Oil and Gas Investor Executive Q&A: Northern Marches South

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[Editor's note: A version of this story appears in the May 2021 issue of Oil and Gas Investor magazine. Subscribe to the magazine here.]

Nick O’Grady, the CEO of Northern Oil and Gas Inc., offers an illustration of the promising M&A market with a story of a recent deal derailed by blackmail.

After performing various studies on an asset, Northern was set to make a deal. But the other party had been waylaid by internet bandits, causing the transaction to fall apart. “The reason I can laugh about it is we’re not short opportunities if we want to buy stuff,” O’Grady said. “There’s a lot for sale.” For most of O’Grady’s tenure as CEO— previously he served as CFO—Northern’s targets have inhabited the Williston Basin. However, the company seeks nonoperated, minority working and mineral interests in oil and gas properties, tacking together 700 net well locations in the Bakken Shale. The business model echoes, to some extent, the mineral and royalty space.

The company made two large leaps outside of the Williston Basin in the past 12 months.

In September, the company made its first move in a deal to buy a small amount of acreage in the Permian Basin. It has since quietly made at least seven additional transactions in the basin, adding more than 245,000 net acres across three basins to its portfolio.

In April, Northern closed on its purchase of a large swath of nonoperated interest in Appalachia natural gas assets from Reliance Marcellus LLC in a $250 million deal, including $126.4 million in cash. The deal added 200 net Marcellus Shale locations to the company’s portfolio.

Matching his company’s atypical asset strategy, O’Grady entered the oil and gas industry through an unusual route. He began his career in natural resources at the Bank of America, spent time at hedge funds such as Highbridge Capital Management LLC and, before joining Northern, worked at Hudson Bay Capital Management in an energy-centric role in equities, public and private credit and direct investments.

Based in Minnetonka, Minn., and powered by just 25 employees, Northern aims to be the go-to resource for operators that want to offload working interests in leasehold they can’t work.

Investor: How have your fared through the pandemic?

O’Grady: We came into 2020 pretty locked and loaded. We are worriers by nature, and so that brought us more prepared than many, but there still was a period there probably in the middle of the year that was quite frightening, where you were just thinking, I simply don’t know how long this is going to last.”

We always were financially prepared to grind through the next few years, but there was a point, I’d have to admit, where I just thought to myself the oil and gas business doesn’t work at sub-$40 oil by and large for the United States. We could sit here and collect hedge payments and make money, but how do we reinvest our dollars?

The good news was that when you really thought about it, that doesn’t really work for anybody, OPEC included. I’d be the first to admit that I’ve been surprised at how fast the recovery has taken place. I think the vaccine was clearly the first step. But I’ve been surprised how fast and how resilient demand has come back.

Investor: You seem to have a knack for making gold out of lead.

O’Grady: You know, life gives you lemons, you make lemonade.

Like any other company we knew we were going to face headwinds in some places as the pandemic took hold. You just have to keep your head down and say, “There’s going to be some opportunity out of all this. And let’s focus on that.” Not sitting there, flailing and complaining about where the oil markets are. We can’t control that. What we can control is making sound decisions.

We came up short last year, in the sense that I think we really wanted to see if we could get something big at those depressed prices. But we did a lot of small stuff. And it’s paying off now. Would I have loved to land something really big last year at $35 oil prices? Yeah, sure. Because you’d look really smart right now. But smart people don’t want to sell their big assets at $35 oil.

Investor: It’s interesting to hear you express disappointment, because you had a good year—especially compared to a lot of companies in this sector.

O’Grady: You’ve got to stay humble, stay hungry and be your own worst critic. It’s the only way you’re going to not do something stupid eventually.

Investor: Talk about your Reliance deal and entry into Marcellus. How did that get kicked off, and how did you say, “We’re going to go for this?”

O’Grady: Well the good news is it was for sale. That’s the hardest part about dealmaking, in my opinion, the social issues. You can always come up with a value, but you have to have someone who is motivated to sell it. Like most people selling homes think their home is worth more than what the market thinks. But when you put it up for sale and it’s effectively an auction, it is worth what it clears.

We were late to the process. They had started a very quiet marketing process for those assets and gone to usual suspects they thought would be interested, including the operator. Bank of America, which is an advisor of ours, had been really trying to find unique opportunities and said they had heard whispers that this might be happening.

“Maybe we can get you invited in.” And so they made a few phone calls, and the Reliance CEO said, “Well, that’s interesting. I wouldn’t think Northern would want this.”

