While shares of Continental Resources (NYSE:CLR) had more immediate upside after my last update, the trend reversed itself after WTI and Brent prices tumbled downward. Continental didn't help its case after it posted pretty weak second quarter results. Overall, I still have a long-bias for the company; however, lacking a margin of safety, I'm hesitant to add to my position at current levels.
Second Quarter Results
Because commodity firms are price-takers by nature, Continental's revenue $10m revenue miss is not paramount to the thesis. The company also fell short of earnings expectations, earning $1.50 (up 13% y/y) versus the Street's $1.69 expectation. Given that refiners reported narrowed crack spreads with less advantaged crude, I anticipated earnings above consensus.
However, production grew only 11% sequentially (23% y/y) which was slightly disappointing given the full-year outlook for 26-32% production growth. Continental actually outsold production by 78,000 barrels because midstream capacity that was supposed to come on-line in the second quarter did not. CEO Harold Hamm noted that production goals remain achievable as production continues to accelerate. Overall, I think production growth should be low on the list of concerns.
The other, and more important, driver of the earnings miss was higher DD&A costs. In addition to ramping up exploration spending, Continental has taken a conservative stance towards reserve bookings, thus DD&A expenses were dually punished. The company's conservative accounting may understate EPS in the near-term, but I am comfortable with the taking non-cash charges that are unlikely to impact the cash generating abilities over the long-term.
Speaking of cash flow, Continental continues to generate robust cash from operations. Year-to-date, operating cash is up 23.8%. With cash flow soaring, the company was able to pay off its $324 million in outstanding 8.25% senior notes and subsequently issue $700 million in 10 year senior notes at 3.8% and $300 million in 30 year senior notes at 4.8%. The move recapitalizes a significant portion of Continental's debt at long-dated and cheap rates. It could also foreshadow future refinancing of higher cost debt with cheaper, long-dated notes. This could actually make the debt an interesting way to benefit from Continental's upside (I have not looked into the terms of the 7.375% or 7.125% senior notes).
I thought the threat of ISIS in the Middle East and Ukrainian instability would make WTI and Brent both move to the upside to a greater extend than what occurred. My error came from underestimating domestic pricing demands than remain tilted in favor of refiners. Bakken and Midland crude remain steeply discounted versus Cushing WTI. Continued infrastructure investments in storage, rail, and pipe will help alleviate domestic price disparity, but these products will take time to come on line.
Oil prices from a global prospective declined after the ISIS conflict failed to make a dent in global supplies. A few years ago, I believe a justified and sustained upward move in crude pries would occur. That paradigm has shifted. I think this is where analyzing Continental becomes difficult.
In the short-term, the market does not seem worried about oil dropping below $80 because the global demand picture remains robust. However, there are some concerns that supply outstrips demand over the next 10 years, keeping oil prices in-check. Fracking technology has become more efficient, so the breakeven for shale producers fell, making supply increases much more affordable. The US can exacerbate the glut by maintaining the crude export ban or continue to keep crude production limited to domestic refiners. I doubt President Obama is enthusiastic to help out any frackers, and chances are Congressional gridlock will prevent any full-fledged reform for the time being.
Therefore, I think the main two upside catalysts remain the antithesis: global supply disruption, but more importantly, changes to existing export laws. The consensus opinion is gridlock, so a lifting of the export ban would send shares up substantially.
How to Play Continental
Shares are no longer a screaming bargain at 17x FY15 earnings and a slight discount to NAV of $153/share. There certainly is some upside to NAV going forward as wells become more productive and proved reserves increase, so I think Continental's fair value will be closer to $165 in FY15.
That said, I think downward momentum in oil prices will continue for the rest of the quarter. If I want to add to my position at all, I'll likely do it via the sale of some cash secured puts. 8-10% upside in the common isn't too appealing to me, but the company becomes substantially more attractive in the $130-$135 range.
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.