- Continental Resources rises from the downturn and posts positive FCF in 2017.
- Debt reduction on tap.
- Where Continental Resource is headed this year and next.
- Production growth driven by D&C program focused on profitable barrels.
Continental Resources, Inc. (NYSE:NYSE:CLR) is a staple of America's unconventional industry with major positions in North Dakota's Bakken/Three-Fork oil play and Oklahoma's SCOOP/STACK region that is loaded with liquids-rich opportunities. Led by Harold Hamm, a well-known industry veteran, Continental Resources has withstood the downturn better than most (particularly those with a large Bakken/TF position) and is ready to pounce on $60+ WTI. Let's dig in.
Better cash flow position leads to a better B/S
By scaling back its capital expenditures when oil prices were low, Continental Resources was able to live within its organic cash flow generation last year. Continental generated $2.08 billion in operating cash flow before negligible negative net working capital effects (reduced net operating cash flow by $1.4 million), which exceeded the $1.953 billion it spent on capital expenditures and minor acquisitions (including small bolt-on acreage purchases and other PP&E additions).
Due to its favorable cash flow position, Continental was able to reduce its debt load by $226.2 million by the end of 2017 versus year ago levels as it paid down debt in Q4. Management paid down another $95 million of Continental’s debt in January 2018, bringing the company's gross debt load down to $6.26 billion. The long term goal is to have that below $5 billion on a gross basis.
From its conference call;
"As of January 31, we [Continental Resources Inc] further decreased total debt by $95 million, improving to $6.26 billion. We're targeting further – targeting free cash flow to further debt reduction, therefore creating additional shareholder value.
You saw last week that we were raised back to investment-grade by S&P. We remain in regular communication with the other rating agencies, and we are focused on returning to investment-grade status there as well. We are well on our way to getting to our short-term debt goal of below $6 billion and with projected free cash flow in 2018 and beyond, combined with the planned asset divestitures, we are focused on achieving our longer term target of $5 billion or lower."
Asset sales funded a large portion of its deleveraging endeavors. Continental has been trimming its Bakken and Mid-Continent position to focus on more productive parts of its acreage, a process that added $144.4 million in cash to its balance sheet last year. The sale of 26,000 net acreages in the Arkoma Basin, along with related midstream infrastructure, and some of its STACK acreage that didn’t fit in with its ongoing development program raised the lion’s share of those proceeds.
"We [Continental Resources Inc] are very active on a number of fronts on the asset divestiture front. I think you'll see some stuff over the next few months out of that. I think you may see some things that are very novel that you might not have expected, but I think you'd be very pleased and enthusiastic about."
Those of you that follow me know I love to see a company pay down its debt when possible, and here is part of the reason why. Continental Resources posted $789.4 million in net income in 2017, or $156.1 million before factoring in the large income tax gain from the book value of its deferred tax liabilities moving lower. Management provides adjusted net income figures, which came out to $153.7 million for Q4 and $190.8 million for all of 2017.
Note that Continental spent $294.5 million on interest expenses in 2017, or roughly 155% of its 2017 adjusted net income generation. Having such a large debt load really depresses financial performance, and Continental needs to prepare for the future. Its interest expenses did move around $26 million lower than last year, but there is room for improvement.
On a side note, being profitable in a weak oil price environment highlights the economic potential of Continental's asset base in a higher crude oil price environment. The increases in its 2018E capex versus 2017 levels is to enable its D&C (drilling and completion) program to bring a larger amount of very profitable wells online.
Marching on upwards
By keeping its capex budget relatively contained this year at $2.3 billion, Continental expects to generate $800-$900 million in free cash flow. Production growth is a key part of this. From 2016 to 2017, Continental’s production base climbed from 216,912 BOE/d to 242,637 BOE/d, which will climb higher still in 2018 to an estimated 285-300,000 BOE/d this year.
Investors should note Continental produced 286,985 BOE/d in Q4 2017, so sequentially it won’t be until later in 2018 when production starts moving materially higher. Management aims to exit 2018 with Continental sporting a production base closer to 310,000 BOE/d.
Source: Continental Resources Inc
Next year, management plans on increasing Continental’s capex budget up to $2.5-$2.8 billion which will deliver 15-20% production growth on an annual basis. While a material increase over 2017 spending levels, Continental did gut spending during the downturn and when comparing to increases in both its FCF generation and oil prices, these planned capex increases appear quite reasonable. As long as management is willing to scale back if WTI moves significantly lower, Continental is back on a fiscally sustainable path. For reference, Continental spent over $3 billion on capital expenditures in 2015.
Source: Continental Resources Inc
With its 2018E free cash flow, management may and should continue paying down debt. Reducing Continental’s annual fixed costs and risk profile will do a lot to win over investors. At the end of 2017, the company had $188 million drawn on its revolving credit line which it could pay down with ease this year.
Farther out, its $2 billion in 5% notes due 2022 could be partially refinanced (recent debt issuances were at a lower yield) and partially paid down with cash. At the end of 2017, its current liabilities were a tad higher than its current assets, indicating future debt reduction will require new sources of cash.
Management made it clear that additional small non-core divestments were on the horizon as Continental continues to sell off properties that either aren't economical or contiguous with its core areas of operations. Those proceeds, when combined with its free cash flow generation, would enable Continental to pay down another tranche of debt.
However, Continental would need to wait a couple of years in order to have enough cash on hand to pay down those maturities in their entirety. This is why a partial refinancing is likely in my view, as Continental has been active in managing its debt profile (managing its maturity schedule and trying to obtain lower interest rates) and would probably want to act sooner rather than later.
Continental issued out the $2 billion in 5% notes with a ten-year maturity back in 2012 through two separate offerings. In 2017, the firm issued out $1 billion in notes with a ten-year maturity at a 4.375% yield. If it were to refinance, it would probably save a modest amount on its interest expenses.
Finally ending the bleeding of cash marked a major turning point in the oil & gas industry, particularly for those that were able to do so in 2017 on the back of strong Q4 performance. Continental Resources was one of those firms. Not having to lean on debt to cover cash flow shortfalls means these firms can pivot back to rewarding shareholders and fixing their balance sheets.
Production growth isn't looked at with disdain when it can be funded through organic means, and Continental Resources has indicated that its 2018-2019 capex budgets won't try to chase oil prices higher. Sure, the firm is spending more sequentially, but keep in mind it spent over $3 billion on capex in 2015, which is more than it will spend in 2019 even at the top end of its guidance. Keeping spending contained enables cash to be added to the balance sheet.
The single biggest fundamental thing holding oil & gas equity prices down, in my view, is the formidable debt loads the sector built up to withstand the downturn. Refinancing doesn't get rid of the root of the problem, and that is massive interest expenses siphoning off much needed cash flow, reducing earnings, and making it hard to scale back when market conditions dictate that is the right call. At the very least, it is likely Continental Resources pays down the balance on its revolving credit line this year as a show of good faith, but it could go farther.
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