Continental Resources: Stacking Up The Profits

| About: Continental Resources, (CLR)
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The STACK leases have the best return using current pricing. The company is increasing production in Oklahoma at the expense of the Bakken.

The Oklahoma results are improving materially, and are expected to further improve in profitability.

The costs in the Bakken are very low, but the oil price differential destroys the Bakken's profitability.

Management carries a significant inventory of drilled but incomplete Bakken wells in an attempt to improve the IRR of these wells.

The SCOOP is also probably more profitable at current commodity pricing than the Bakken.

Continental Resources (NYSE:CLR) has been associated with the Bakken for a long time. That association is unlikely to end anytime soon. However, there is some new projects that will be expanding in the future with lower costs than the Bakken. These other areas have less of a differential in selling prices and offer other advantages for a superior return.

Source: Continental Resources First Quarter 2016 Earnings Update Slides

The Stack leases in Oklahoma (PDF file download) currently offer the company the best return for its investment by far. While the wells are more expensive, the selling price appears to be better than the Bakken and the overall return shown in the slide above is excellent. But the company is also finding cost advantages in the Scoop also. So the company's drilling activity is shifting towards the state of Oklahoma.

Source: Continental Resources, First Quarter 2016 Earnings Update Slides.

These prospects are in the early development stage, and the results keep getting better. The company:

...announced the completion of an industry record well in the over-pressured oil window of Oklahoma's STACK play. The Verona 1-23-14XH flowed at an initial 24-hour test rate of 3,339 barrels of oil equivalent per day, comprised of 2,345 barrels of oil, or 70% of production, and 6.0 million cubic feet of 1,370-Btu natural gas (British thermal units). The Verona is producing from the Meramec reservoir through a 9,700-foot lateral at a flowing casing pressure of approximately 2,400 psi, on a 34/64-inch choke"

The market wonders just how good the average completion and resulting production results will be. Between the first slide and this announcement, it is clear that costs are going down and production is going up. So this group of leases may be increasing the lower cost difference and production superiority over the Bakken leases. A majority of the budget will be spent in Oklahoma on these profitable plays. Long term results are far from certain as very few wells are more than a few years old, but the payback appears well within industry norms and the related profitability appears more than satisfactory even when oil prices are extremely low. Focusing on these leases will probably help increase Continental Resource's cash flow and enable the cash flow to handle the debt load better.

The wells are currently located south and east of the major earthquake problem in Oklahoma, so as management noted in the conference call, they are not worried about the earthquake problem. There is a small possibility that stance could change in the future but right now the future of these leases are relatively earthquake free.

Source: Continental Petroleum First Quarter, 2016, Earnings Update Slides

The Scoop wells are a little more expensive with a total cost of $10 million and they produce more gas. But the flow rates are so large that they are still very profitable for the company to drill and produce. Plus the company achieves 2,000 MBOE in reserves for each successful well. This is more than double the reserves for a Bakken well, with better product pricing, and only about 67% more cost. As with the Stack wells, the production management feels that they can still improve results.

All of the Oklahoma wells enhance the low cost reputation of this company. The acreage appears to be in the best spots and the company is clearly drilling low cost wells. This company will be in a far better position to survive a commodity price downturn than it was during the downturn that just ended because of the Oklahoma lease development. Especially if the long term debt is not increased.

The profitability of these wells may enable the company to develop these leases without incurring more debt. Since the balance sheet shows about 75% more long term debt than equity, development without debt is a very high priority. Plus the cash flow dried up in the first quarter when it decreased to less than $300 million. These Oklahoma wells give the company a tangible way that its lenders can understand to increase its production. That will make the bankers a whole lot less nervous and much easier to work with in the future.

The company has more than adequate credit and not much debt is due in the near future, so should the Oklahoma wells turn out to be as profitable as the preliminary results indicate (or more profitable than the market can imagine due to operational refinements), this company's profits could be much more than the market can currently imagine within a few years. Oklahoma production is currently about one quarter of the company's total production but much of the capital budget will be spent here enabling this very profitable part of the business to increase in importance.

Source: Continental Petroleum First Quarter 2016 Earnings Update Slides.

There is also some cost-cutting in the Bakken area, though management was careful to stress that there would be a significant inventory of drilled but uncompleted wells at the end of the fiscal year. During the conference call management talked more about the effects of more pipeline capacity and other steps taken to improve product movement from the Bakken to market. Clearly management expects enough improvement to keep the Bakken properties. Otherwise, as several analysts noted, the Oklahoma results are so good, that exiting the Bakken could be a realistic possibility. EUR's are climbing and operating costs are declining; so the question is at what point will the Bakken be comparable enough to legitimately compete for capital expenditures. Most of the company's production comes from the Bakken, but currently only about one-third of the capital budget will be spent on these leases because of the profitability issue.

Source: Continental Resources First Quarter 2016 Earnings Update Slides.

The company has some of the lowest costs in the industry. The Scoop and the Stack will probably not be raising that average cost. However, both plays will raise the average selling price. Much of the industry cannot survive a selling price per BOE that is under $20. This company has survived but with the long term debt at approximately $7 billion, the higher selling prices that the Scoop and Stack production receives will be providing some very welcome financial relief even if the commodity prices don't rise.

Both the Scoop and the Stack appear to be profitable enough to enable the company to develop the production from cash flow. Hopefully Continental Resources will use the increased cash flow to reduce its financial leverage in the future. The company has adequate liquidity with a credit line that is less than half used. But bankers are not the most patient when cash flow declines as it did in the first quarter. With the commodity price rally, the cash flow should improve for the second quarter and the rest of the year. But the best long term solution appears to be the Scoop and the Stack development followed by property sales to work down the long term debt. At the current time the stock is a little pricey for the value of the long term debt and market value combined, but the development of the Scoop and the Stack could change that. This company is an industry low cost leader and should do well in the future.

Disclaimer: I am not a registered investment advisor and this article is not advice to buy or sell stock in any company. The investor needs to do his own independent investigation that includes reading the company governmental filings and press releases, as well as anything else relevant to determining if this company fits the investor's risk profile.

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.