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NOG: Lasting Fairy Tale or Looming Horror Story?

by Melissa Davis - 9/13/2011 6:17:56 PM

* Editor’s Note: The following is the first story in a two-part series on Northern Oil & Gas.

To some, Northern Oil & Gas (AMEX: NOG) looks like a Cinderella stock without the fairy-tale ending.

An obscure microcap company just a few short years ago, NOG has magically transformed itself into one of the hottest names in the energy sector by capitalizing on easy oil discoveries in the Bakken shale to generate a huge – if unsustainable – explosion in growth. With its revenues tripling and its profits more than doubling over the course of the past year, records show, NOG has understandably won over a growing crowd of fans. 

NOG’s highflying stock recently hit a record of almost $34 a share, up 1,500% from its 2009 lows, before finally giving up some of its breathless gains earlier this month. Even at its current price of $28.25, however, NOG still boasts a $1.72 billion market value that reminds skeptics of Cinderella on that wondrous night just before midnight struck.

To be sure, as recent headlines clearly indicate, NOG comes with a powerful bull story. In a nutshell, the bull case – which magically addresses the key issues raised by company bears in the past – goes something like this. NOG employs a well-connected CEO who has used his family’s deep roots in Montana and nearby North Dakota to negotiate valuable leases in the oil-rich Bakken shale. Moreover, NOG has secured that land at cheap prices – spending a fraction of the amount paid by larger Bakken players – by focusing on small “non-operated” properties that have yet to be explored. The company has then kept its overhead to a minimum, employing fewer than a dozen full-time workers, by partnering with established operators that actually drill the wells in exchange for a majority share of the gains that flow from those projects.

As a result, NOG has managed to minimize risks and maximize returns – without a single report of a dry hole – while generating massive gains for the company and those who have purchased its popular stock.

NOG has posted an impressive string of record-breaking numbers throughout that breathless rally. This month, however, NOG quietly disclosed a special “adjustment” that jumped out at skeptics of the company. Specifically, critics note, NOG recorded a $3.5 million depletion charge – signaling a potentially material slowdown among its fast-gushing wells – that caused a big spike in its fourth-quarter depletion expense. With Bakken wells notorious for their rapid depletion rate, critics say, NOG has long faced that inevitable hit.

“Their depletion numbers have appeared low,” says John Hempton, chief investment officer of Bronte Capital Management in Australia. “I think they will be taking more depletion charges – which may be very large – in the future … When you’ve extracted the oil, but you haven’t depreciated the land and the wells necessary to obtain it, that’s basically the end game.”

NOG failed to answer questions for this story.

Temporary Gushers

Unlike NOG and other U.S. Bakken players, Hempton says, more conservative companies take those hits as they come. He points to Petrobakken Energy (Toronto: PBN.TO), a Canadian oil company that drills in nearby Bakken fields to the north, as a specific example. For Hempton, Petrobakken’s once-pretty stock – now ugly despite its young age – offers a snapshot preview of NOG going forward.

Sacha Peter, the founder and managing director of Divestor Investments in Canada, last fall rejected Petrobakken as a candidate for his successful growth portfolio after concluding that the company had likely seen its glory days already. A specialist in both physics and accounting, who boasts an impressive stock-picking record that’s generated consistently high gains, Peter pointed directly at Bakken depletion trends when declaring Petrobakken a “value trap” earlier this month.

“The big operational issue in the … Bakken fields is that your production falls off steeply after the initial drilling,” Peter explained. “Although the capital expenditure can be justified, the economics are not as pleasant as what most people may anticipate by looking at the ‘trend’ of oil production based on first-year results.

“Most of the growth in revenues has to be looked at with the knowledge that the first year of wells will be extraordinarily high,” he added, “while the second and subsequent years will have slower, but steadier, production.”

By now, Hempton feels, Petrobakken accepts that painful fact and accounts for it accordingly. With its early Bakken gushers declining by 75% after one year, he calculates, Petrobakken is now recording depletion expenses that exceed half of the company’s total revenue. 

At some point, Hempton says, NOG will have to take its medicine as well. Compared to Petrobakken, he says, NOG has taken only minor depletion charges so far.

“Northern Oil, operating in very similar fields, has taken depletion charges as low as 10% of revenue,” Hempton says. “If you underestimate the depletion rate, you get a humongous – but unsustainable – growth in earnings. 

“You have profits that go through the roof,” he adds, “before they go through the floor.”

