The level of WTI crude and indeed, not just the spot price but the entire WTI futures curve, is the critical determinant of short-term valuation of an oil producer such as Continental Resources, Inc. (NYSE:CLR). With the front month future settling at 35.89 on April 5, CLR closed at 29.49.
WTI has been around the current value of about 36 a number of times during the preceding half-year: in mid-March, early March, early January and during the middle third of December. This is shown in the following chart, with CLR prices plotted according to the scale on the left, and WTI levels according to the scale on the right.
Click to enlarge (Source: Quandl)
There is a strong relationship between the crude oil price and the price of CLR. The following chart of CLR vs. WTI is for the preceding 6 months. The straight line indicates the rough trend.
The data point corresponding to the most recent WTI front month future's settlement and the CLR closing price on the same date is shown in red. It is noticeably higher than the trendline. Indeed, the valuation of CLR as of April 5 close is the most optimistic value assigned to the stock by the market among all times WTI was around 36 in recent history.
The idea then is to sell CLR and buy oil as a pair trade. To avoid the need to trade WTI futures and potentially have to roll the long future position over to the next month if the convergence takes longer than the lifetime of the current futures contract, one could buy The United States Oil ETF (NYSEARCA:USO) instead of buying WTI futures. The following chart shows the CLR daily closing prices versus USO for the preceding 6 months. Similarly to the prior comparison of CLR and WTI, there is a strong positive correlation between CLR and USO. The most recent point on April 5, shown in red, is once again far above the trendline, suggesting that CLR is overbought relative to the current price of USO.
Click to enlarge
Before I conclude, let's review several potentially relevant factors that might affect this trade.
CLR did not announce any changes in the capital structure since December. It has not issued any new stock. Its long-term debt position is unchanged. It has not made dramatically greater use of its revolver, while the downgrades by S&P and Moody's are, if anything, minor negatives due to increased interest rates on their revolver and the term loan. All-in-all, CLR is still the same company it was in December.
The market has rewarded amply the decision by Continental to cut its 2016 CapEx budget. Postponing completion of DUC wells and drilling new wells could be a fundamentally good factor if the market expected significantly higher long-term oil prices. One way to evaluate this is to consider the spread between the 13th month WTI future, one that would currently settle in the spring of 2017, and the front month future. As is seen from the following chart, this spread has tightened dramatically in the preceding two months and indeed represents a smaller contango than in December 2015. So while the front-month WTI future is roughly where it was in December, the anticipated long-term oil price as exemplified by the 13th month future is actually 2-3 dollars lower presently than it was as of December. In this environment, postponing the expenses might not do much good.
Click to enlarge
In conclusion, I find CLR to be very richly priced at $29.49 relative to where the stock traded at comparable times in the past with WTI near 36, and see $26 per share to be more consistent with the patterns of the preceding 6 months. A way to benefit from a correction of this relationship to its recent-term average is to sell CLR and buy USO.
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.