What Continental Resources Should Do Next

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Summary

Continental Resources (CLR) can churn profits and free cash flows while growing production in 2020, just as we’ve seen in the third quarter. The shale driller’s performance could get even better if the company meaningfully improves productivity of its oil-producing wells and realizes efficiency gains in the Bakken region. Additionally, successful debt reduction efforts can also have a positive impact on the company’s valuation.

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The price of the US benchmark WTI crude has been hovering close to the mid-$50s since the start of the third quarter, down from the April peak of more than $65 a barrel. The weakness can be attributed partly to the ongoing trade war between the US and China – two of the world’s largest economies – which has hurt the global economic outlook and crude oil demand’s prospects. Markets have also been weighing the possibility of further extension or deeper production cuts from the Organization of the Petroleum Exporting Countries and its allies in 2020. The ongoing cuts from OPEC+, a decline in drilling activity in the US and the subsequent deceleration in production growth and reduction in stockpiles are some of the key factors which have prevented oil from falling further. Beijing and Washington, however, could be getting closer to signing an initial trade deal, although it seems unlikely that the trade dispute will resolve anytime soon. The future of oil prices, therefore, is still looking uncertain and the commodity could continue trading within the $55 to $60 a barrel range.

Continental Resources, which gets most of its oil from the Bakken shale field in North Dakota and Montana, is a low-cost operator that can continue generating profits and free cash flows at $55 to $60 oil. This was evident from the company’s third-quarter results.

During the three months ended September, the WTI spot price averaged $56.37 per barrel. The commodity traded at a discount of more than $5 per barrel in the Bakken field. Continental Resources’ average sales price was $51.28 per barrel in Q3-2019, down from $65.78 a year earlier. The company’s total price for oil and gas in oil equivalent terms was $33.30 as opposed to $44.85 in Q3-2018. But the company received support from production growth which partly offset the impact of weak prices. Its total output climbed by 11.9% to 332,315 boe per day as oil production rose by 20.3% to 198,074 bpd. Around 58% of the company’s total production came from Bakken while the majority of the remainder came from Oklahoma’s SCOOP and STACK oil plays (called the South segment). Production increased by 14% in the Bakken to 191,268 boe per day, 27% in SCOOP to 80,115 boe per day, and fell slightly by 5% in STACK to 53,070 boe per day.

The weakness in prices pushed the company’s profits 40% lower to $0.54 per share. It still, however, generated robust levels of cash flows (ahead of working cap. changes) of $760.8 million. The company spent $681.5 million as capital expenditure, including $578.1 million in exploration and development drilling and completion. From this, we can see that Continental Resources generated enough cash flows to fully fund its capital expenditure. As a result, it ended the period with free cash flows of $79.3 million ($760.8Mn-$681.5Mn). The company’s cash exploration and development spending, taken from the cash flow statement, was $740.6 million. In these terms, the company had free cash flows of $20.2 million ($760.8Mn-$740.6Mn). Either way, the results show that Continental Resources is a low-cost operator that can deliver free cash flows in a weak oil price environment.

Continental Resources will likely post higher levels of production in the fourth quarter on a sequential basis which can have a positive impact on its earnings and cash flows. In the third quarter, Continental Resources completed a total of 137 wells (gross) in the Bakken and the South regions. That’s substantially higher than the 57 wells completed in the second and 79 in the first quarter. Continental Resources’ third-quarter production, however, remained relatively flat on a sequential basis, partly because the company brought a number of wells online at the end of the quarter. But it expected to place around 50 gross wells to production in late-3Q19 and early-4Q19 which will help push its total production higher.

In addition to this, Continental Resources will also benefit from the start-up of two major NGL pipelines in the coming months which should help push its realized prices for NGL higher. ONEOK (OKE)'s 240,000-bpd Elk Creek NGL Pipeline is expected to start-up in Q4-2019 followed by the 400,000-bpd Arbuckle II pipeline which will begin operations in Q1-2020. These lines will help ease the supply glut in the Bakken region and will give the shale drillers access to lucrative markets.

Continental Resources has shown that it can generate free cash flows while growing production at a double-digit pace in a sub-$60 a barrel oil price environment. The company hasn’t laid out its plans for next year but I expect it to continue delivering double-digit growth, profits, and free cash flows in the future. Continental Resources has budgeted capital expenditure of $2.6 billion for 2019 and I am not expecting an increase in spending in 2020. The company will likely exhibit capital discipline and operational efficiency by highlighting its ability to grow production with flat-to-declining levels of CapEx.

Continental Resources has substantially improved returns in the South region after it shifted to unit development mode. The oil-rich SpringBoard project in SCOOP has reported strong results due to operational efficiencies. In the third quarter, SpringBoard oil production exceeded the company’s target by 31%. Thanks to the drilling efficiencies, the company can now drill its forecasted oil volumes with fewer rigs. Continental Resources has reduced rig count in Oklahoma from 19 to 12 units while still targeting strong growth. The South region will likely get even better in 2020 and make a bigger contribution to the company’s production mix.

Although Continental Resources is looking good heading into 2020, there’s still room for improvement in two areas. Firstly, the company has successfully turned Bakken into a cash-generating asset after it started the multi-zone development program in 2017 but we haven’t seen any meaningful improvement in well productivity (measured in terms of average cumulative production per well in a year) in the last couple of years. The good thing is that the Bakken wells have delivered consistent returns as its drilling programs for 2017 and 2018 paid out in just around 12 months, and the company is expecting a similar performance from the ongoing drilling program for 2019. Continental Resources’ Bakken wells can generate reliable returns in the future as well. However, other exploration and production companies have been improving well productivity and can extract more oil with fewer capital dollars. To keep abreast with the rest of the industry, Continental Resources should deliver meaningful productivity and efficiency gains at Bakken.

Secondly, Continental Resources hasn’t been able to cut down its debt load in 2019. The company had $5.57 billion of total debt at the end of the third quarter and carries an above-average debt-to-equity ratio of 85%. Continental Resources set debt reduction as one of its primary long-term targets and expects to reduce net debt (debt minus cash) to $4.2 billion by 2023 from $5.49 billion at the end of last year. But this year, Continental Resources’ net debt increased slightly by around 1% to $5.54 billion. As indicated earlier, the company generated free cash flows this year but it used the excess cash to repurchase shares instead of repaying debt.

Continental Resources hasn’t told shareholders exactly how it intends to cut debt by more than $1 billion in the next few years. However, the company has ample breathing room since it is not facing any significant debt maturities in the near-term. Its earliest maturing debt relates to 5% senior notes of $1.1 billion due in 2022. The company will likely devise a clear debt reduction strategy which could primarily rely on free cash flows and present it to shareholders when it releases its 2020 plan in the first quarter of next year.

Shares of Continental Resources fell by 19% in the last six months, largely due to the weakness and volatility in oil prices. The drop was in-line with the performance of its peers (XOP) whose shares also tumbled by almost 20% in this period. In my view, the company’s shares could outperform next year if it continues to deliver double-digit production growth, free cash flows, and achieves meaningful efficiency gains in the Bakken and South regions. Successful debt reduction can also have a positive impact on the company’s valuation. The company’s shares are priced 5.24x on an EV/EBITDA (fwd) basis, lower than the large-cap peer average of 6.07x, as per data from Seeking Alpha Essential. Continental Resources is a relatively higher beta play than other oil producers who have a stronger balance sheet, but I think those investors who can stomach some risks should consider buying this stock.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.