- Less than a year ago Continental Resources was expecting to see a continued decline in its debt. The current crisis threatens to wipe out all the progress made and more.
- While it is still sitting on, decent acreage, Continental's main project, the Bakken is starting to show signs that the average acreage it is drilling is of diminishing quality.
- If oil prices will recover soon Continental can still preserve itself. If however oil prices will not recover soon, it is likely to be forced to sell some assets.
As I pointed out in a recent article in which I covered EOG (EOG), the current economic crisis may leave many shale producers with no choice but to either declare bankruptcy or sell off some of their best assets. A few may be left standing and they may even be in a position to pick off some of the better assets left on the carcass of the industry. EOG looks like a good bet to be among those few. Continental Resources (NYSE:CLR) on the other hand is a big question mark. It does have some strengths, but all the negatives may outweigh the positives at this point. In the absence of a timely increase in oil prices to a much higher level compared with the current price environment, it may find itself struggling. It may survive this difficult period, but not without having to resort to selling some of its better, more profitable assets.
Continental's Q1 results paint a worrying picture.
While the net earnings numbers showing a loss of $186 million in the first quarter of 2020 shows an ugly picture, it is not the entire picture. Accounting rules tend to often distort the true profitability picture by including items such as depreciation and impairments in the costs and expenses section of the income statement. This tends to have a distortive effect, especially on commodity producers which tend to be volatile. The increase in long term debt tends to be a better indicator in regards to what is going on in regards to profitability. in the absence of major investments or divestments, it tends to reflect a mismatch between money spent on all operations and the money derived from operations. In the case of Continental, its long term debt increased from $5.3 billion in the first quarter of 2019, to just under $6 billion in the latest quarter. At the end of 2019 its debt was also $5.3 billion, meaning that the large quarterly jump was mostly due to the lower oil price environment.
The average price of WTI oil was $45.76/barrel in the first quarter of this year. That average was enough to cause a roughly $700 million gap between Continental's costs and its revenues, based on its increase in debt during the first three months of the year. What this means is that in the second quarter we will likely see a further jump in its debt level. For a company that produced $4.6 billion in revenues in 2019, this debt load is starting to become troubling, given that it is higher than a full year's revenue stream.
Another measure of the financial health of mining companies I like to look at is the debt servicing costs as a percentage of total revenues. Interest expenses totaled $63.6 million in the first quarter of the year, while total revenues came in at $881 million. This means that 7.2% of Continental's revenues had to go to debt servicing. It is true that revenues will most likely improve in the coming quarters as oil prices will recover. At the same time, the current increase in its debt load will also cause a rise in interest payments, so the current rate of debt servicing to revenues ratio is likely to remain with the company for a while. In the event that oil prices will remain subdued for a prolonged period, this measure of financial health will deteriorate greatly in the coming quarters and years. In my view, any ratio above 5% is a signal that investors need to start worrying. Anything over 10% and a company can be considered to be in deep trouble unless it can retreat bellow that number in a timely manner.
In a presentation made in late 2019, Continental expressed optimism in regards to continuing to cut its debt to more manageable levels, as the chart above illustrates. Looking at the situation now, it seems increasingly obvious that the opposite is likely to happen. Continental may see its debt load rise back to levels seen back in the 2015-2016 period when we had the first price shock to the system of the shale industry. If oil prices will fail to recover to a significantly higher level, its debt levels will probably surpass the high levels seen due to the last oil price crash.
Acreage quality set to decline.
While its debt will be back to the levels seen in the last crisis or even worse, its acreage quality is declining with every year that passes. In other words, the net quality of its acreage is probably worse than it was during the last oil price crash.
As we can see, the 2019 production curve so far tends to lag behind the 2018 curve just slightly. We should keep in mind that technical improvements are on-going within the shale patch, therefore the data thus far suggests that the acreage that was being drilled last year, was most likely net inferior to the 2018 acreage that was being drilled. I suspect that things will look even worse in the coming years. This year may be an exception as Continental will focus extra hard on only bringing the best of the best wells on-line, in order to minimize its financial losses. Beyond this year, it will most likely see a continued trend of well performance deterioration, which will not be a welcome trend given the added pressure of more debt that is now accumulating and will have to be serviced.
As is the case with most of the rest of the shale patch, in the absence of a relatively prompt recovery in oil prices Continental Resources will see tough times ahead. At times its stock may continue to recover from recent lows, together with the oil market. But eventually, the fundamentals will catch up and those fundamentals do not look all that good. Unless average oil prices will return to a range of $80-$100/barrel for a sustained period of many years, which will allow Continental and other shale peers to repair their increasingly dire financial situation, it will have to resort to more drastic measures, such as selling some of its best acreage. Such measures will come with some downside, including a decline in production and revenues, as well as a sacrifice of its profitability going forward.
We should be clear in regards to what kind of assets Continental will be able to sell and what it will not be able to sell at a decent price that would help it dig itself out from under the crushing debt pile that it will accumulate by the time the current economic crisis will be over. There will be few buyers for second-tier acreage unless it will be fully developed and any prospective buyers will buy the future production in place at a deep discount in relation to its estimated value, which is not necessarily a good move for sellers because they already spent all the money to develop the inferior acreage. All that it will do is deepen the loss per well when it's all tallied up. Continental may have no choice but to take the loss to its long term viability, in order to shore up its finances in the short term if the price of oil fails to recover to a significantly higher level fairly soon.
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