Continental Resources: A Great Stock For Oil Bulls

Summary

• Continental Resources will benefit from the increase in oil prices and improvement in Bakken oil’s differential to WTI.
• Continental Resources posted less than 4% increase in oil and gas volumes in 9M-2017 but it has ramped up activity in the Bakken formation, which was evident from Q3-2017 results.
• In 2018, the company will likely post more than 20% increase in total production as compared to 2017. This growth rate may be the strongest among large-cap E&Ps.
• Continental Resources will likely swung to positive free cash flows in 2018 from negative free cash flows of $97M in 9M-2017.

If you’re bullish on oil, then Continental Resources (NYSE:CLR) is the stock for you. I believe the company will likely significantly grow its earnings in 2018 due to higher realized prices and around 20% production growth. Meanwhile the company, which burned cash flows in 2017, will likely report strong levels of free cash flows in 2018. That should fuel its stock’s outperformance.

Image courtesy of Pixabay.

The oil prices have improved substantially since the start of Q4-2017. The price of the US benchmark WTI crude has gained 20% since then to more than $60 a barrel – its highest level in 2.5 years. The strength has been driven in large part by the efforts of Organization of the Petroleum Exporting Countries and its allies, including Russia, who have agreed to extend their production freeze agreement through entire 2018. The decline in inventory levels in OECD nations, including the US where commercial crude oil stocks have fallen by 20% from the historic highs seen in March 2016, has also helped push oil prices higher.

At the same time, the Bakken-focused oil producers, such as Continental Resources, have benefited from the improvement in regional prices. In a recent presentation, Continental Resources said that the Bakken oil’s differential to WTI gradually shrunk from -$8.26 a barrel in 2016 to -$5.54 a barrel in Q3-2017. I believe this is largely driven by the deployment of additional takeaway capacity in the region, particularly the 470,000 barrels per day Dakota Access Pipeline which came online earlier this year and has gradually ramped up. Continental Resources has said that this differential will drop to -$4.98 per barrel in Q4-2017 and will head lower in 2018. That should lift the company’s realized prices.

Remember, Continental Resources has no hedges in place. This means that unlike some of its peers, such as Pioneer Natural Resources (PXD) who locked a large chunk of their 2018 production at less than $58 a barrel by Q3-2017, Continental Resources can fully capitalize on oil’s rise to $60 a barrel. In 9M-2017, Continental Resources swung to an adjusted profit of $37.14 million, or $0.10 per share, from a loss of $299.2 million, or $0.81 per share a year earlier, and also posted 56% increase in operating cash flows to $1.35 billion. That gain was driven in large part by 29.1% increase in average realized sales price for crude oil to $43.26 a barrel. Moving forward, Continental Resources will post higher realized prices which will fuel further earnings and cash flow growth.

On top of this, Continental Resources, which has been keeping a lid on its oil and gas production, will also start targeting strong growth. In fact, I believe in 2018, Continental Resources will report one of the highest levels of production growth rates among large-cap independent oil producers.

So far, Continental Resources has reported a modest 3.8% increase in production in the first nine months of the year, on a year-over-year basis, to almost 227,700 boe per day. The increase was driven by an uptake in drilling activity, mainly at its core Bakken properties. By comparison, its peers Pioneer Natural Resources and EOG Resources (EOG) have posted higher production growth rates of 13% and 7% respectively for the same period.

But Continental Resources’ production growth has only recently started to kick in as it brought 122 gross wells online in Q3-2017, up from 50 wells in Q3-2016 and 100 wells in Q2-2017, and worked through its inventory of DUCs (drilled but uncompleted or completed but not producing wells). That’s fueled a 14.2% increase in Bakken production (North Dakota and Montana) on a sequential basis and 26.8% on a year-over-year basis to almost 130,000 boe per day in Q3-2017. This drove 7.3% growth in total production on a sequential basis and 16.8% on a year-over-year basis to 242,800 boe per day. Continental Resources will likely continue growing its output at strong double-digit rates in the coming quarters, driven by strong growth from Bakken wells and a drop in DUCs.

Continental Resources has said that following improvement in oil prices to well over $50 a barrel, it is targeting 15% to 20% growth in total production in the coming years. I believe the target is well within the company’s reach. Its production briefly touched 300,000 boe per day in October. For the fourth quarter, the company has said that its output will average at around 280,000 boe per day and it will exit 2017 with production of between 280,000 and 290,000 boe per day. This will translate into full year production of a little over 240,000 boe per day. If, in 2018, the company’s production climbs slightly from the exit rate to 295,000 boe per day, then that will translate into a strong 23% production growth for the full year. With a production growth rate of over 20%, I think Continental Resources may even surpass EOG Resources and Pioneer Natural Resources who’ve put some of the strongest growth numbers among large-cap independents in the last few quarters.

I believe that with higher realized prices and ~20% increase in production, Continental Resources will put solid earnings and cash flow growth numbers. Note that although Continental Resources turned a profit in 2017, it actually burned cash flows. The company generated $1.35 billion of cash flow from operations but spent $1.44 billion as capital expenditure and therefore faced negative free cash flows of $97 million. But in 2018, I think it is reasonable to assume that the company will post around 40% increase in operating cash flows (already up 56% in 9M-2017 with little production growth). Continental Resources will also likely increase capital expenditure, though the spending levels likely won’t climb as much. If the company grows its capital expenditure by 10%, then it could post positive free cash flows of almost $397 million, as per my rough estimates.

