On August 29th, 2014, shares of Whiting Petroleum traded at $92.92 per share. It was about a $15 billion company. Although it does not pay a dividend, it has an important distinguishing characteristic for an oil exploration and production company: the costs to produce a barrel of oil is the lowest in the industry compared to its peers of a similar size. Whiting pays $17.99 in production costs for each barrel of oil, and is profitable at the enterprise level as long as the price of oil remains above $36 per barrel.
Even though the price of this E&P has fallen quite a lot, it does remain profitable. If the price of oil remains around $45, Whiting Petroleum will make around $150 million in profit. Right now, the business finds itself with a low cash position (it had $699 million in cash on hand last year, and only has $28 million in cash on hand now). It is selling $1 billion in Oklahoma assets to build its cash position up to $700-$800 million to have more strength in the event that the price of oil remains in the $40 to $50 range for a long time.
The reason it catches my attention is because it has delivered 15% annual returns since its IPO (and the price of the stock shot up 80% before IPO investors had a chance to get a crack at it), and has delivered 22% annual returns for people that bought this company during the financial crisis. The small-cap and mid-cap E&P companies that survive deep declines in commodity prices have a very strong snapback effect when prices recover and the price of the stock tends to rise quickly and substantially in response.
John Paulson, who rose to fame during the mortgage crisis with his bet that mortgage-related securities would fall significantly in price, owns 8.7% of Whiting Petroleum. The price of the stock, which hit a low of $23 in December, has risen to $40 on speculation that it will be bought out in a takeover (Hess, Statoil, and ExxonMobil will be analyzing its specific assets and meeting with management next week to contemplate a takeover).
The reason why the bigger players are interested in Whiting is because it has 338 million barrels of oil in North Dakota (the Three Forks and Bakken Fields) as well as Texas that are being produced at that low cost of $17.99 per barrel. Many oil companies that are inefficiently run are not currently profitable at $45-$50 oil. Yes, the $150 million or so in current profits is much lower than the $300-$400 million that the company was making before the oil price declines.
By the way, this is slightly non-intuitive if you are new to studying oil companies, but the price of oil doubling from $50 to $100 does not mean that the oil company’s profits double. It’s a little trickier than that—when it costs $17.99 to produce a barrel of oil and then it gets sold for $50, the profit margin is 177%. If the price of oil goes to $100, the profit margin is 455%. It is more than a doubling because the price of production is fixed, and any gains flow directly to the bottom line.
The reason why you don’t always see this relationship play out clearly when studying the balance sheets of oil companies is because when oil prices rise the oil companies develop hard-to-reach oil that costs $40-$50 per barrel to produce (but those projects go dormant because it does not make economic sense to pay $50 to produce oil that will be sold for $45).
When I reach conclusions about Whiting Petroleum, I mean what I said in the headline. There is a 30% chance that it will get bought out and investors will earn a quick return on their investment. The other 70% is that the company continues as a standalone enterprise. If it does that, then the profile looks like this: If the price of oil recovers to $100+, investors will probably come closing to tripling their investment. If oil goes to $70-$90, investors will probably double their investment. The risk is that the price of oil will decline—if it goes down to the $30s and stays there for a few years, then it is unlikely that Whiting Petroleum could remain solvent. It would have to sell off a substantial amount of assets—and thus be weaker when a recovery happens—or someone like Exxon would buy it for scraps because Whiting’s current bargaining power would be lost with another 25% decline in oil prices.
In short, you are in deep trouble if the price of oil declines and stays there for an extended period of time (defined as thirty months or longer). However, if there is a recovery, someone owning Whiting will do quite well—blowing past the returns of what people get with Exxon and Chevron—if the price of oil shoots back to the $80-$120 range. It’s an intelligent speculation at this point. The North Dakota assets are especially nice, and the costs of producing each barrel are low. It’s just a matter of what the world is willing to pay for what Whiting Petroleum produces.