The plunge in oil prices has forced several fast-growing shale oil producers to go into maintenance mode by cutting capital expenditures and holding production flat. Continental Resources (CLR) has gone one step further by cutting spending to a point where its production will head lower in 2020 from last year. But this could put the company in a better position to balance cash flows at low oil prices. The company, however, is a high-beta play, with no downside protection with hedges and a weak balance sheet, which investors should avoid at the moment.
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The oil prices have plunged by 60% this year, with WTI falling from more than $60 a barrel in early-January to just $24 at the time of this writing. The rapid spread of the coronavirus from China to virtually all over the world has hammered an already tenuous oil demand outlook. The global economic situation is getting worse as several countries have enacted travel restrictions and strict lockdown measures to contain the outbreak, bringing business activity to a standstill. At the same time, Saudi Arabia and Russia have started an oil price war to gain market share. The Kingdom and its allies are planning to increase production within weeks. The market’s demand and supply fundamentals could worsen in the short term which can push additional pressure on oil prices.
Previously, I wrote that Continental Resources will likely abandon its production growth forecast and make a major downward revision to its CapEx budget for 2020, considering its plans were based on an oil price environment of $55 per barrel. The company has recently provided an update that shows Continental Resources will cut CapEx and drilling activity in a big way as it tries to conserve cash flows.
Continental Resources originally planned to spend $2.65 billion in 2020, in-line with last year’s expenditures, which would have driven a 4% to 6% increase in total production. Oil production was forecasted to increase by a modest 1%, but the growth was slated to accelerate in 2021 when the company was going to place some major projects online. But now, Continental Resources has cut its CapEx guidance by 55% to $1.2 billion. The company will significantly cut drilling activity by removing a majority of rigs. Continental Resources will work with 3 rigs at Bakken, down from 9 rigs originally planned for 2020, and 4 rigs in Oklahoma’s resource plays, down from 10.5 rigs. This large cut in spending and drilling activity is going to push the company’s production down by less than 5% from 2019.
Continental Resources will provide additional details with its first-quarter results. I think the company will also likely scrap its long-term target of growing production at an average of 8% to 10% each year through 2023, considering that plan assumed oil price scenarios of $55 per barrel for 2020 and $60 for 2021-23 which seems too optimistic now with oil trading in the $20s. Additionally, the long-term forecast was also underpinned by the company’s ability to grow production this year, which isn’t going to happen now.
I think Continental Resources has made a bold decision to cut spending and drilling activity to a point where total production starts to decline. A number of oil and gas producers have also announced major spending cuts, such as EOG Resources (EOG) which has slashed CapEx by 31%. But most of the large-cap E&Ps are shifting into maintenance mode by scrapping their growth plans and focusing on keeping the output flat. Continental Resources, however, has moved more aggressively than others, which clearly indicates that the company’s priority is to preserve its cash flows at all costs, even if doing so pushes its output lower. The company might also shift its long-term focus from growing output to protecting cash flows at low oil prices.
Continental Resources’ aggressive cost-cutting measures have put it in a better position to balance cash flows at low oil prices and generate free cash flows if oil recovers. The company has said that it can achieve cash flow neutrality at oil prices of less than $30 per barrel. This implies that Continental Resources can generate around $1.2 billion of cash flow from operations at oil prices of less than $30 per barrel which will fund the CapEx of $1.2 billion. If the commodity ends up averaging more than $30 per barrel in 2020, then Continental Resources can generate more than $1.2 billion of cash flow from operations and deliver free cash flows.
Continental Resources hasn’t given any details related to its cash flow breakeven level. In my view, the company likely needs WTI oil prices of around $27 to $29 a barrel to balance cash flows, assuming $1.2 billion of CapEx and declining production. In this case, however, the company likely won’t have any excess cash flows left to fund the dividends. My estimate is based on the company’s forecasted oil price sensitivity which shows that every $5 per barrel change in oil prices moves Continental Resources’ cash flows by approximately $300 million.
At $30 WTI, Continental Resources can probably generate modest levels of free cash flows which can help fund some of the annual dividends of $72 million. But in the current oil price environment of around $24 a barrel, Continental Resources likely can’t generate enough cash flows to fully fund its capital expenditures. As a result, the company might face a cash flow shortfall (or negative free cash flows). If oil prices drop further, then Continental Resources could burn even more cash flows.
That’s also true for the broader exploration and production industry. Pretty much nothing works in US shale with oil trading below $25 per barrel. All shale oil drillers will likely burn cash flows at these prices. But companies like Pioneer Natural Resources (PXD) and EOG Resources, who have hedged a large chunk of their future oil production and also have an under-levered balance sheet, can stand firm in this difficult period. Their hedges minimize the exposure of their cash flows to the oil price weakness and their rock-solid balance sheets can help meet any potential cash flow shortfall. Continental Resources, however, neither has any hedge coverage nor a strong balance sheet.
Continental Resources doesn’t hedge its oil production as a rule. During good times, a lack of hedges gives the company an opportunity to capitalize fully on rising oil prices. But it also leaves the company’s cash flows fully exposed to the oil price weakness during the downturn. A plunge in oil prices will hit Continental Resources’ cash flow from operations more severely than those oil producers who have used derivative contracts like swaps to hedge future production.
Continental Resources also has weak financial health. It carried $5.33 billion of debt at the end of last year which translates into a debt-to-equity ratio of 79%. That’s higher than the large-cap peer median of 57%, as per my calculation. Continental Resources is also facing some near-term debt maturities. Its 5% senior notes of $1.1 billion which become due in 2022 have been callable since 2017. The company has a total of $3.6 billion of debt maturing from 2022-24. This approaching debt wall could become a major concern in the future if oil prices continue to stay low for an extended period.
In my opinion, Continental Resources has made the right decision to significantly cut spending and reduce production to protect its cash flows. But in this environment of extremely weak and volatile oil prices, I believe investors should play defense and avoid the high-risk exploration and production stocks like Continental Resources that have weak balance sheets. Shares of Continental Resources have tumbled by 70% this year, underperforming the SPDR S&P Oil & Gas E&P ETF (XOP) which is down 64% in the same period. The company’s shares are priced 4.8x in terms of EV/EBITDA (forward) multiple, below sector median of 5.3x, as per data from Seeking Alpha Essential, but I think investors should avoid this stock.
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.
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