The company will then likely use the excess cash flows to repay debt in order to improve its balance sheet. Continental Resources carried $6.6 billion of debt at the end of Q3-2017, most of which is due after 2021. But the company aims to reduce its debt to $6 billion in the near-term and $5 billion in the long-term. Debt reduction should have a positive impact on the company's valuation.

US$’000	9M-2016	9M-2017	FY-2017*	FY-2018*
CFFO	$863,888	$1,347,981	$1,797,308	$2,516,231
CapEx	$878,928	$1,444,991	$1,926,655	$2,119,320
FCF	-$15,040	-$97,010	-$129,347	$396,911

Click to enlarge

Data source: CLR 10-Q Filing. *Author’s estimates.

Conclusion

For these reasons, I believe Continental Resources will deliver a solid performance in 2018, thanks to double-digit production growth, strong earnings growth and will likely report positive free cash flows as opposed to 9M-2017 when it faced a cash flow deficit. The company’s shares rose almost 3% last year, easily outperforming its peers whose shares tumbled by 10%, as measured by SPDR S&P Oil & Gas E&P ETF (XOP). I think the stock, which seems reasonably valued with EV/EBITDA (2018e.) multiple of 8.87x, will likely continue to outperform in 2018.

Note from author: Thank you for reading. Do you think Continental Resources will outperform in 2018? Please share your comments below. If you like this article, then please follow me by clicking the " Follow" link at the top of this page.

Analyst’s 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.

Comments

[wrdemott1]

I've been analyzing oil producers from a technical perspective, looking at 6 month to 10 year perspectives. CLR is great at holding a trend and going up and down faster than other companies. I am deciding between March versus LEAP calls.

[1Horse]

Is there a scenario where these guys make say, a $2 Bn free cash flow to equity ( a 10% cf yield)? Or is this company going to ride oil all the way up and then down having not cumulatively produced much in the way of free cash flow to equity?
I guess, the real question on this shale business model is - can they hold production flat and pay equity holders at some point? Or is capx going to always suck up all the cash flow - even to just run in place?

[1Horse]

So - they produce their DUCs for a few months and generate a small amount of fcf. Then what?
Service costs are inflating double digits and they need to keep up huge capx just to stay flat. So new drilling outside of the sweet spots with increasing drilling costs - not a good recipe.
And we do know that oil is cyclical. If they cant produce prodigious cash flows with oil at $65-70, when are they going to do so?

[User 21793061]

Pretty standard profile in this article. Couple question areas I have on the company:

1. What is the outlook for their Bakken production? They did a huge amount of DUCs (eschewed a lot of completions). Now they are aggressively completing them. But how many until this is done? And how are they doing at getting more than normal frack crews (more than just covering their drilling)--I hear having difficulties getting enough services. Also, their wells seem a lot better lately, but how much of that is high grading. [Not negative or positive, just a lot of questions.]

2. What is up with the STACK? At first they were great about showing all the wells and their % gas versus time. But they have stopped sharing that. MAkes me think oil decline is a problem more than they thought. Don't know, but worry. These guys tend to share good information and not the opposite. And it isn't confidentiality as they were sharing the info initially.

[Sarfaraz A. Khan]

21793061, thanks for the comment.
Bakken will drive the production growth. DUCs will likely drop to normalized levels in 2018. Management has hinted that this could be around 60s, down from 2017 exit rate of 150.
Good question on STACK. I think its not as oily as they initially thought. Also, CLR seems to have recognized that Bakken will drive the crude oil growth in the foreseeable future while STACK oil won't (can't?) play a meaningful role.

[User 21793061]

Thanks. Good response on DUCs. Hope I did not come off as expecting all the answers from you. Just sharing my question areas.

I guess one more area to watch is OK Springer completions, which are oily. Not sure what price is needed to ramp those up. I personally think 60s won't last through the year, but we could be in upper 50s for a couple years.

It is interesting, perhaps not even by exact design, how they have some optionality to shift between OK gassy and Bakken oily.

It will be interesting to hear their 2018 strategy.

It's years out, but I could see DAPL and other pipes from Bakken getting too full soon (Bakken nears records even now) and then train differentials slowing ND growth again. May sur need for Keystone. Although major issues remain with NE as the "approval" shifted the route from what had been planned/negotiated for years.

[Trading Alpha]

Great company and energy pioneer but the market has already substantially brought it back into favor.The stock is already up 200% from its lows and is at 68% of its 2014 high water mark of $80. I'm playing the more leveraged E&P companies that are less than 10% of their last high water mark. LGCY and NOG for example

[TopDoggie]

I am with you trading. If oil keeps climbing a lot of companies will triple, quad or more. Mean while this is 50 to a 100%. Big difference in returns if you're a bull. On the flip side if oil stays range bound this has a little more safety.

[jcolbyclark]

Harold Hamm, no hedges, and over $60/WTI... = MASSIVE PROFITS. CLR should double in stock price to $100/share.

[Calculus]

they're alive and politically connected...2 not so minor things indeed. think I'd wait for some stability in production and management. first but truly one of the great success stories in the energy patch.