- CLR is up 38% year-to-date, and roughly the same since I recommended them in November 2013.
- Higher WTI looks like the next positive catalyst.
- Shares are getting expensive, but the firm's fair value should grow considerably.
- I'm holding the stock right now, but I'm struggling to find better opportunities.
In late 2013, I profiled Continental Resources (NYSE:CLR) as one of my favorite ideas at the time. I assigned a near-term price target of $146 per share. While the stock initially struggled, shares are now up roughly 37% year-to-date, trouncing the broader market.
Although I do not believe the stock is tremendously undervalued at this point, I do think the stock price has some room to the upside in the near term.
The Upside Catalyst: Higher Oil Prices
Commodity price forecasting is not among one of my better talents. Generally speaking, I like to look at supply and demand fundamentals and form a directional opinion rather a specific long-term price outlook. Thus far, the American oil boom has largely been absorbed by the market. Since the beginning of 2013, WTI oil has only dipped below $90 a handful of times, and spot prices currently sit 13% higher than at the beginning of the year. Ultimately, WTI is a great benchmark for Continental, and every incremental penny in price flows through to the bottom line.
Oil prices have demonstrated strength, particularly in light of recent instability in Iraq. Extremists may have taken control of Iraq's largest refinery and domestic supplier, which will probably disrupt the country's ability to export oil. At the very least, global supply probably will not exceed demand growth in 2014.
The company continues to have much of its production hedged with several swaps and collars, but supply is growing quickly enough to provide the company with some modest exposure to the spot market. Nevertheless, higher oil prices are positive for Continental.
Longer-Term: Keystone Pipeline and Logistics Expansion
At the same time, mid-continental producers have other micro issues to work through, primarily a lack of transportation options in the region. Continental continues to sacrifice price to ditch product. However, I think more transportation is on the way.
The Keystone Pipeline just passed a small hurdle as a Democratic Senator proposed a bill for a workaround of the Obama veto. While the bill remains a few senators shy of receiving ample support to avoid a filibuster, I think the attractive economic impact in a country coming off negative GDP growth during the first quarter will incentivize additional support.
The pipeline will service not only Alberta, Canada, but also the Williston Basin in North Dakota, providing the transportation infrastructure needs to narrow its discount to WTI. As I noted previously, any price gain is very accretive to earnings, and narrowing spreads will provide Continental participation in pricing upside. Keystone would not alleviate supply issues overnight, but its eventual completion would be very positive for the company.
I also anticipate some additional pipeline activity (one expansion from Alberta to Wisconsin is coming) in form of existing pipeline capacity expansion as well as pipelines that provide superior transportation to rail hubs.
The Risks: Electric Revolution
The last person I want to be in the world is the one who completely underestimates the impact of technological innovation. Electric cars have been around forever, but what if a true revolutionary breakthrough is discovered?
Frankly, while this concern sometimes lingers in the back of my mind, I think the reality is that we shall see the stages of advancement clearly enough to know when we may hit a global inflection point. The current technology slate does not support electric car proliferation, and even if it did, it could take a while for it to supplant gasoline for large trucks, planes, and barges.
Furthermore, I think the socioeconomic climate will dictate a slow and gradual change. The US oil revolution is creating such a tremendously positive economic impact in a country that is desperately in need of jobs. Policy designed to squash this growth will likely not be feasible if Congressmen continue to cherish remaining in office.
At the end of Q1, Continental held roughly $5 billion in long-term debt on its balance sheet. Operating cash flow for FY13 was about $2.5 billion. Q1 EBIT of $421 million easily covered the $63 million in interest expenses. Giving the viability of Continental's reserves, I wouldn't be surprised to see the company add more leverage going forward. Founder and CEO Harold Hamm is not that interested in diluting his ownership stake, and the company continues to plow significant cash into expansionary capex spending.
The company added some additional leverage by selling $1 billion of senior unsecured notes at 3.8% and $700 million of senior unsecured notes for just 4.9%. Continental also retired $300 million worth of 8.25% notes due in 2019. Ultimately, I think Continental can support some additional leverage, but the importance of Hamm should not be understated.
The oilman has made himself one of the richest men in the world, and you are betting that wells keep flowing and oil prices staying high because odds are he's going to be bullish on the amount of oil you can get out of the ground. Every oil producer wants to bring as much product to market as possible, and thus far global demand strength and supply disruptions have given producers no reason to slow production growth.
The natural gas revolution translated into an extremely oversupplied market and several uneconomic fields. As much as I think the industry will attempt to flood the market, I think global demand will be able to keep pace.
This is where it starts to get a little murky for me. Management believes it can add an additional 500MMboe by 2017 in reserves, but I think the future growth beyond that remains relatively solid. Improving technology continues to make more wells economically feasible.
Presumably the amount of cash this enterprise is able to generate over the duration of its life span will continue to improve year after year. Assuming WTI oil prices remain in the $80-$110 range, and we see no dramatic decline in proved reserve growth, I can see the fair value of Continental growing 15%/year. At $156, I think we're approaching the upper end of where the company should be valued today. However, I think more upward momentum in WTI will make the market more comfortable assigning Continental a richer multiple.
I'm Not Adding Shares…But I'm not Selling
Lots of factors come into play when buying and selling, so for me, a hold makes most sense at this time. While I do not really want to put more capital to work in the name, I also don't have a ton of other ideas I'm comfortable adding to. Running a concentrated portfolio means usually only take large sized positions, so selling creates a sizeable cash drag. All things considered, I'm happy to take a little more upside risk while I find a better position to build. If the shares run to $165-$170, it becomes difficult not to take some off the table.
Disclosure: The author is long CLR. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.