.)

This is not value; this is relative value, with 15% FY14 EPS growth the focus. NOG has an enviable portfolio: it takes partnership stakes in other E&Ps’ development projects, which enables it to diversify its exposure in the Bakken shale, which some estimate is only 10% developed. Further, NOG has underperformed its peer group on a 12-month basis. Of the major partnerships it has, Kodiak Oil ($KOG) is the closest by stock performance, and NOG lags it by 30% ttm.

Consensus says FY13 net income will be $71M and interest expense is tracking ~$31M annualized. That mean a larger conglomerate could instantly juice earnings just by giving NOG’s assets access to cheaper capital. NOG just issued 8% unsecured notes, so even halving their cost of capital would increase net income >20%.

I’ve owned NOG twice in the past 4 years–once majorly successful, once minorly unsuccessful. I have some research to comb through this weekend, but barring any red flags (e.g. accelerating depletion rates), I expect to execute upon this swap after the open on Monday morning, because NOG closed this week in the midst of a 30-minute bull flag.

–Romeo

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