Buying Continental Resources

Summary

• Continental Resources is well positioned to benefit from higher oil prices, thanks to its low cost structure and decision to refrain from hedging production.
• The company's balance sheet is strong and current oil prices have significantly eased the pressure on its financials.
• While the stock is very volatile, I expect a breakout backed by a high short float and the need to catch up with oil after the most recent downtrend.

It's time to discuss one of the few trades I executed over the past few months. As markets have been volatile, I have been looking for great stocks to buy at good prices. The Oklahoma-based E&G giant Continental Resources (NYSE:CLR) is one of these companies. In this article, I will discuss the company's low-cost profile, COVID-19 measures, its balance sheet, and my expectations going forward.

Source: PR Newswire

Tough Times Require Tough Measures

On November 11, 2019, I wrote that Continental Resources was one of the best oil plays working on a bottom. I mentioned rapidly rising production, strong free cash flow, and low breakeven prices. In addition to that, I started mentioning a global growth bottom after the economy had peaked in 2018. All of this turn into a strong bull case as the stock quickly gained more than 14%. Unfortunately, then COVID-19 happened, and we all know how that turned out.

Right now, Continental Resources is down roughly 62% since the start of the year and 12 months ago. As the graph below shows, global oil demand imploded in the first two quarters of 2020 by almost 20%. As a result, the global supply fell as well. Continental Resources shut roughly 70% of its crude output in May in one of the largest production cuts announced among domestic oil producers. EOG Resources (EOG) is curtailing about 25% of production and canceling almost 40% of planned new wells that were expected to go online in 2020.

Source: Seeking Alpha (HFI Research)

Since February, Continental Resources has taken a number of steps as described in its latest May investor update. In February, the company decided not to overproduce into an oversupplied market and reduced its capital spending to levels equal to 2019. Back then, it turned out to be a smart move as the West wasn't even hit by COVID-19. In March, management decided to reduce the budget by 55% compared to original guidance. Then, in April, it was the first E&P to announce the voluntary curtailment of operated production.

Its 2020 priorities are pretty much similar to priorities from companies in entirely different industries: balance sheet protection, cash flow preservation, and delivering capital-efficient operations. The fourth measure is the conservation of the company's top-class assets in order to increase production as soon as market conditions improve.

Balance Sheet Strength Is Satisfying

Before I discuss any other fundamentals, it's important to start with financial strength because I don't buy any companies close to bankruptcy regardless of whether we are close to a turning point in oil markets. I made that mistake in the past with stocks like Whiting Petroleum (WLL).

Anyhow, Continental Resources has a solid balance sheet. As of the end of the first quarter, total liabilities are valued at 56.9% of total assets. Net debt is valued at 2.3x EBITDA with total debt being valued at 88% of total equity. None of these numbers scream "value dividend investing" because the company is different. Even if oil remains low for an extended period of time, I do not foresee any problems or needs to sell shares. Right now, current assets cover 120% of current liabilities. Additionally, the company generated $478 million in free cash flow in its first-quarter, thanks to $1.13 billion in new debt issued. The company has not used secondary share offerings to increase cash, which I believe is one of the most important takeaways. A lot of struggling oil companies use secondary offerings to stay afloat. Continental Resources is too strong to be forced to sell shares.

Data by YCharts

Why I Bought The Company

The aforementioned balance sheet strength is one of the reasons but not the main reason why this company is a good buy. As you can see below, crude oil has advanced quite a bit after going negative in April. Right now, the price of oil is above the 2016 bottom levels as investors are expecting a strong demand recovery in the remainder of the year and further supply control (first graph of this article). In addition to that, the dollar index has declined more than 5% from its 2020 peak. This means that dollar-denominated debts abroad are easier to service. This boosts global economic growth and stabilizes commodity prices. Note that this is one of the many factors. Economic growth is still very weak. This is just a good start to get commodities going again.

Source: TradingView

Like many drillers, Continental Resources has been lagging the price of oil as the stock price has not gone anywhere since April. This is one of the reasons why I bought it at $12.80. I expect the stock to gain momentum as investors start to buy beaten-down stocks that have much more potential than their stock prices seem to suggest right now.

Buying based on the expectations that oil prices are further rising, and the fact that Continental Resources is lagging might work. However, there is still more to it. Right now, the company is the lowest cost operator among oil-weighted peers. It has an operating breakeven price of roughly $8 WTI. Its cash cost is just slightly below $10 per barrel. All things included, the company needs $30 WTI to sustain its business. Right now, it is almost $8 above that price, meaning financial pressure on the company is rapidly lingering. A low breaking even price also allows the company to get production back online sooner than some competitors if oil prices stabilize. Besides that, the company does not hedge its production. Whereas other producers will have to deal with lower selling prices due to hedging IF oil were to rally hard, Continental Resources will immediately get the full benefit from higher average selling prices.

Moreover, while I do not base my trading ideas based on insider trading activities, it is good to know that insiders seem to agree. In 2020, insiders have bought a lot of stock at prices below $10 as you can see below.

Source: FinViz

While insiders are buying, the market, in general, remains quite negative. Right now, the company's short float is 30.4%. In other words, roughly one-third of shares are sold short in a market that seems to offer more upside potential than downside risk.

Right now, the stock is poised to break out of the downtrend that started in early May. I believe if oil remains steady, Continental Resources has room to run to $20 over the next two months.

This brings me to the last part of this article.

Takeaway

I started adding some stocks that I consider to offer a good risk/reward. Continental Resources is one of these stocks. The company has a great balance sheet and very low breakeven prices, thanks to low operating costs and no oil hedges. If WTI is able to rise further due to recovering demand and a weaker dollar, I believe we are looking at a stock that has the potential to double over the next 12 months - or even earlier, depending on the economy.

While I believe I got in low at $12.80, I have to mention that this company is volatile. If you decide to go long oil stocks, make sure to adjust your exposure accordingly. Continental Resources has a beta of 3.5 right now. In other words, expect huge daily moves to both the upside and downside. Even if the stock were to bottom, high volatility in combination with high exposure can do serious damage to one's portfolio.

Nonetheless, all things considered, I think we are looking at a pretty good risk/reward for the mid-term and maybe even long-term depending on the economic recovery. I just had to buy stocks in what I consider one of the best oil stocks on the market.

Stay tuned!

Thank you very much for reading my article. Feel free to click on the "Like" button and don't forget to share your opinion in the comment section down below! My long-term investments are stated in my Seeking Alpha biography.

Analyst’s Disclosure: I am/we are long CLR. 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.

This article serves the sole purpose of adding value to the research process. Always take care of your own risk management and asset allocation.