And he asked to talk to us, and we talked for about an hour. We told Reliance what we were all about. And he said, “Why don’t we invite you to this process? The bad news is you have about two and a half weeks to come up with a decision.” It was definitely not a place that we had spent a ton of time on prior, which made the timing more challenging than usual. Like I have said, we are economic creatures, but we had not spent a ton of time thinking this is a major area of focus.

But when we sat down with Bank of America and started crunching numbers and trying to determine what we really thought that the clearing price would look like. If we could get it done at certain valuation levels, it would compete with anything in our portfolio. My team was at first a little reluctant understandably, but we all went from pretty skeptical to pretty excited.

Investor: How did the deal progress?

O’Grady: We weren’t sure if we were going to be competitive. Bids were really dovetailing at a time of lows in the space—the stocks, oil, were all getting killed. And we were looking at this and saying to ourselves that we’ve got to be pretty tight on how we bid the process.

I don’t think we were the high bid by some amount, but the ability to close—to have access to public capital—they understood that we could actually do it whereas some competing bids were unfunded private equity commitments and such.

It was probably the hardest process we’ve been involved in. It’s not the largest transaction we’ve ever done. But it is very complex in terms of structure. It is an undivided interest across the entire property. So as opposed to most places, we operate where we own our own leasehold within a unit. This is a percentage ownership across a huge swath of acreage that Chevron [Corp.] had controlled.

Investor: Were you specifically looking to go into natural gas?

O’Grady: No, no. I don’t want to say we’re basin agnostic because you want to go to somewhere where there are levels of activity. That’s how you’re going to look smart when you’re buying undeveloped land, you want to make sure that there will be consistent future activity. 

We’ve been 80% oil for the life of the business and certainly since I’ve been here. We had another avenue that could depend on a fuel that’s not tethered to liquid hydrocarbons. In that respect, we see it as just another arrow in the quiver that we can allocate capital if the market so decides.

Investor: You also made a new entry in the Permian Basin. Could you speak about the rationale to push into the basin?

O’Grady: I got here in June of 2018, and they were already pulling up well reports and data and running type curves and looking at various analyses. It was pretty obvious right away what the wellhead returns were. It’s a very good play. So there’s a reason there are 180 rigs working there today. It’s long inventory, great productivity, though there’s a lot of variability, and I think that’s sometimes not fully understood.

What we found was even in early 2019 and late 2018 that the embedded acreage value that the assets were selling for meant for the actual returns were zero or pretty close to it.

So you had a 100% return at the wellhead. When you looked at what you had to pay to enter, it was zero. Now it wouldn’t have been zero forever because what companies were paying for is the future inventory, which would have eventually driven a return, but that was dependent on high levels of activity.

Investor: Hence the reluctance.

O’Grady: We want to make money, not drill holes on the ground and produce more. Underwriting based on the assumption of consistently growing activity is a dangerous thing. And so we found ourselves wholly uncompetitive, to be candid. Whereas in the Bakken we felt like if a Permian well was even a slightly better return, apples to apples, when you factored in the entry cost the Bakken was a better place for our money.

In the core of the core and in both places, they’re pretty equal at the wellhead, to be honest. So we kept watching, we kept communicating with a lot of the operators who were selling nonoperated interests. We talked to many nonoperated owners directly about potentially partnering, but we were never really going to get there on price.

Investor: What changed?

O’Grady: Well, flash forward to the pandemic. You have a flushing of two-thirds of the activity in the basin, and suddenly those entry costs really matter because whatever development you underwrote might be, even in a recovery, pushed out to three years. And some of the activity may never come back to the levels that it was.

Suddenly we found ourselves going from being uncompetitive to competitive. But as we talked about it with the board of directors, their view was there were two paths: go buy a big package, and get a bunch of inventory and some producing wells in hand and start there and build up on it that way.

Or do it more surgically and buy 50 acres at a time to build confidence, build that data, commit small amounts of capital and then build from there.

“My team spends time looking at these assets and really trying to predict the future and doing it in a way in which there are more things that can go right then can go wrong for us.

A mentor of mine once told me, “Don’t turn a small mistake into a big one.” By doing it piece by piece, you’re watching and making sure that you’re doing it correctly.

Investor: What about future Permian deals?

O’Grady: I think we’re ready to take that bigger plunge, and I think with healthy prices people are more willing sellers. I don’t think we’ll be doing just pure ground game forever in the Permian. But there is an advantage also to doing the small-scale acquisition. You can focus on quality in any package you buy. There’s going to be a portion of any package deal, no matter what, that’s going to be relatively uneconomic.

The hard part is, is building scale. We announced the first acquisition in September. We rarely announce a deal that small. But that’s not what it was really for. It was to basically plant our flag in the ground to the people that we’ve been conversing with and saying, “We’re here, and now we’re doing it.” I think we’ve done eight plus transactions now. In the Williston, we continue to pick away, but I think in the Permian just the overall levels of activity are so high. It’s going to become a natural growth vehicle.

