Key Takeaways:
· Continental Resources is an oil and gas E&P with the largest shale position in the Bakken.
· Production and proved reserves have significant room to grow.
· A supermajor oil company like Exxon or Chevron could be interested in acquiring Continental.
· We believe shares have 35% upside from current levels.
Production of shale oil in the Bakken (1) continues to grow rapidly, and the long-term production fortunes in the region remain as positive as ever. Let’s take a look at Continental Resources (click ticker for report: ), a firm we believe has 35% upside from current levels and one that recently made our list of The 25 Cheapest Stocks on the Market.
(1) The Bakken field of North Dakota and Montana is one of the premier crude oil resource plays in the United States. It has been described by the United States Geological Survey (“USGS”) as the largest continuous crude oil accumulation it has ever assessed. Estimates of recoverable reserves for the Bakken field have grown from 4.3 billion barrels of crude oil, as published in a report issued by the USGS in April 2008, to potentially 11 billion barrels of crude oil in North Dakota alone, as reported by the North Dakota Industrial Commission (“NDIC”) in January 2011. In October 2011, the USGS began a study to update their 2008 assessment of recoverable reserves for the Bakken field to include reserves from the Three Forks formation and take into account improved well performance due to advances in drilling, completion and production technologies. Results of the USGS study may be announced in late 2013. Source: CLR 2012 10-K (page 10)
Background and Resource Base
Continental Resources can trace its heritage to 1967, beginning as a driller in Oklahoma. Though the company remains headquartered in Oklahoma and does maintain drilling operations in the state, the lion’s share of the firm’s oil and gas production is in the Bakken Shale in North Dakota, where Continental acquired 300,000 acres in 2003.
Image Source: CLR 10-K 2012
As exhibited above, the company’s net acreage has increased considerably since 2003, now sitting at 2.24 million net acres of oil and gas fields. Even more positive with respect to our assessment of the firm’s future outlook, the company has developed just 897,542 of these net acres while 1.35 million net acres remain undeveloped (both figures in table shown above).
Of this undeveloped net acreage, leases on 873,782 (65% of net undeveloped)* acres are set to expire unless production begins during the next three years, with expirations heavily tilted toward 2013 (359,999 in the year, as shown below). If the firm is not able to renew leases before they expire, any proved undeveloped reserves associated with the leases will be removed from the company’s proved reserves. However, rising production throughout the Bakken region year-to-date should prevent some of this acreage expiration, in our view, making proved reserve estimates reasonably reliable.
* Net Acre Expirations: 359,999 +234,297 +279,486 = 873,782 (in table below)
The below table showcases Continental’s estimated proved crude oil and natural gas reserves and PV-10 by reserve category at the end of 2012:
Image Source: CLR 10-K 2012*
* PV-10 is a non-GAAP financial measure and generally differs from Standardized Measure, the most directly comparable GAAP financial measure, because it does not include the effects of income taxes on future net revenues. Standardized Measure at December 31, 2012 is $11.2 billion, a $2.1 billion difference from PV-10 because of the income tax effect. Neither PV-10 nor Standardized Measure represents an estimate of the fair market value of (the firm’s) crude oil and natural gas properties.
Management is optimistic about future proved reserves, as it anticipates having proved reserves of 1,524 MMBoe (million barrels of oil equivalents) by 2017—up significantly from its 785 MMBoe at the end of 2012. Even if production rises significantly in the years ahead, the firm will have the capacity to replenish its reserves. We’re big fans of this growth profile.
Image Source: CLR September 2013 presentation
Production
Production is expected to grow 38-40% in 2013 followed by growth of 26-32% in the following year. This will take Continental from an annual production rate of 35,716 MBoe in 2012 to 62,103-66,003 MBoe by 2014, as shown in the slide below. That’s approximately 74-85% higher in only two years! With relatively low production expenses per Boe, the company remains well-positioned to capture a nice spread.
Image Source: CLR September 2013 Presentation
Cash costs per barrel also look great. Currently, Continental’s cash costs are running in the $18-$19 per-barrel range, and this figure could improve with technological innovation and modest operating leverage, leaving the firm with a sufficient margin of safety for profit making (relative to where crude oil prices are). Still, we’re not factoring any abrupt changes in its cash costs with respect to our estimate of its intrinsic value.
Image Source: CLR September 2013 Presentation
We also don’t believe Continental will have to take on too much leverage to expand its drilling operations, given its improving operating cash flow. The firm currently has $4.4 billion in debt on its balance sheet, but thanks to some timely debt issuances, the current quarterly interest expense runs the firm just $61.3 million compared to operating income of $574 million during its most recent quarter. Total debt/EBITDAX stands at 1.8 relative to the industry average north of 2, so we’re not too worried about its credit at this time. However, we’ll be watching this closely if crude oil prices start heading south.
But…We Expect Crude Oil Prices Will Be Higher in the Long Term
Image Source: Oilprices.com
Crude oil price action in recent months has been negative, as West Texas Intermediate (WTI) experienced its usual summer spike. However, our comprehensive outlook for oil prices presents our thoughts on crude prices in the near-term and long-term. For the next 3-4 years, our base case scenario predicts crude oil prices to fall modestly as additional supply comes to market. However, we expect prices to recover materially thereafter (as shown below):
Image Source: Valuentum
<< Valuentum’s Comprehensive Outlook for Crude Oil and Natural Gas Prices
Bottom line—we think short-term price weakness in crude oil will be overtaken by long-term supply/demand fundamentals to drive prices higher over the long-term. For Continental, sales become substantially more profitable whenever the prices of crude oil and Henry Hub Natural Gas rise. Combined with Continental’s strong cost controls and increasing reserve base, the company has room to become substantially more profitable in the coming years.
Valuable Leases Make Continental a Target
Image Source: CLR September 2013 Presentation
Continental has an enviable position in the sense that it is the largest land leaseholder in the Bakken. Of the supermajors, only ConocoPhillips (click ticker for report: ) holds a major stake in the Bakken. Other than Continental, the largest leaseholders in the Bakken are Hess (click ticker for report: ), EOG Resources (click ticker for report: ), and Whiting (WLL).
Both Exxon (click ticker for report: ) and Chevron (click ticker for report: ) are eager to replenish oil reserves, but both supermajors were notoriously late to the game in terms of shale. An offer at our point fair value estimate would cost a company around $27 billion—a little more than one year of free cash flow at Exxon. A larger premium would still make acquiring Continental less expensive than bidding for EOG. Given the friendly M&A environment and potential for proved reserve growth in the Bakken, a supermajor could make a move in the not-so-distant future.
Valuation
Shares of Continental trade at a discount to our fair value range of $111-$185 per share. Though the fair value range is a relatively wide one, given that our fair value estimate depends on volatile long-term assumptions (including the price of crude oil), we think a wide range is appropriate.
For more information on how we think about fair value ranges in valuing companies, please click here.
Our point fair value estimate of $148 per share represents upside of 35% from current levels ($107 at the time of this writing), and continued strength in oil prices could prove our forecast conservative.
With Continental registering a relatively high mark on the Valuentum Buying Index and offering strong secular growth exposure to North American shale oil, we continue to watch the firm very closely. We’ll be looking to add the company to the portfolio of our Best Ideas Newsletter on any material pullback.