Following an energy paradigm shift stemming from the International Energy Agency's recent pronouncement that the U.S will become the world's largest oil producer within seven years, investors are scrambling to find firms that can capitalize on this surprising development. Much of the new production will be driven by a technique known as fracking, a means of drilling horizontally into rock that releases gas and oil at depths that were previously unattainable. Fracking involves pumping water, chemicals and sand at high pressures to break apart underground rock formations. Most people have heard of fracking, but how do you play it from an investment standpoint?
Continental Resources (CLR) is one such firm that has dedicated its operations to utilizing the fracking technique while capitalizing on the shale boom currently playing out in North America. The company has tied its fate to both the Anadarko Basin and Bakken regions, which have been imperative to accelerating the growth rate of US oil production. With the largest amount of land in the Bakken and a sizable and rapidly expanding position in the Anadarko Basin, Continental Resources represents possibly the best way to obtain exposure to the Bakken region.
Continental Resources' Position Within the Industry
A period of growth emerged in the American oil and gas production industry as producers took advantage of the shift to horizontal drilling to develop reserves that were previously unrecoverable. Crude oil began to develop a major spread between natural gas prices beginning in about 2006. Harold Hamm, Continental Resources' CEO, founder and chairman, believed that the valuations for crude oil would be superior to natural gas and shifted the company's resources to explore shale deposits that were more levered to crude oil production. The Bakken was a natural fit for Continental Resources since 86% of its overall revenue generation is derived from crude oil. Over time the company acquired more land in the region. Currently they are the largest leaseholder with over 1,119,218 acres under lease. Continental Resources' management is very bullish in the Bakken and believes that there are potentially over 24 BBoe recoverable. This estimate is well over what the United States Geological Survey reported in 2008, but that report's calculation may soon become outdated and face upward revision. Harold Hamm has made a living by being bullish on the Bakken while others have been far more skeptical about the possibilities. Even if his estimate turns out to be overly optimistic, the Bakken field is large enough to have ample growth opportunities for an extended period of time.
Continental Resources' management has an impressive record of production and proved reserves increases. In 2009, the firm's management set an ambitious roadmap of tripling reserves and production within five years. The guidance for increasing production and reserves by 2014 assumes growth of 30 to 35%. This ambitious target entailed significant capital expenditure increases. Capital expenditures have increased from approximately $434 million in 2009, $2.2 billion in 2011, $2.3 billion through the first three quarters of 2012, and are expected to total approximately $3 billion for fiscal 2012. The production increases from the capital expenditure increases have been impressive. Continental Resources produced 25,887 MBoe at the end of the third quarter 2012, up from 10,151 MBoe through the first three quarters of 2009, an increase in production of 36.6% annually. The proved reserve growth has also been strong. Crude oil proved reserves have grown from 257,293 MBoe in 2009 to 508,438M Boe in 2011, an increase of 40.6% annually. Not only is Continental on pace for achieving its target for 2014 production and proven reserve growth, they are actually ahead of schedule at the end of 2012. Never satisfied with impressive prior results, Harold Hamm set another challenging objective of tripling production and reserves once more by 2017.
The majority of capital expenditures are currently in the Bakken, but Continental also devotes a significant and increasing amount of expenditures in the Anadarko Basin, from 5.3% in 2010 to 23.1% in 2012. Anadarko Basin production has grown strongly over time as well, from 740 Boe per day in 2009 to 9,820 Boe per day in 2011. Proved reserves have grown in the Anadarko Basin from 3,859 MBoe in 2009 to 93,637 MBoe in 2011. Continental Resources production was 3,627 Boe per day in SCOOP in the first 9 months which is 307% higher than last year. Management estimates returns of 40% to 55% on investments on the SCOOP region assuming $3.50Mcf and WTI crude oil at $90Bbl.