Investor: Are there other areas that are outliers that are interesting to you?

O’Grady: There are some spots in the Eagle Ford in the core, assuming it’s not too drilled up. But we really like to have assets that are self-funding that have producing properties and lots of life left in them. There are still some good parts of the Eagle Ford. The Haynesville is not really a geologic risk, but it has really high-volume producing wells with eventual, super steep declines. So you really need to know what you’re doing. But we have seen some Haynesville packages that have been interesting. I don’t think we’ve come close to transacting on them just yet.

The Bakken’s going to remain front and center for as long as we’re around. We have so much data.

The Permian is obviously an area that’s growing for us. The Marcellus, it remains to be seen as it’s so blocked up, but there are some large nonoperated businesses in the Marcellus. I don’t think there’s going to be the same level of day to day ground game. You don’t see a lot of little pieces of leasehold coming up for sale like we do on some of the other basins.

Investor: Just a couple of years ago we saw IPOs in mineral and royalty space. Is it possible for Northern to be a template for other companies that could go public?

O’Grady: Using the mineral space as an example, as we do have some mineral joint ventures, it is very similar to the working-interest business. But what I will tell you is that the mineral business is very, very competitive. There are a lot of privately funded companies chasing it. As a former banker and investor, I can tell you the mineral business generally on a return basis is significantly lower than the working-interest business. It’s also lower risk, but there’s probably a thousand basis points delta between the return profiles.

“We announced the first [Permian Basin] acquisition in September. We rarely announce a deal that small. But that’s not what it was really for. It was to basically plant our flag in the ground to the people that we’ve been conversing with and saying, ‘We’re here, and now we’re doing it.’”

Some of that is to offset the higher risk, and some of it is just that there are a lot more dollars chasing minerals than there are in the working-interest business. But the question is why? The answer is that those companies went public at huge valuations because they’ve become yieldcos. So like any smart enterprising private equity firm, it has nothing to do with profitability. They go and buy a bunch of minerals, package them up and flip them to the public markets at a large valuation, and you look really smart. It’s no different than the Permian a few years back.

When I look at them analytically, most are paying out almost the entirety of their cash flows in distributions. How they reinvest and replace their inventory may be entirely dependent on the public markets and the fungibility of the equity. So the question would be, do I think that other working interest business could go public? The answer is probably not. It’s hard to build scale in the business. Even as a 55,000 boe a day company now, we’re small relative to other publics. There are very few small public companies left. Most of them either gone bankrupt, merged, been taken out or liquidated.

Investor: There’s already hesitancy to invest in oil and gas companies. Is that part of the equation?

O’Grady: I think going public in this market is going to be tough. You’re going to have to sit there and say, would I spend all this money to take this huge discount and go public when I could just sell to somebody else for a better price? Is there even a market for a small cap to go public? That’s where we really come in, which is that we’re the largest public company that’s exclusive to nonoperated assets. We view ourselves as a consolidator, and we can be a good partner much like a real estate investment trust gobbles up buildings from smaller competitors. I think we can provide upside in the form of public currency and save a lot of time and effort. It doesn’t mean there won’t ever be copycats, but I think it would be pretty tough sledding in today’s market.

Investor: Following your deals in the Marcellus and Permian, an analyst wrote about Northern’s “Golden Age” of nonoperated. Do you feel it’s the golden age?

O’Grady: I need to specify that is a quote taken from me written by [chief strategy officer] Mike Kelly. I read it aloud, kind of like Ron Burgundy in Anchorman where he’ll read anything on the teleprompter and then paused afterward. And I looked at Mike and said, “What did you just make me say? And then the next day it was in several of the headlines.” It was pretty funny, but we were just so swamped at the time getting ready to sign the deal. He slipped one by me.

But yes, I do think it’s a golden age for our business. We face limited competition and unmatched scale that drives our cost structure lower. Capital markets are tight for private institutions, and most nonoperated capital is in private hands. There is more limited access to cheap bank debt now. And so it puts a natural governor on new money going into private equity. A lot of it is now chasing renewables and ESG and all that sort of stuff where they can still raise fresh capital. On the public side, the average operator, about 10% to 20% of their capital is not operated. It is interests they own in other people’s wells.

They want to spend their money drilling their own wells to the extent that they can raise funding from us as we purchase that acreage and take over those capital obligations. It’s a big deal for them because they want to spend their money on the things they control.

