CLR Is An Example Of Why Shale Industry Is Not Responsive To Higher Oil & Gas Prices

Summary

• The core Bakken acreage in CLR's portfolio seems to be mostly spent, leaving Continental with few options but to manage a halt in production growth, while aiming for profits.
• For the current quarter, production is set to be just under levels seen in Q3 of 2019.
• Continental's production performance is typical of the industry, given increasingly scarce prime acreage, a damaged reputation in terms of profitability, and other factors.
• Continental's profit outlook looks good, on the back of disciplined operations and strong oil & gas prices, but it has a longer term problem of declining acreage quality.

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Investment thesis: After almost a full decade of chasing production growth at the expense of profits, the shale industry is now discovering the benefits of aiming for profits instead. Continental Resources (NYSE:CLR) is not only concerned with aiming for profits, perhaps building on its current dividend yield of about 1.9%, but also with trying to preserve its prime acreage portfolio as much as possible, in order to prevent becoming over-dependent on second-tier acreage. I foresee a balancing act, where higher oil & gas prices will lead to a slight increase in drilling second-tier acreage, which will cut into profit margins. Continental will probably pull back on second-tier acreage drilling in response to lower oil & gas prices, which will lead to a slight decline in overall production. It will keep prime acreage drilling rates steady unless the oil and gas markets will do something drastic, with sustained consequences. It is difficult to ascertain at what point it may run out of prime acreage, but when that will happen, Continental will have a very hard time maintaining profitability. For now, it should continue providing steady profits, dividend returns as well as improve on its debt situation.

Continental posts healthy financial numbers for the quarter and YTD.

For the third quarter of this year, Continental produced revenues of $1.34 billion and net earnings of $369 million. That is a profit margin of 27.5%, which is very healthy. Long-term debt declined from $5.53 billion at the end of last year, to $4.74 billion as of the end of the third quarter. For the nine months so far, its interest expenses declined from $192.5 million in the first nine months of 2020, to $185.8 million. It is not a massive relief from interest payments, but it is headed in the right direction. In terms of the interest costs to revenues ratio, it is just under 5%. Around 5% is the interest cost/revenue ratio that I tend to regard as the borderline where investors should worry in regards to commodities producers.

I ideally like to see that ratio maintained under 5% even when commodities experience a significant and sustained price pullback. In other words, even in the worst of times that ratio should ideally not be exceeded. It is clearly not the case with Continental. For the first nine months of last year, the interest cost to revenue ratio was just over 11%. I don't believe we are likely to have a similarly bad year on the horizon for the oil markets as we did in 2020, therefore I think it is unlikely that Continental will see such elevated levels of interest costs to revenues again for the foreseeable future. The continued decline in long-term debt should help to contain those costs for the longer term.

Continental's production is shifting more towards natural gas, but that should not be a reason for investor concern.

In the past decade, a well-defined profile emerged for relatively successful shale producers. It goes without saying that they had to win the prime acreage lottery. In the first half-decade, a relatively well-defined contour emerged of where the sweet spots in most major shale fields were to be found. Continental bet heavily on the Bakken and it did secure major patches of prime acreage in the four-county core of the field, but it also had significant acreage in the less lucrative parts of the field. Much analysis focused on factors such as project execution, but that played a mostly secondary role in the relative success of most drillers. Many efficiently run companies, with decent drilling costs, still went under, because they lacked decent quality acreage.

The other major factor that contributed to success for most shale producers last decade was being more heavily invested in liquids-rich acreage, rather than natural gas. The reason behind this was the fact that the shale oil boom was affecting a global market, while the natural gas boom was affecting the regional markets, given that it is much harder to transport it to other continents, and sometimes even different parts of the continent, given pipeline availability issues. The shale oil boom was responsible for knocking the price of oil from its multi-year $100/barrel price range by the middle of 2014, which did cause some pain for many oil producers. The reduction in the price of natural gas in North America however was ruinous for shale producers that were overly reliant on natural gas production.

Source: EIA.

As the chart suggests, expectations near the beginning of the century were for much higher natural gas prices. Then, prices settled in a lower range at the beginning of last decade, but they were still reasonable. After the 2014 oil price crash, that took natural gas with it, US shale drillers faced a prolonged period of very low natural gas prices. Far lower than what most drillers could sustain, thus it became viewed as a liability.

