Kodiak Oil & Gas Corp (USA) (KOG), Continental Resources, Inc. (CLR): Want to Invest in Oil? Know What You are Buying

I had a conversation with a friend recently about investing in oil. It went a little something like this.

Friend: “I’m thinking about investing in oil.”

Me: “OK, what kind of oil company?”

Friend: “Well, domestic prices are increasing and takeaway capacity is improving across the country, so I think it’s a good time to be in the exploration and production space.”

Me: “OK, what kind of exploration and production company?”

Friend: “Huh?”

Just as there are different parts of the entire oil industry, there are several different types of exploration and production companies, and the distinctions go much further than just market cap. Let’s take a look at the different types of exploration and production companies so you can determine what is best for your portfolio.

Source: Chesapeake Energy media relations.

For the inner wildcatter in all of us
The shale boom in the United States has created a new gold-rush type attitude for many domestic players. As we learn more about the potential of shale resources, we are finding that some regions are more geared for rapid growth. Two of the most prominent players that have exemplified this movement are Kodiak Oil & Gas Corp (USA) (NYSE:KOG) and Continental Resources, Inc. (NYSE:CLR). Both have made their mark as companies that have worked almost exclusively in the Bakken formation in the U.S., and their early entry has translated into rapid growth.

Source: Continental Resources and Kodiak Oil & Gas 10-K filings; author’s calculations.

In the case of these kinds of investments, growth is the name of the game. So don’t expect a dividend anytime soon. Both of these companies put just about every available dollar from working capital back into the business, and are normally dipping into the debt markets to cover expenses as well. One of the issues with regions like the Bakken is that the decline rates after initial production are very high, so a company needs to constantly drill more wells just to maintain existing production. This sprint style of growth can reap big rewards for investors, but if these types of companies start to miss targets, then things could get ugly.

Growth with a side of predictability
One of the big misnomers in today’s E&P space is that every company should be enjoying big gains in production. The reality, though, is that the strategy to drill isn’t the best strategy for every oil play out there. Fortunately for investors, there are some investments that come with a slightly lower chance of an ulcer. Both Occidental Petroleum Corporation (NYSE:OXY) and Denbury Resources Inc. (NYSE:DNR) provide more certainty than faster-growing peers but for two totally different reasons.

In the case of Occidental Petroleum Corporation (NYSE:OXY), 68% of its oil comes from California, the Permian Basin in Texas, and Qatar. These assets have much slower decline rates than most shale plays, which means that Occidental can spend less to maintain production levels. This, in turn, leads to cash that is given back to shareholders through Occidental’s attractive dividend yield of 2.9%.

While Denbury Resources Inc. (NYSE:DNR) may not have a dividend, its unique business model provides a level of predictability that is extremely uncommon in the oil and gas space. The company focuses on enhanced oil recovery through CO2 flooding of wells that have outlived their use from traditional oil extraction methods. This translates to less capital for new acreage and less to bring a well up to production. Also, since the company’s production is dictated more by CO2 supply than anything else, it is able to roughly predict its production levels for years down the road.

Source: Denbury Resources investor presentation.

Dividend hunters
Right now, Denbury Resources Inc. (NYSE:DNR)’s business model generates a load of free cash flow, and the company is investigating ways to return that excess cash to shareholders. On its recent conference call, management announced it was considering a conversion to a master limited partnership, which should make dividend-hungry investors salivate. In may ways, Denbury shares similar traits with other exploration and production MLPs like BreitBurn Energy Partners L.P. (NASDAQ:BBEP) and Linn Energy LLC (NASDAQ:LINE). What makes this route so attractive for investors is that these two companies have dividend yields of 10.9% and 12.5%, respectively.

Being a successful E&P MLP is a challenging route because it attempts to bring together two diametrically opposed forces. It needs to have steady cash flows to support a high-yielding distribution while operating in a capital-intensive environment with high commodity risk. To make these opposites attract, MLPs do two things: They focus on developed, mature, long-life wells that will generate cash for several years and hedge their oil and gas production to lock in prices. That hedging strategy can backfire, though, as Linn is currently under an informal investigation from the SEC regarding its hedging strategy.

What a Fool believes
The investment options in the E&P business are just as diverse as the entire energy space, and each one can serve a purpose in an investor’s portfolio. The one thing that shouldn’t change, though, is your approach to investing: Focus on the long term and do your homework. These tactics will help you be successful no matter what industry you choose.

The article Want to Invest in Oil? Know What You are Buying originally appeared on Fool.com and is written by Tyler Crowe.

Fool contributor Tyler Crowe owns shares of Linn Energy. You can follow him at Fool.com under the handle TMFDirtyBird, on Google +, or on Twitter @TylerCroweFool.The Motley Fool recommends BreitBurn Energy Partners and owns shares of Denbury Resources. 

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