Continental Has Production Costs As Cheap As They Come And A 25% Production Growth Rate

| About: Continental Resources, (CLR)

Summary

Production will grow about 25%.

Cash Costs are about $12 BOE which is among the best in the industry. Depreciation, however runs about $21 BOE and may remain high for several years.

The expansion into Oklahoma may turn out to be more speculative than investors bargained for, even though the well type and operations do not appear to be causing earthquakes.

BOE Reserves Per $1000 doubled to $94. Much of this progress has been hidden by dropping oil and gas prices.

The differential has been lowering as the company pipes out its production and the company expects the differential to decrease.

Now this is a company with some exceptional rates of return. Continental Resources (NYSE:CLR) is growing right through the industry downturn, and the reason appears to be that the latest technology and costs is making drilling wells profitable, even in the current low cost environment. This is good news for shareholders, especially in an industry where profitable growth is hard to come by these days.

Source:Continental November 4 Update

From the above slide, the current major project areas show a decent rate of return considering the low commodity pricing environment. At forty dollar oil prices, the rate of return on investment approaches 20%. This is the borderline for many companies in deciding to drill for increased production. Therefore, depending upon the view of the company about future oil prices, drilling may or may not continue at this price level. The CEO stated many times, that if the projection is for these current prices to remain for a while, the activity level at the company will decrease to accommodate the lower prices. Right now, with the company projecting current production growth, the forward projection of oil and gas prices would have to be for an increase.

Source:Drillinginfo.com - Continental

The only challenging thing is two of the graphs, Scoop Springer and Scoop Woodford Condensate represent production in Oklahoma that in some cases is in some of the heaviest earthquake areas of the state. From the above map, large sections of this play are not in the main earthquake areas that are closer to south and east of Oklahoma City. However, as this past week events demonstrate, other areas of the state do experience strong earthquakes and the appropriate authorities are taking action to quickly reduce the number of earthquakes. In the conference call, the CEO listed the Stack play as a possible play for joint venture or monetization in another way, shape, or form.

The company has deferred further drilling on some of its holdings until oil prices rise more, and may well be advised to move very carefully in the future on all of these leases. It is one thing for operators with a lot of experience to try and tackle profitable plays in Oklahoma. It is something else for an out of state operator, such as this one to try and make money until the earthquake issue is sorted out. On a preliminary basis, the cost basis looks more than reasonable, and the wells appear to have adequate returns for the company. However, this area has some unusual geological challenges for oil and gas explorers and operators, the costs of which are slowly unfolding and may change the company's plans about expanding in this area.

Currently, at least some parts of the play appear to have very little water ((good!)). The less water, the less disposal problems. However, the main question not resolved by regulators is what is causing the earthquakes. While the initial answer appeared to be high pressure disposal wells, the solution (at least for now) has spread to all disposal wells. Whether the final solution will go beyond that is currently unknown. It is very unlikely that the state would shut operators down, unless there is some strong proof that the operation is doing a lot of damage, however, changes to current operating procedures, and possibly some undetermined increase in costs may need to be factored in until the future is a lot more clearer.

Source:Continental November 4 Update

From the above slide, the current costs have dropped significantly.

The cash cost per BOE is among the lowest in the industry. As far as cash margins, there are dozens of competitors that have no margin or a nominal margin in this environment. This company clearly has enough margin to service its debt.

However, reporting profits in this environment make take awhile. The reason is that the depreciation, depletion and amortization charge continues to run in the $21 BOE area. The depreciation is a mixture of old well costs and new wells costs modified by the cost ceiling adjustment. Therefore the depreciation charge may not reflect the current cost to drill and produce oil for quite some time, possibly even years later.

Property impairments of $616 million last year are among some of the smaller charges that have been reported. This year there has been more than $300 million of impairments, of which $97 million was deducted this quarter. Compared with many companies in the industry, these charges could have been far worse, and shows some conservatism to the company's accounting system.

"For the Bakken play, the current estimated drilling and completion cost has decreased to $7.0 million per operated well, compared with $9.6 million per operated well at year-end 2014. At these lower costs and targeted estimated ultimate recovery (EUR) of 800 MBoe per well, the Company has cut its finding cost in half since year-end 2014, doubling its capital efficiency."

This quote from the third quarter earnings news release, goes with and further describes the slide below. Some savings, such as lower drilling times, and other operational changes are permanent savings. Pressuring the service companies has resulted in more temporary savings.

Source: Continental November 4 Update

From the above slide, the current costs have dropped considerably, and this has led to double the number of BOE in reserves per $1000 dollars invested. There are two important discussions that the company skips in this analysis. One is the payback, which from the first slide in the article with rates of return in the twenty percent range, the normal assumption would be a payback around two years. The second discussion will revolve around reworks.

First the payback discussion. From the first slide, one would assume a payback of two years ( or slightly longer) with current oil prices near $40 BOE. Now, that may be on the border of desirable, however, oil and gas prices are no longer at their all time highs, and it may be to the advantage of the company to have these wells producing when prices begin to rise. The company already has a fair number of wells drilled but not completed, because it is uneconomical to do so, or because the company believes that the economics will improve. However, these uncompleted wells cost capital and are not earning a return. This is a strain for a company with an already reduced cash flow.

