Continental Resources (CLR) reported an increase in losses in its second-quarter results, while the company’s debt has also climbed but its future is looking better. With the increase in oil prices and restoration of curtailed production, the Oklahoma-based oil producer’s earnings should recover. It will also likely generate strong levels of free cash flow in the second half of 2020, which will help the company in reducing its debt. The second quarter was tough, but we’re now looking at production recovery, earnings growth, and free cash flow-powered debt reduction.
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Earnings Recap and Review
The second quarter was one of the most difficult periods energy companies have ever faced, as everyone is well aware. The US oil prices plunged to historic lows, with the WTI spot price averaging under $28 per barrel in the period, down from nearly $46 in Q1-2020. The extraordinarily low oil prices forced many shale oil producers to shut in a number of wells and curtail production. Unlike many exploration and production companies, Continental Resources had no hedging contracts to cushion the blow of weak oil prices. The company drastically cut production and focused on conversing cash flows and protecting the balance sheet. The oil producer’s earnings and cash flows plunged, which was widely anticipated, as I discussed in my previous article.
Total production fell by 39% from last year to 202,815 boe per day in Q2-2020, led by a 51% decrease in oil production to 95,174 bpd, which can be attributed to the slowdown in drilling work and shut-in of 55% of operated oil volumes. The company realized crude oil and natural gas prices of just $16.35 per barrel and $0.12 per thousand cf, down from $54.66 and $1.66 respectively in Q2-2019. The drop in production and low prices pushed Continental Resources’ operating income (EBITDAX) down by 96% from last year to $36 million. The company swung to an adjusted net loss of $0.71 per share from a profit of $0.59 per share a year earlier.
Continental Resources reported negative $20.25 million of net cash flow from operations for Q2-2020, down from $783.4 million a year earlier. Excluding working capital changes, its cash flows fell by 74% from last year to $206.16 million. This was, however, enough to fund the non-acquisition capital expenditures of $190.8 million. From this, we can estimate that the company ended the second quarter with free cash flow of roughly $15.4 million (ex. impact of non-controlling capital contributions and distributions). The free cash flow came after the company significantly cut CapEx by 77% from last year. Continental Resources has seen its debt climb to $5.74 billion from $5.32 billion at the end of 2019. Its financial health has worsened, with debt-to-equity ratio climbing to above-average levels of more than 90% from around 80% a year earlier.
Continental Resources struggled in the second quarter, but it is now well-positioned to grow earnings and cash flows. The earnings growth will be driven in large part by the improvement in oil prices. The WTI crude oil price has been trading near $40 per barrel since early-June and was at $42 at the time of this writing. The increase in prices came after the global oil demand recovered as the economies opened up and people got back to work. The reduction in supplies from OPEC+ and other nations, including the US, has also helped prop up prices.
The markets, however, remained concerned about the continuous spread of the coronavirus pandemic and resumption of some of the supplies from OPEC+. But crude’s stability in the low-$40s a barrel range is still a positive development. Continental Resources will realize substantially higher oil prices from Q3-2020, which will push its earnings and cash flow from operations higher.
Continental Resources’ production will also recover as the company restores curtailed output in response to the improvement in oil prices. The company made some of the industry’s most aggressive production cuts in the second quarter, curtailing 70% of its operated oil volumes in May and June. But by the end of this month, the company expects to restore nearly all of that output. That’s going to push its total production higher in H2-2020 from Q2-2020. The company has forecast Q3-2020 production of 280,000 to 300,000 boepd and expects to exit the year with an output of 310,000 to 330,000 boepd. This means that its production will meaningfully increase from ~203,000 boepd produced in Q2-2020 through the end of the year.
The increase in production and prices will give a boost to Continental Resources’ earnings and cash flows. Its cash outflows as capital expenditures, on the other hand, will likely decline even further. As a reminder, Continental Resources has substantially cut its CapEx budget for this year by 55% from the original guidance to $1.2 billion or lower. The company spent 70% of that budget in the first half, which implies that its CapEx will fall from $841.5 million in H1-2020 to $358.5 million in H2-2020, or just $179.3 million per quarter. I believe the rising cash flows and falling CapEx will allow Continental Resources to deliver strong levels of free cash flow in the second half of the year. The company is targeting $500 million of free cash flow for H2-2020 at $40 oil, which, in my view, is an achievable target.
The free cash flow can help Continental Resources address what is arguably the company’s biggest weakness: its above-average levels of debt. It has seen its debt climb meaningfully this year. A look at the company’s debt profile reveals that the increase in debt was driven by $587 million drawn from the $1.5 billion revolving credit facility. Continental Resources is not facing any short-term debt maturities. Its earliest debt maturity relates to the 5% senior notes worth $1.1 billion due 2022, but these notes have been callable since 2017.
The great thing, however, is that Continental Resources is now on track to generate strong levels of free cash flow throughout the remainder of this year. The company intends to use the free cash flow primarily for debt reduction purposes, which is a sensible approach. With $500 million of forecasted free cash flow for H2-2020, the company is now in a good position to achieve its target of ending the year with a total debt of $5.4 to $5.5 billion, which implies a $250 million reduction at the mid-point from Q2-2020. Due to the timing of the working capital changes, the full impact of free cash flow on the company’s debt might get delayed. But I think this meaningful debt reduction by the end of 2020 will establish a good momentum heading into 2021, when we might see even bigger debt reduction.
Continental Resources’ management remains laser-focused on improving the balance sheet. In 2021, if oil prices end up averaging close to mid-$40s a barrel, as indicated currently by the futures, then I expect the company to generate decent levels of free cash flow. That’s assuming it spends $1.2 billion as capital expenditures (maintenance level) to hold the production flat. Under this capital plan, the company’s cash flow breakeven level would lie in the high-$30s to low-$40s a barrel range. If, for instance, oil prices end up averaging close to $50s a barrel, particularly if we find a health solution that helps in containing or treating COVID-19, then Continental Resources might generate strong levels of free cash flow. All of that excess cash will then be used for repaying the debt. I expect the company to meet its goal of bringing the total debt down to $5 billion or lower by the end of 2021.
In my opinion, Continental Resources is a great leverage play on oil prices. It gives investors un-hedged exposure to the commodity. The rise in oil prices will not only push the company’s earnings and cash flows higher but also drive debt reduction, which should have a positive impact on its shares. The stock has risen by 24% in the last three months, easily outperforming its exploration and production peers whose shares (XOP) fell by 2.7% in the same period. Due to the outperformance, Continental Resources stock is now looking expensive, currently trading more than 9.03x on an EV/EBITDA (forward) basis, as per data from Seeking Alpha Essential. That’s above the sector median of 7.6x and slightly higher than its five-year average of 9.01x. I think value hunters should wait for a dip before buying this stock.
Note that Continental Resources is a high-beta play, considering it carries above-average levels of debt. Moreover, it typically doesn’t hedge its oil production. This allows the company to capitalize on an oil price recovery but also leaves its cash flows fully exposed to any potential weakness in prices. If, for instance, oil prices come under pressure again, then Continental Resources’ earnings, as well as cash flows, will likely plunge, just as we’ve seen in the second quarter. That’ll make it difficult for the company to generate strong levels of free cash flow and achieve its debt reduction targets.
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.