With the natural gas price recovery, we are seeing more recently, we need to change our perceptions accordingly and stop viewing shale producers which might be increasing the share of natural gas as a percent of total production as being negative. Continental is seeing a great deal of increase in natural gas production as a percentage of total production, with an increase of 23% in the nine months of this year, compared with the same period in 2019. Oil production declined by about 20% for the same period. Crude oil now makes up just under half of Continental's total production. This should not worry investors though, because there are plenty of factors that should support natural gas prices for the longer term. LNG exports are one such factor. On the supply side, it does look like natural gas production is now stagnant. The highest level of US natural gas production was reached in November 2019, according to the EIA. While production levels have remained relatively close to that record high, and a new record could be set any given month, the overall pattern of behavior of the collective US oil & gas industry does suggest that production stagnation is set to continue for the foreseeable future, with only minor deviations from current production levels expected to occur. Natural gas prices should therefore also stabilize around current levels, with weather patterns, as well as LNG demand being the most likely drivers of the price of natural gas going forward.

Prime acreage availability is of great concern.

We know that the Bakken field is mostly running low in regards to prime drilling spots, which is why production in the field is significantly off its record highs. North Dakota's portion of the Bakken field has seen a peak in production in October 2019 at a daily rate of 1.46 Mb/d. It is currently at 1.07 Mb/d. Continental's own production in the field is down from 195 k barrels/day in the first nine months of 2019, to 168 k barrels/day in the first nine months of this year. While production per new well seems to be steady, suggesting that it is still drilling high-quality acreage in the field, the number of wells it is drilling is in decline.

Source: Continental Resources.

As we can see, with three months to go, Continental drilled 93 wells so far, as of the end of Q3. For the whole of 2019, it drilled almost twice as many wells. This is a clear indication that Continental resources is working very hard to ration the remaining prime acreage in its Bakken acreage.

Continental still has ample second-tier acreage in the field, but I expect it will take a sizable and sustained increase in oil prices before it will tackle such projects, beyond just minor drilling activities. It is an emblematic situation that keeps most shale drillers from increasing their overall drilling activities. We might now be in an oil & gas price range where some of the upper-end of the second-tier acreage could become viable to explore. There is just simply too much uncertainty in regards to where the oil & gas market might be headed for drillers to be willing to risk tapping far less profitable reserves.

Continental's natural gas production is rising, in part because it secured some decent acreage outside of the Bakken.

Source: Continental.

While Continental is by no means surging in terms of drilling activity in its Oklahoma acreage, which is mostly natural gas, it is not reducing drilling by much either. It is consolidating its drilling into the most profitable parts of its acreage, as evidenced by the improving production results from its wells. The fact that it still has room to consolidate its drilling into the most profitable parts of its Oklahoma acreage, means that it conceivably could have significant prime acreage left in reserve. It is uncertain just how much of it there is, but for now, Continental can be assumed to be able to profitably produce natural gas from its Oklahoma acreage for some years to come.

In the past few years, Continental moved into the Permian and the Powder River area, with acquisitions meant to perhaps secure a future after its prime acreage in the Bakken area shrinks in importance, to the point where it can threaten the company's viability. After all, just last decade investors were piling into stocks like Continental, in the hope of seeing magnificent growth in production rates. It goes without saying that allowing its production to precipitously shrink would scare away investors, perhaps even more dramatically than we saw them piling in especially in the early years of the shale boom. These acquisitions should provide Continental with enough decent acreage to keep profitable production going at current levels for some years to come, even as its Bakken production will most likely continue to shrink.

Continental is set to maintain production, continue consolidating its debt situation, while managing its prime acreage portfolio, in order to try to stretch it out for as long as possible. This will involve producing some second-tier acreage, but not excessively as a way to strike a balance between maintaining profitability, production, and resource longevity simultaneously. Any increase in production will be approached in a timid fashion, only once there will be some sure signs of a prolonged period of higher oil & gas prices. Because of the global natural gas situation that looks increasingly tight in the Europe-Asia regions, a new price floor for US natural gas is likely forming right now, which seems to be about double the price it has been in the past five years or so. Continental should therefore not be greatly affected by its shrinking oil revenue stream, even as natural gas production is increasingly taking over. It will more or less mirror the fate of the overall US shale industry this decade. Continental may perhaps be the most perfect fit in terms of being that emblematic company that one can follow as a way to gauge how the overall shale industry is set to do going forward.

Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.