Next the company has not really discussed reworks. While it's always nice to report increasing EUR's, the fact is that these wells need rework from time to time to get those EUR's. If drilling were to stop, and cash flow used to reduce debt until oil and gas prices improve, would the oil represented by the EUR's still be available with the reworking technology currently known. Or at some point would the well become unprofitable to fix, and just be shut-in until oil prices improve. It's probably better for the investor to focus on the first graph with the rates of return, hope the well pays back before the reworks start, and then hope the maximum return as shown by the EUR's actually happens. The company is predicting continuing production improvements, and cost improvements so there is a possibility that the EUR's could increase in the future (as will well profitability). If oil prices would stabilize (and they should in the near future), these improvements would result in shorter paybacks and increasing profitability. Currently most operational improvements are masked by declining commodity prices.

"Continental's facility is unsecured and not subject to any borrowing base redetermination.

Additionally, there are no terms within our facility that would allow for or mandate collateral or a borrowing base calculation to come back into place. Therefore, we are not and will not be subject to any borrowing base redetermination. Our only covenant is a debt to total capital ratio. Capital includes debt of no greater than 0.65. At September 30, we were at 0.57. When calculating this covenant, it is important to note that the calculation, according to the terms of credit agreement, specifically excludes any non-cash impairments after June 30, 2014. Obviously, we have ample room under this covenant."

This quote from the third quarter conference call, contains some important qualifications about the debt of the company. First notice there is no credit line redetermination. There are very few oil and gas companies that can make that statement. Plus there is only one covenant that matters. Again, very few companies in the industry are in the position of this company. The debt is mostly bank debt, but that debt is on extremely favorable terms and conditions. Note especially that most of the cost ceiling non cash charges are not included in the calculation. That is an extremely generous concession made by the banks that few companies can boast of.

Source: Continental November 4 Update

From the above slide, the current borrowing costs are more than reasonable. With no debt maturities for several years, liquidity is not an issue. The credit line matures in 2019, and therefore provides ample liquidity, especially with the ability to double that line should the need arise. The investment grade rating is borderline, but that is far better than a lot of companies.

Source: Continental November 4 Update

From the above two slides, most of the capital budget is still flowing to the Bakken. However, a slowly increasing amount is heading towards the Oklahoma projects. The Oklahoma expansion gives this company a more speculative twist than might be expected, even though the wells and its operations appear to skirt many of the main issues in Oklahoma. It will be interesting to see how this venture works out given that the company itself is probably not currently a major target for operational changes, and probably won't be. The earthquake issue appears to be affecting all operators in the state regardless of exposure to the problem.

Continental Resources, Inc. and Subsidiaries

Unaudited Condensed Consolidated Statements of Cash Flows

         
   

Three months ended September 30,

 

Nine months ended September 30,

In thousands

 

2015

 

2014

 

2015

 

2014

Net income (loss)

 

$

(82,423)

 

$

533,521

 

$

(213,992)

 

$

863,293

Adjustments to reconcile net income (loss) to net cash provided by operating activities:

                       

Non-cash expenses

   

465,606

   

328,395

   

1,505,141

   

1,509,093

Changes in assets and liabilities

   

115,497

   

(16,518)

   

124,343

   

(94,535)

Net cash provided by operating activities

   

498,680

   

845,398

   

1,415,492

   

2,277,851

Net cash used in investing activities

   

(634,396)

   

(1,148,973)

   

(2,597,699)

   

(3,226,260)

Net cash provided by financing activities

   

132,031

   

(321,098)

   

1,183,697

   

1,072,217

Effect of exchange rate changes on cash

   

(4,818)

   

-

   

(8,916)

   

-

Net change in cash and cash equivalents

   

(8,503)

   

(624,673)

   

(7,426)

   

123,808

Cash and cash equivalents at beginning of period

   

25,458

   

776,963

   

24,381

   

28,482

Cash and cash equivalents at end of period

 

$

16,955

 

$

152,290

 

$

16,955

 

$

152,290

Source: Continental Third Quarter 2015 News Release

From the third quarter earnings report, the company is clearly not living within its cash flow. It borrowed another $132 million this quarter to add to its debt load despite all the talk of living within its means. Therefore debt grew nearly $1,184 million despite all the talk of living on cash flow. With oil and gas prices continuing the drop that started at the beginning of the year, the company clearly must do much better to live within its means (and cost savings and well design improvements will help here). The company noted that it has rigs coming off contract in the next few months. Therefore if lower prices persist, it has the option of going with fewer rigs in the future. In the meantime, it will report slightly more growth than it originally budgeted for the year, and expenditures should also be below the budgeted figures for the year.

The good news is that with cash flow from operations at nearly $500 million for the quarter and $1,415 million for the nine months, the company is clearly on track for cash flow of nearly two billion for the year. With long term debt of $7.1 billion, this represents a debt of more than three and one-half times cash flow, a fairly comfortable figure. Hedges helped approximately $.57 BOE, so the cash flow is mostly from operating profits. Again, few companies in the industry can make that claim.

Also the company is increasingly using pipelines to deliver its production to market. As pipeline capacity increases the company expects the negative oil and gas differential to continue to decrease. This is another less predictable factor that will increase cash flow in the future regardless of the direction of oil and gas prices. The current decrease in oil and gas drilling activity has allowed the pipelines to gradually catch up with the demand.

With the kind of cash flow that the company currently maintains, and may well increase in the future, this company could make an interesting investment for investors with a fairly long term horizon. Despite the balance sheet leverage (long term debt is nearly twice shareholders equity), the cash flow ratio is more than reasonable. The company has no debt due for several years, and has no credit line redeterminations to worry about. In fact, the company has the ability to increase its credit line if it wants to. Depreciation and other non-cash charges may keep the company from reporting profits but clearly, the company is sailing through the current downturn extremely well. Oil and gas prices should be near their bottoms, and an industry price recovery is inevitable. When that recovery comes, this company will be well placed to take advantage of it.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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.

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