Math Test

By now, NOG bears have already taken a close look at those in charge of the company’s books. They have uncovered potential weaknesses – in the company’s CFO, its outside auditor, even its boardroom audit chair – every step of the way.

NOG appointed a new CFO early last year, records show, promoting former Vice President of Operations Chad Winter to that important post despite his apparent lack of credentials for the job. Winter has never registered as a certified public accountant in NOG’s home state of Minnesota, records indicate, and (unlike the company’s other leaders) has in fact never even reported that he holds a college degree. Even so, filings show, Winter fills three key positions at NOG – CFO, principal financial officer and principal accounting officer – that are regularly assumed by CPAs, with established records of experience and training, at other companies.

Winter has already scored generous rewards for his service to NOG, records indicate, picking up 250,000 shares of stocks – worth more than $7 million at current prices – the very month that he assumed control over the company’s finances. He cashed in $900,000 worth of NOG stock less than two weeks ago, records show, when he joined the company’s top executives in a rampant insider-selling spree.

Meanwhile, records show, NOG relies on a modest auditing firm in faraway Utah to double-check its numbers. Early on, corporate filings show, NOG retained tiny Mantyla McReynoldsa tarnished firm focused on the microcap arena -- and never upgraded its auditor despite the company’s dramatic change in status. 

Notably, records show, the Public Company Accounting Oversight Board has flagged Mantyla for weak oversight in the past. In fact, those records show, the PCAOB specifically cited Mantyla for its failure to adequately “test the completeness and valuation of revenues” – the very metric that looks most impressive at NOG – following a detailed review of its work.

For its part, Mantyla notes that it received a clean review following its most recent PCAOB inspection. Moreover, Mantyla says that review specifically examined audits for its largest client and found no deficiencies in the firm’s work. Mantyla refused to identify any of its clients by name, however, or even the number of clients that have risen above risky penny-stock status.

If news records serve as any guide, though, Mantyla counts NOG and Voyager Oil & Gas (AMEX: VOG) – a younger Bakken play led by the brother of NOG’s own chief – as its biggest clients by far. With market caps of $1.72 billion and $228 million respectively, NOG and VOG stand out like powerful giants in a crowd of weak toddlers. Compared to NOG and VOG, records indicate, Mantyla’s other clients – penny-stock companies with market values ranging from $58 million at the high end down to less than $1 million at the low – look almost worthless if in fact they still exist at all. 

Musical Chairs

Moreover, records indicate, NOG has held onto another tainted number cruncher as well. For years, records suggest, NOG has paid a jobless CFO – replaced twice in a matter of months -- to chair its internal audit committee. 

Shortly after it went public, records show, NOG proudly appointed Lisa Meier – the CFO of Flotek Industries (NYSE: FTK) at the time – to serve as a member of its board and as chair of its audit committee. Back then, records show, NOG proclaimed that Meier had proven “instrumental” in Flotek’s acquisition-fueled growth and the company’s capital-raising activities. Flotek’s stock was a $40 highflier at that point, records show, and would go on to hit a record $55 just one month later.

But Flotek soon reversed course and began to dive on a series of profit misses, Reuters later noted, with the company announcing that Meier had resigned “to pursue other interests” less than a year after the company’s stock hit its all-time peak. Flotek had fallen below $17 by the time that Meier departed from the company in August of 2008, records show, and ultimately bottomed out in late 2009 below $1 a share. While Flotek has since bounced back to $6.89 a share, records show, it has never fully recovered from that devastating hit.

Meanwhile, records show, Meier landed a new job the week after leaving Flotek to pursue other opportunities. She became CFO of Platinum Energy Resources (OTC: PGRI.PK), records show, a company that had seen its stock fall by almost half to roughly $4 a share in the year leading up to her arrival. Meier lasted less than three months on that particular job, records show, with PGRI plunging to $1.25 a share during her brief tenure at the company. PGRI spent the next two years stuck below the $1 mark, records show, and still fetches just $1.35 in thin trading on the lowly Pink Sheets despite a recent bounce.

If Meier ever secured another job after that, her bio shows, she never bothered to report it. For its part, NOG simply states that Meier “was appointed Chief Financial Officer and Treasurer of Platinum Energy Resources Inc. in August 2008” – almost suggesting that she still works there – even though she spent just a few months at that company, leaving more than two full years ago, and offers no further updates to her career.