This is our specialty. We’ve been able to be a really good partner. A lot of name brand public companies come to us all the time, and we buy 50 acres at a time, sometimes bigger packages. But for us, that really is our bread and butter because in the areas we’re in we can give you an answer in 24 hours because we have all the data and often times are already involved in the units. So that surety of close is really important.

Investor: We’ve talked already about your data capabilities. What are the top factors that you look at when you’re deciding on acreage?

O’Grady: Let’s use the Williston as an example, because it’s our largest asset. We have 350- plus type curves by area, by unit, by formation and by operator. There are lies, damn lies and statistics, as they say. So, you can go into an area and pull up on Enverus a bunch of well results and draw a conclusion pretty quickly and say, “This area, look at all these wells and these are XYZ EUR, and I bet they’re going to cost XYZ.” And what I’d tell you is that when you look at that data, you can in fact only see the production rates on these wells.

You don’t see actual well costs, and you don’t always appreciate the delta necessarily between operators and their cost and midstream structures.

You’d be shocked to see that two operators and units immediately adjacent to each other will have sometimes 50% differences in returns on their wells. For some of them, it’s because they’re poor cost sourcers. We have some operators that are incredibly efficient drilling the exact same type of well for millions of dollars less. And that has a huge impact on the returns. Others have poor midstream contracts.

Investor:Your data gives you a more precise picture?

O’Grady: Right. That’s one of the reasons we’ve been very careful and operator-centric as we’ve been picking away in the Permian Basin. It’s one of the reasons in the Marcellus, we were so excited about EQT [Corp.], because we had enough data to know that they were an extraordinarily efficient operator, particularly compared to the prior owner of the assets we were acquiring.

We had underwritten it based on the prior owner running the asset forever. Our engineers sat there and started going line by line versus what we were expecting. It was savings across the board: longer laterals, EQT widened the spacing on the wells to ensure that they there’s no communication and lower drilling costs. All the things that we would hope to see. The other thing was that because it’s a joint venture, there are shared G&A costs, which were extremely high. EQT did not acquire the Chevron employees, and it dropped about 70% overnight.

Investor: What’s the balance between getting additional PDP or additional production and runway when you strike a deal?

O’Grady: As a nonoperator, it’s a little different question than it is for an operator. If you talk to operators in both the Permian and the Williston, then the thing that they’re always worried about is inventory. They always want to have more and more core inventory, and it gets blocked up because they need to buy a thousand acres at a time in order to develop it. So if you are a large operator and you want to drill a bunch of new wells, you need to find a thousand contiguous acres in an area you liked in order to prosecute a drilling program. We can buy 50 acres in any unit and be perfectly happy. We’ve been called the “dustbuster” and the “coyote” before. We are good with either term.

We much prefer to buy properties that have both runway and production. Generally speaking, I’d say we find ourselves the least competitive when, it’s one of those extremes or the other, if it’s just producing barrels or raw land.

It’s really the balance of those two that we have found is our sweet spot. If you look at most of the deals we’ve done, it’s generally been a self-funding deal that has some near-term development and a bunch of undeveloped over time that we try to pay as little as we can for.

Investor: It seems like every deal for you is like solving a Rubik’s cube.

O’Grady: The reality is most deals fail. We might have 10 processes going at any given time, and it’s still been, between doing major transactions, usually over a year before we’ve been able to close one.

Like I mentioned before, social issues are really important. What do they want? What are their motivations? Can you solve for their needs? Are they realistic to what the market will bear or not? We’ve had multiple processes in the Williston in which we bid on something and the seller told us no. They then put it up to auction, we’ve won the auction. They’ve said, no again. Then they’ve come back again later and said, “OK, we’re serious this time. We’re auctioning it again. We’ve won. And then they cancel it yet again. Why? Because it just doesn't meet their own view of what it’s worth. After a while you might just have to accept that this is reality. I think of Dan Aykroyd in “Trading Places” pawning his watch, where BB King tells him, “In Philadelphia, it’s worth 50 bucks.”

The one thing I’d add is the advantage of being public. For those not satisfied with their asset values, we can provide upside in the form of our equity as they contribute their assets, and assuming good execution, we hope our equity can provide yield as well. We did a small deal in the early fall at the lows with some stock. Obviously, we bought these properties well, in the downturn, but the seller won too, and their stock consideration has nearly tripled from the issue price.

My team spends time looking at these assets and really trying to predict the future and doing it in a way in which there are more things that can go right then can go wrong for us. That’s being a nonoperator because you are betting on that future. You really have to be very careful about what you pay for upfront, because it may not happen that way. As a nonop, we have greater control of spending, more options for redeploying capital, but timing is the one thing that’s the hardest to predict, and the thing that requires the most discipline in forecasting.