The Unavoidable Risk in Resource Investing

The spot price of oil has pulled back to the $100.00-per-barrel mark, but oil stocks are holding up extremely well and the price strength is almost across the board, from related services to the big integrated producers. 

Earnings expectations for many within the oil group have been going up for this year and next, while valuations, even among fast-growing producers, aren’t generally overdone. Earnings have caught up to share prices over the last couple of quarters. 

Not every investor wants to be in oil. But for those who do, the sector can be a key component of an equity portfolio. There’s a lot of income and capital gain potential with related businesses and plenty of options on how to play the industry. 

One junior energy producer we’ve been looking at in these pages since early 2013 is Kodiak Oil & Gas Corp. (KOG). This is a highly liquid Bakken oil play and institutional favorite. The company reports after the market closes this Thursday; its news is material for oil and gas speculators. 

Kodiak has a very good track record of generating significant production and financial growth. In the fourth quarter of 2013, the company’s oil and gas sales soared to $266.5 million, representing a comparable gain of 104% over the fourth quarter of 2012. 

Average production of barrels of oil equivalent per day (boepd) grew to 36,100 in the fourth quarter of 2013, basically doubling the average boepd in the comparable quarter. 

Kodiak’s total oil and gas sales in all of 2013 were $905 million for a gain of 121% over 2012. Earnings growth was less robust, as the company is investing a tremendous amount in new production. The bottom line in 2013 was $141 million, or $0.53 per diluted share, compared to $132 million, or $0.49 per diluted share, in 2012. 

Being a highly liquid Bakken oil play, institutional investors have been all over this story, and for a number of quarters, the position was very highly valued. 

But the company’s earnings have caught up to the price and it’s more reasonably valued now. This is still a growth story; however, the rate of growth is slowing. Wall Street consensus on total sales growth is around 40% for this year and 20% for 2015. 

The one thing we know about resource investing is that no matter how good a growth story is, stock prices still move commensurate with spot prices. This is unavoidable and a very big investment risk in itself. (See “Despite Consolidation in Oil Sector, These Junior Oil & Gas Stocks Have Momentum.”) 

Because there is so much institutional investor participation in the fastest-growing junior energy producers, these stocks are typically priced for perfection. If Kodiak doesn’t have a good first quarter, investors will jump ship. 

One trend we’ve seen in oil services recently is good financial results, mostly due to growth in international markets, particularly Asia and the Middle East. Domestic activity is about flat with last year. 

In capital markets, $100.00 for West Texas Intermediate (WTI) crude is a psychological barrier. Below it, even fast-growing stories like Kodiak are vulnerable. 

This article The Unavoidable Risk in Resource Investing was originally posted at Profit Confidential