Continental Resources (NYSE:CLR) announced that it has cut its capital expenditure budget nearly in half in 2015, allowing the company to survive the storm in all likelihood despite the fact that the business has pulled off all of its hedges recently.
The low cost status, long term debt profile and anticipated cash flow neutrality at some point next year will allow the business to survive the current storm, at current energy levels.
Continental announced its second, but much larger cut in its capital expenditure budget just ahead of Christmas. Earlier, Continental had already reduced the 2015 budget by $600 million to $4.6 billion. Now, Continental expects to spend just $2.7 billion next year, a 48% reduction from the original budget.
Despite the dramatic cut, Continental still anticipates to grow production by 16 to 20% compared to 2014. The rig count which is seen at around 50 rigs currently will drop to 34 at the end of the first quarter, and is expected to average 31 for the entire next year. These rigs are anticipated to complete some 280 net wells for the year with total costs per well seen down 15% amidst lower service costs.
CEO Howard Hamm rationalizes the decision to remain prudent with respect of the company's leverage, and thereby target cash flow neutrality by the middle of 2015.
Great Value For Spending
Based on projected production of 200,000 barrels of oil-equivalent for the final quarter of this year, average production for the entire year of 2014 is seen around 175,000 barrels of oil-equivalent.
Initially, Continental aimed to spend $5.2 billion, thereby growing 2015 production by 26 to 30% compared to average production in 2014. At the midpoint of the guidance incremental production is seen at 49,000 barrels, at a cost of $5.2 billion.
Following the latest reduction, Continental is spending just $2.7 billion in order to grow production by 16-20%, or 31,500 barrels per day. A 48% cut in the capital expenditure budget results in just a 36% reduction in production growth, which implies that production maintenance spending is very low. This leaves me wondering what production in 2015 will look like if the company were to completely cut its budget for next year.
2015 Cost Estimates
Continental has already outlined its cost estimates for the upcoming year. Production expenses are seen at $5.50 to $6.00 per barrel of oil-equivalent. Taxes on revenues are seen between 7.5 and 8.5% of those proceeds, with general and administrative expenses seen at $2.00 to $2.50 per barrel of oil-equivalent. Equity compensation is seen at just $0.75 and $0.95 per share as depreciation charges are seen between $20 and $22.5 per barrel of oil-equivalent.
Based on anticipated production of 206,500 barrels for 2015, and assuming 70% production in oil with the remainder in gas, we can estimate Continental's revenues for 2015.
Assuming current prices of WTI at $55 per barrel and gas at $3 per Mcf, we can anticipate Continental's revenues. The company anticipates to sell oil at a $7-10 discount to WTI benchmark prices while gas is anticipated to be sold at a $0.75 to $1.25 premium compared to its benchmark. This could result in oil revenues of $2.45 billion and gas sales of little over $540 million, for combined revenues of $3 billion. The blended average proceeds are therefore seen at around $40 per barrel of oil-equivalent for 2015.
So far the proceeds, and let's now focus on the costs. Production costs are seen at $5.75 per barrel of oil-equivalent. Taxes at around 8% should cost the business close to $3.20 per barrel of oil-equivalent. Add to that general and administrative expenses of $2.25 per barrel and one ends up with cash costs of around $11.20 per barrel of-oil equivalent. Non-cash costs are seen at $21.25 per barrel resulting from depreciation charges, with equity compensation totals $0.85 per barrel, for total non-cash costs of $22.10 per barrel.
In total these cash and non-cash costs are seen at $33.30 per barrel of oil-equivalent. That said, Continental has typically recorded large property impairment charges as well, although is has not provided a guidance for these costs in 2015. These are however non-cash costs, which is very important to consider.
While the anticipated proceeds of $40 per barrel of oil-equivalent still exceed the guided costs of $33.30 per barrel for 2015, in practice, the company is more likely to break-even as the company will most likely take large property impairment charges as well. These charges totaled $223 million in the first nine months of the year of 2014. Of course the company has to pay interest costs and income taxes as well.
Cash Flow Outlook
As seen above, Continental is close to breaking even at current levels, based on its income statement. The reality is however that many of the company's costs result to depreciation and impairment charges, which are non-cash costs and result in great operating cash flows.
If the company can take in $3.0 billion in revenues next year, its cash costs are much lower. Above I calculate cash costs at around $11.20 per barrel of oil-equivalent, which translates into actual costs of around $850 million, with non-cash costs coming in around $2 billion assuming $1.6 billion in depreciation charges and another roughly $400 million in impairment charges.
As a result the $2.0 billion non-cash charges starts to approach the $2.7 billion capital expenditure budget for next year. At current break-even levels, this implies a cash flow shortfall of $700 million next year.
The Balance Sheet
Continental has roughly $5.8 billion in debt outstanding against which it holds very small cash holdings. That said most of this leverage has longer maturity dates as $4.5 billion is due in the period 2022-2024, with no debt maturing in the coming five years.
If current oil and gas prices will not move from current levels in 2015, it is likely that Continental's net debt position will increase towards $6.5 billion next year. If the company will post EBITDA of around $2 billion, assuming a break-even result based on the income statement, and after adding back depreciation and impairment charges, this results in a leverage ratio of around 3.2 times which is below the 4 times covenants maximum ratio.
With cash flow neutrality assumed later in 2015, leverage ratios will peak at these levels if the company remains prudent in its capital budgeting, assuming that energy prices hold steady at current levels.
Given the pro-forma analysis above, Continental is very likely to whether the storm given the late maturity profile of its debt, the low cost producer status and prudent capital budgeting decisions made for 2015. Cash flow neutrality seen in 2015, will limit the increase in leverage going forwards. Yet all this analysis is based on survival of the company and not necessarily the profitability of the business and valuation resulting from that. Arguably, Continental can easily survive the fall in oil prices, provided that prices will stabilize around current levels.
At $38 per share, equity in Continental is valued at little over $14 billion which combined with a net debt position of close to $6 billion values the business at $20 billion. Given the lack of earnings at current oil prices, the valuation relies heavily on future anticipated earnings. With production seen at around 75 million barrels of oil-equivalent next year, every $10 increase in oil prices could boost operating earnings by $750 million, or by $450 million on an after-tax basis. As such a $20 rebound in oil prices could result in nearly a billion in after-tax earnings, which arguably creates real appeal at 14 times earnings for the equity, in this extremely well-run, low cost producer.
No one can predict energy prices going forward, but given that Continental is well-positioned to whether the current storm and trades at appealing multiples even if oil prices only recover to a certain extent, I think long term investors with a risk tolerance can still pick up some shares at current levels. A rebound to just $75-$80 for WTI could allow for a billion in after-tax earnings.
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