Thanks to her well-paying gig at NOG, records indicate, Meier may not even need a full-time job at this point. As chair of both the audit and the compensation committees at NOG, records show, Meier picked up almost $250,000 worth of stock – a sum roughly equivalent to her base salary at Flotek – for her 2009 service to the company. 

By then, records show, Meier was already sitting on a pile of cheap stock options (priced at $5.18 a share) that could eclipse the compensation she had already received. By cashing in less than one-quarter of those options and selling additional shares, records indicate, Meier added another $400,000 to her bank account in August of last year. With NOG racing toward an all-time high, records show, Meier then scored another $340,000 this month – dumping a chunk of stock just days before it peaked – as she joined company executives in a massive insider-selling spree.

Meanwhile, records indicate, Meier still holds most of her cheap options. By exercising those at current prices to supplement her earlier gains, records indicate, Meier would have enough money to retire as a multimillionaire before she even turns 40 years old.

Sticker Shock

For now, analysts who follow NOG seem as enchanted by the company as ever. They continue to unanimously recommend buying the stock, responding to the recent surge by simply raising their price targets to levels as high as $40 a share. At that point, NOG would see its market cap – which hovered around $100 million just a couple of years ago – approach $2.5 billion and basically turn the 11-person company into a multibillion-dollar corporation. 

Earlier this month, however, ValuEngine computer models – immune to the contagious enthusiasm that can infect human crowds – flagged NOG as a potentially overpriced stock that could prove vulnerable to a significant correction. With NOG resting above $32.50 a share, ValuEngine issued a hold recommendation on the stock and pegged its real value a full $10 below that price.

“This makes NOG 44.68% overvalued,” it emphasized in a new report published just two days after the company announced its latest financial results. “Fair value indicates what we believe the stock should be trading at today, if the stock market were perfectly efficient and everything traded at its true worth.”

That analysis, which incorporates both traditional measurement tools and computerized price-reversal forecasts, actually excludes one of the most relevant yardsticks in the industry. Back in mid-2008, Barron’s portrayed NOG as overpriced when its $317 million market cap essentially valued its assets at $4,592 an acre. At the time, Barron’s calculated, a major Bakken player had recently paid a maximum of $1,500 per acre for similar undeveloped property that – if applied to just 50% of NOG’s own Bakken assets – would drag the company’s market value down toward $200 million instead. NOG’s market cap actually plummeted to about half that level the following year, records show, but staged a comeback so powerful that its former per-acre valuation now looks downright cheap.

NOG’s current $1.72 billion market cap suggests that its Bakken property, purchased by the company itself for an estimated $40 per acre (initially) to $1,100 per acre (now), is valued by investors at a hefty $11,500 per acre instead. To put that number into perspective, based on figures supplied by the company itself, NOG’s market cap pegs the value of its Bakken acreage above the top-dollar prices paid by actual drillers for majority stakes in lucrative projects throughout that energy-rich region.

“Certainly, we’ve seen some (deals) out there for $7,000, $8,000, $10,000 an acre,” CEO Michael Reger stated during the company’s third-quarter conference call last November. “We’re just not paying that.

“We’re paying a small fraction of that for these non-operated interests, and the only knock on them is they’re non-operated … So we’re buying the best stuff, in many cases, for 15 cents to 20 cents on the dollar.”

Mixed Messages

But NOG’s market cap clearly indicates that investors are paying a rich premium for those very same assets. If investors instead valued that property at $7,000 an acre – a price far beyond any that NOG itself would be willing to pay – the company’s market value would drop by roughly 40% and leave its stock hovering around $17 a share.

Even some long-term energy bulls, willing to gamble on small players with the potential for big upside, have shied away from NOG after working through the math.

“I actually like the company’s business model, but I can’t justify its valuation,” says one energy expert with an impressive record of picking future winners in the sector. “When you buy it, you’re paying a big multiple for that acreage …

“And you’re not buying anything special. You might as well just buy Whiting Petroleum (NYSE: WLL) or Continental Resources (NYSE: CLR) instead.”

Besides EOG Resources (NYSE: EOG) – formerly known as Enron Oil & Gas before massive fraud forever ruined the Enron name – Whiting and Continental ranked as last year’s top oil producers in North Dakota, the Rocky Mountain Oil Journal reported, the most fertile region of the Bakken shale and the fourth-largest oil producer (trailing only Texas, Alaska and California) in the entire country. NOG itself appears nowhere on that list, although the company’s status as a non-operator (serving as a minority partner to those three heavyweights) offers a reasonable explanation for its absence from that group. With NOG pegging its own production at roughly 900,000 barrels of oil equivalent (BOE) last year, however, the company would have ranked below 20 other producers if it had been included on that list.