Ensuring positive cash flows in the future will be of paramount importance for Continental Resources in the years to come. Even though Continental Resources is growing aggressively they still utilize a relatively small amount of debt in their capital structure considering the volatility of the business. Management has stated that their long term goal is to maintain a roughly 1.5 Debt/EBIDTAX ratio, although that will fluctuate somewhat year to year depending on conditions. EBIDTAX is a non GAAP measure that management feels is appropriate to measure operating performance and is defined as earnings before interest, depreciation, taxes, depreciation, depletion, amortization and accretion, property impairments, unrealized derivate gains and losses, and non-cash equity expense. The Debt/EBIDTAX was 1.28 in 2011, 1.14 in 2010, and 1.16 in 2009. The Debt/EBIDTAX ratio increased to 1.65 for the first 9 months of 2012 due to the costs of the acquisitions and significant escalation in capital expenditures. Continental Resources' management has stressed that the company is striving to become an investment grade credit over time. These goals may come to fruition within the next couple of years. In a November 6, 2012 credit report, S&P revised their outlook on Continental Resources from BB+ to positive. In March 5, 2012 Moody's raised its credit rating on Continental from Baa3 to Baa1. The S&P report mentioned that the potential catalysts towards achieving a rating upgrade, "would be continuing to improve production and reserves while maintaining a conservative capital structure, and moving closer towards cash flow neutrality." A key component towards this third piece will be a reduction in the rate of increase of capital expenditures. The expected fiscal 2013 capital expenditure budget of 3.6 billion is not quite as substantial an increase as in 2012. Incremental capital expenditures should decrease in 2014 and beyond, and the cash flow from operations should continue to grow allowing Continental Resources to ultimately become cash flow positive.
The operating margins which excluded derivatives in the calculations were 45% in the first 3 quarters of 2012 compared to 47% in 2011, 45% in 2010, and 21% in 2009. Continental Resources' profit margins are among the best in the industry, in part due to the fact that their portfolio is very concentrated in crude oil and they have been extremely cost-focused. One negative has been the fact that Continental Resources receives poorer yields on its crude oil shipments in part due to widening differentials between their realized crude oil price and NYMEX crude prices (which have recently been as high as $20 per Boe). Reasons cited for this include the dramatic increase in production in the Bakken and Canada and limited capacity in pipelines particularly in Cushing.
However, the railroad infrastructure is dramatically expanding to accommodate the increased domestic crude oil production. There are a number of major pipelines scheduled for to go online in 2013 and beyond, which have the potential to reduce the differential. While Continental Resources is one of the lowest cost producers in the Bakken, there has been significant cost inflation in the region. They have dropped well costs from $10.2 million per well to $9.2 million per well this year. Continental Resources has targeted an additional million dollar savings per well next year to drop their well costs to $8.2 million. The decrease in well costs has the potential to protect margins when the industry is facing significant cost pressures. If WTI crude oil stays in the $85 to $95 Bbl range and differentials are at about $8 per Boe, it seems likely that Continental Resources will protect its high margins with continued efficiencies and cost saving initiatives. However, it seems unlikely that the company will generate significant margin expansion without an uptick in oil or natural gas prices or a significant decrease in differentials.
The largest risk stems from the fluctuation of crude oil prices which represents 86% of its revenue and 70% of its production. Continental Resources does hedge both natural gas and crude oil production, but a significant portion of its operation is still unhedged. There is also a risk of geographic concentration, due to the fact that roughly 90% of 2012 planned capital expenditures were between the Bakken and Anadarko Basin. If production or reserve growth were to decline in these areas or should energy-negative legislation pass, Continental Resources' growth prospects would be dramatically curtailed. Continental Resources is dependent on finding new reserves and producing in places that may or may not be recoverable. Additionally, there has been significant cost inflation in the Bakken. A risk for Continental Resources is that the company is still free cash flow negative and requires access to the capital markets in order to fund operations.
The growth in production from the move to horizontal drilling has unlocked growth for oil and gas investors. Despite the upside provided by this growth, a number of risks loom for Continental Resources and the industry. Continental Resources provides the long-term investor with one of the most favorable tradeoffs of risk and reward amongst oil and gas production companies.
Disclosure: I am long CLR.