Budget Slashed In Half Relative To The Initial Plan
Continental Resources (NYSE:CLR) revised its 2015 capex budget down to $2.7 billion. This is the second capex revision announced by the company in just two months. As a reminder, on November 5, Continental announced that it had decided to reduce its initial 2015 spending plan to $4.6 billion from the previous forecast of $5.2 billion (an approximately 12% reduction). The November 5th decision was likely made in response to the price of WTI declining to approximately $80 per barrel.
Based on the new operating plan announced yesterday, Continental anticipates that its production growth in 2015 will be in the 16%-20% range compared to estimated 2014 production. This compares to 23%-29% production growth guidance under the previous $4.6 billion capex plan.
Continental plans to decrease its current average operated rig count from approximately 50 to approximately 34 by the end of first quarter 2015 and average approximately 31 operated rigs for full year 2015. The combined operated rig count in the SCOOP and Bakken is being reduced from 45 rigs under the $4.6 billion capex plan to 27 rigs under the revised plan (16 rigs in the SCOOP and 11 in the Bakken, on average for the year). In Northwest Cana, where Continental's drilling costs are is being carried by its JV partner SK E&S, Continental plans to operate four rigs (the program is being reduced by one rig from the previously announced plan).
Highgrading Drilling Inventory
Continental is focusing its development program in the Bakken on its best locations. The Company now expects to complete 188 net wells focused primarily in its core acreage, targeting an increased average EUR of 800,000 barrels of oil equivalent per well (up from the 700,000 boe estimate previously).
In the SCOOP Woodford/Springer plays, Continental made no change to previous EUR targets. The revised 2015 budget is based on completing 81 net wells.
In the Northwest Cana play and other areas, the Company plans to complete 11 net wells.
Analyzing The Growth Rate
While the 16%-20% year-on-year growth rate is impressive, a more relevant metric is the production increase from the end of 2014 to the end of 2015 which is more closely correlated with the pace of capital spending during 2015. Using the midpoint of Continental's growth guidance, I estimate that the company's production will grow by ~10% from the end of 2014 to the end of 2015. In my calculation, I assume Q4 2014 average net production of ~190,000 boe/d and an exit rate of ~195,000 boe/d, slightly below the company's guidance of 200,000 boe/d exit rate.
I expect that Continental's production growth will slow down in the second half of the year, as the sharp reduction in the rig count will begin taking its toll on the output volumes. In fact, quarter-on-quarter growth rate may decline to low single digits towards the end of 2015, based on my estimate.
Therefore, even though the headline production growth rate may appear very strong, in reality the $2.7 billion spending run rate may correspond to only a single digit production growth rate. Of note, the revised budget already anticipates that completed well costs will average at least 15% below 2014 averages as service costs adjust to lower commodity prices. While there is little doubt that the sharp expected drop in E&P drilling activity will translate in a material pricing compression throughout the entire supply chain (services, equipment, materials and labor), the 15% well cost reduction indicated by Continental for 2015 should not be taken for granted as such cost reductions may take some time to materialize.
Targeting Cash Neutrality?
Continental commented that its revised budget targets cash flow neutrality by mid-year 2015. However, the company did not specify what commodity price assumptions underpin its projections.
Based on my analysis, the budget appears to be based on average Nymex prices for the year of $60 per barrel for crude oil and $3.50 per MMBtu for natural gas. Under these price assumptions, I estimate that Continental will generate ~$2.2 billion in discretionary cash flow in 2015. In addition to that, Continental will have realized ~$520 million from the recent hedge monetization and the sale of interest in Northwest Cana to its JV partner. As a result, the company's $2.7 billion budget appears to be fully funded under the $60 oil/$3.50 natural gas price scenario.
In the event commodity prices decline further, Continental may need to take additional steps to reduce its budget. Assuming $50 per barrel WTI and $2.75 per MMBtu gas (which I view as a stress test scenario), Continental would potentially face a budget shortfall of over $400 million (here I assume a stronger decline in completed well costs and basis differentials at the low end of the guidance range). Should Continental prioritize preserving its credit quality and financial flexibility (the company currently has its credit facility fully undrawn), spending cuts may be required. Credit considerations are not the only ones that would contribute to potential spending cuts. Even more importantly, at $50 per barrel WTI, it is difficult to justify committing capital to new well drilling, even if management takes an optimistic view on the longer-term price of oil.
Continental's budget reduction appears commensurate with the degree of uncertainty in the commodity market, particularly in light of the recent statements by Saudi Arabia that appear to confirm the Kingdom's goal of inducing a sustained reduction in the pace of the industry's capacity build.
Despite the radical reduction in spending, Continental's production will sustain strong growth momentum during the first half of 2015, with a flattening expected in the second half of the year. This confirms my earlier thesis that the current oil price (~$60 per barrel) may not be low enough to deliver a quick supply response.
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