Whiting produced 15.4 times as much oil in North Dakota last year (and millions of additional barrels elsewhere), records show, but the company’s market cap is just 4.52 times the size of NOG’s own. If the market valued NOG in a similar fashion (while generously ignoring Whiting’s production outside North Dakota), records indicate, NOG would see its stock plunge by 70% to just $8.30 a share. Even if the market used Continental in that formula instead (which yields a somewhat smaller disparity), records show, NOG would trade at just half its current price.

Hempton spotted NOG as an attractive “short” candidate, promising gains on a decline in the stock, all the way from the opposite end of the globe. As a rule, Hempton normally focuses on small-cap companies when searching for overpriced stocks that look vulnerable to a fall. In this case, however, Hempton discovered NOG in his hunt – despite its giant market cap – because of its lingering resemblance to many overhyped names in the penny-stock arena. 

“It started out as a reverse-merger promote,” Hempton notes, offering a stark reminder of NOG’s roots in a microcap world best known for its rampant “pump-and-dump” schemes. “It turned out to be a successful one. They bought real acreage, so they’re not going bust.

“The bull story is real. But the promote is real as well. And in the end,” he concludes, “I just can’t make the depletion numbers work.”

* Important Disclosure: Prior to the publication of this article, TheStreetSweeper (through its members) has effected a “short sale” of 50,000 shares of the stock of NOG beginning on March 17, 2011, at an average price of $28.7536 a share, with the intent of profiting from decreases in the price of the stock. It increased its short position to 53,000 shares, at an average price of $28.7889 a share, on March 21. TheStreetSweeper covered 20,000 shares of its short position at $28.64 on March 22; it covered the remaining 33,000 shares at $26.435 on March 23. TheStreetSweeper may choose to take additional positions in the stock going forward and will fully disclose the details of those trades if and when they occur.

Update: TheStreetSweeper began establishing a new short position in NOG on April 22. It has sold a total of 13,471 shares of NOG short, at an average price of $24.60 a share, since that time. It covered that position at $23.5025 a share. 

New Update: TheStreetSweeper established another new short position in NOG on May 9, when it sold a total of 38,500 shares short at $21.23 a share. It covered 18,900 shares at $20.25 a share on May 12 and the remaining 19,600 shares at $19.95 on May 16. TheStreetSweeper may choose to establish a new short position in NOG and will fully disclose the details of that investment if and when it occurs.

New Update: TheStreetSweeper began establishing a new short position in NOG on Aug. 30, when it sold 2,000 shares of the company's stock short at $20.90 a share. It covered that position on Sept. 2 at $19.22 a share. TheStreetSweeper sold 3,000 shares of NOG stock short on Sept. 8 at $20.35 a share and then covered that position by repurchasing the stock on Sept. 9 at $19.21 a share. It established a new short position in NOG on Sept. 13, when it sold 2,000 shares of the company's stock short at $20.74 a share. TheStreetSweeper may choose to adjust the size of this position going forward and will fully disclose the details of any future transactions as they occur. 

New Update: TheStreetSweeper established a new short position in NOG on Dec. 26, when it sold 4,000 shares of the company's stock short at $24.40 a share. It covered that position on Dec. 27 at $23.89 a share. It then established another short position in NOG on Jan. 3, selling 8,100 shares at $24.86 a share. It shorted an additional 4,500 shares on Jan. 4 at $25.33 a share and has now sold a total of 12,600 shares of NOG short at an average price of $25.03 a share. TheStreetSweeper covered 4,500 of those shares on Jan. 5 at $24.81 a share, reducing its short position to 8,100 shares at this time. It covered the remaining 8,100 shares on Jan. 6 at $24.79 and no long has a position in the stock.

* New Update: TheStreetSweeper established a new short position in NOG on Jan. 10, when it sold 6,400 shares of the company's stock short at $25.39 a share. It covered all 6,400 shares on Jan. 12 at $24.58 a share and no longer has a position in the stock at this time.

As a matter of policy, Melissa Davis – the editor of this website and the author of this story – will never take a financial position (short or long) in any of the stocks that she covers. To contact Ms. Davis, please send an email to editor@thestreetsweeper.org. 

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