Continental Resources: Data Suggests Beginning Of The End Of Prime Acreage Honeymoon

Summary

• With oil prices declining from $70/barrel to $56/barrel from Q3 2018 to Q3 2019, Continental's profits were cut in half, confirming that Bakken's best acreage needs about $50/barrel for viability.
• Continental's well data suggests that wells drilled and completed this year are slightly under performing wells drilled last year, which suggests beginning of end of prime acreage drilling.
• Wells seem to be underperforming despite evidence that Continental further consolidated drilling into core areas, meaning that well interference is playing increased role, signaling over saturation.

While I never took a great deal of interest in the shale patch as an investment opportunity, I have been paying very close attention to the industry as a way to gauge where the overall global oil market is headed. I found that one of the best ways to gain a clearer picture is to focus on certain companies which can serve as a gauge with regard to shale profitability in certain parts of specific fields. For instance, for Eagle Ford's second tier areas, I mostly followed the now bankrupt Sanchez Energy, given that its acreage was mostly located in Dimmit County, where well results were overall inferior. The fact that it went bust is a clear indication in my view with regard to where things stand when it comes to profitability in Eagle Ford's second tier acreage. When it comes to Bakken's first tier acreage I have been mostly following the financial results posted by Continental Resources (NYSE:CLR). It's not a perfect gauge, given that it also operates in other fields, but currently about 57% of its total production volume comes from Bakken's first tier acreage. In terms of revenue, the ratio is much higher, given that most of its oil production comes from Bakken. Based on the latest quarterly numbers, it seems that we are getting close to the point where oil prices may be just high enough to sustainably produce oil from Bakken's best acreage, but this is definitely close to the point where it becomes uneconomical. This is potentially bad news for the longer term, because there's also evidence emerging that its first tier acreage may be getting saturated.

Lower oil prices cut Continental's profits in half

In the third quarter of 2018, the average price of WTI was just under $70/barrel, which is when Continental achieved a net profit of $314 million, on revenue of $1.28 billion. For the latest quarter revenue declined to $1.1 billion, even as overall oil and gas production increased by 12%. Net income was cut in half to $158 million, compared with the same quarter from a year earlier. The average price of WTI was just over $56/barrel in the third quarter of this year. The decline in revenues and profits is mostly a reflection of the $14/barrel decline in oil prices.

There seems to be no operational improvement that would have helped to compensate for the decline in oil prices. Despite constant industry-wide claims of constantly improving drilling economics, it seems Continental at least has not seen improvements of note in the past year. This however may not necessarily be a sign of lack of technical improvements, but rather an indication of lower quality acreage or well saturation issues offsetting the effect of technical improvements.

Interest payments on Continetal's debt improved just slightly, but we are still looking at about 6% of total revenues going to debt servicing costs. I personally prefer to see the debt servicing cost to revenue ratio well below 5% for miners. Ideally, it would have to be much lower for shale drillers, which are likely to start transitioning their drilling activities into lower quality acreage. Long-term debt looks steady as well at $5.6 billion, just slightly down from over $5.8 billion for Q3, 2018, meaning that the current oil price level is just enough to keep Continental from accumulating more long-term debt, at least for as long as it can continue drilling mostly in its prime acreage.

Source: Continental Resources.

As we can see from the chart, there's no significant change in Continental's debt this year, therefore the current oil price level is in no way sufficient to help Continental pay down its accumulated debt. We should keep in mind that we need to see debt reduction is relevant for all shale producers at this stage, because we are most likely looking at only a few more years of prime acreage drilling. Continental is forecasting that it will reduce its long-term debt to $4.2 billion by 2023, by which time it will most likely be forced to drill in mostly second tier acreage, or overly saturated first tier acreage, where well interference can greatly diminish profitability. From my perspective, even that $4.2 billion in debt will be too much of an extra burden once Continental's prime acreage will be largely exhausted. The way things are going at the moment, Continental will not come close to achieving its debt reduction goal.

I should note that there may be some early indications that Continental's average Bakken well performance may already be under performing slightly compared with last year.

Source: Continental Resources.

The under performance may be just slight, hardly of great financial consequence. Supposedly there are constant technical improvements in drilling techniquea, which should be leading to a net gain in well performance. Assuming that this year it was no different in this regard, this may be an indication that average acreage quality that Continental drilled this year is already in decline.

Continental sitting on some of the best acreage in the Bakken, so the rest of the industry probably facing similar problems

Source: Continental Resources.

An interesting aspect of Continental's slight decline in well performance is that it seems to have happened despite the fact that if we look at the map, it seems that it actually consolidated its drilling into its core area. For instance, it did not drill in Divide and Burke counties, where acreage quality has been on the lower end, even though Continental did so rather intensely in 2018. What this means is that acreage quality within its core area is starting to decline. This is most likely a result of drilling on the fringe, as well as perhaps well saturation issues causing well interference.

Continental Resources has been the largest operator in the Bakken by acreage as well as number of wells drilled, and a great deal of it has been in the Bakken's core area. Based on Continental's own numbers, it does seem that there's a slight decline in its average acreage quality that it's drilling this year, compared with last year. It remains to be seen whether this will be repeated next year as well, which if it is the case, it will in my view confirm the beginning of the end of the prime acreage honeymoon era for Continental's Bakken operations. The rest of Bakken's prime acreage producers are likely not far behind, if this is the case. With no viable argument to be made in favor of forecasting significantly higher oil prices in the next few years, due to a weak global economy, as well as ample spare capacity, Continental, as well as its peers, should be in for a rough ride ahead.

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.