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Morningstar | Seeing Higher Crude Prices, Continental Adds Rigs in the Bakken and Oklahoma

Narrow-moat rated Continental delivered production of 297 mboe/d in the third quarter, which was 22% higher sequentially and 2% higher year over year. Accordingly, the firm is still on track to hit its annual production guidance of 290-300 mboe/d, with an exit rate of 315-325 mboe/d. Further, management highlighted that volumes should see another jump in the fourth quarter, driven by a surge in Bakken completions (70 new Continental wells are expected online in the period, which would equate to 40% of the yearly total). And 2019 output should beat our prior estimates as well, due to the deployment of several additional rigs (two in the Bakken and five by year-end in the SCOOP).

The firm’s financial results were strong as well, with adjusted EBITDA and adjusted earnings per share coming in at $983 million and $0.90 respectively (comfortably ahead of consensus estimates, which were $892 million and $0.71). Nevertheless, we have trimmed our fair value estimate to $60 (which is still higher than the current price following the recent slump). This was mainly driven by an uptick in unit production costs, which rose to $3.77 in the period and exceeded our $3.25 estimate for the third consecutive quarter (forcing management to raise the midpoint of annual guidance from $3.25 to $3.63). Going forward, we now expect nominal production costs to average $3.60 per barrel of oil equivalent.

However, the valuation cut also reflects our increasing concern over the sustainability of industry activity at the current level, with at least 100 more light tight oil rigs in service than necessary to keep the market balanced in the long run. We therefore assume that Continental will only continue operating about 30 rigs for two years, reverting thereafter to a more modest pace with about 20 rigs.

Our negative stance on crude is also unchanged, and our midcycle forecast is still $55/bbl for WTI. The justification in “Oil Prices Are Unsustainably High, Stretching Energy Valuations” is still valid, even though the recent sell-off in energy stocks means the bearish valuation conclusions no longer apply. Continental, as one of the few narrow-moat rated industry cost leaders, is capable of thriving in a lower price environment. We therefore anticipate sustainable excess returns on invested capital as well as annual free cash flows of at least $1.5 billion over the next 10 years. As such, the stock’s recent decline could be interpreted as a buying opportunity, albeit one with minimal margin of safety given our high uncertainty rating.