Naked on the hedge front

Opposing views on Continental’s $433M monetization

Betting oil prices have hit bottom, Continental Resources has monetized nearly all of its outstanding crude oil hedges for 2015, 2016, and 2017. For the oil-focused producer, the move positions the company to "fully participate in what we anticipate will be an oil price recovery," explained Harold G. Hamm, chairman and CEO, in a prepared statement reporting the company's 3Q14 financials.

Despite a 25% reduction in oil prices in recent months, Hamm noted that the Oklahoma City, OK-based company will defer adding rigs in 2015, thus reducing the 2015 capex budget by $600 million to settle at $4.6 billion, but said the company views the "recent downdraft in oil prices as unsustainable given the lack of fundamental change in supply and demand."

In the same release, Continental CFO John D. Hart said the monetization of the hedge positions generated proceeds of $433 million, adding strength to the company's balance sheet, noting that the company remains "committed to capital discipline and protecting our investment grade rating."

Reaction to the move by analysts is mixed. Some like the strategy, while others feel the company may have taken an unnecessary risk.

Bold move?
In a recent note to investors, Wunderlich Securities said it was impressed Continental's moves, calling the company "the brave soul that sticks its neck out for what it believes." While maintaining its Hold rating on the stock, the analysts see the company making strides to further expand its multiple.

The company is "truly playing the oil market," said the analysts, and the continued execution on core Williston and SCOOP plays provide solid growth and rates of return for the company to exploit heading into 2015, they continued.

"The balance sheet can support continued (or further) oil weakness and the production base generates strong cash flows. While Continental is naked on the hedge front, it has ample liquidity given its cash balance and undrawn credit facility that provides safety in a depressed market. Frankly we think this strength is what allowed the company to make this move and we are excited to see how it turns out knowing that, at worst, Continental has ample liquidity to continue growing," the analysts continued.

The "at worst" scenario is that oil prices continue the downward trend long-term. While Wunderlich Securities analysts see oil moving back into the $90/bbl range, others are wary.

Saudi Arabia, the world's largest exporter, is the swing player in the current oil price war, and it has yet to move to cut production to lift prices. With that, some analysts are uneasy with the risk taken by Continental.

Or unnecessary risk?
The move "adds an unnecessary element of risk in an uncertain time for oil prices," said CLSA's Eric Otto in a recent statement to investors.

"Even if Continental is right about commodity prices, we think it is moving from a prudent steward of capital that creates shareholder value by finding and developing crude oil and natural gas reserves to one that attempts to speculate on commodity prices," he said.

As for Hamm's belief that prices will rebound quickly and on a sustained basis, Otto disagrees. OPEC views light tight oil (LTO) producers as setting the floor for oil, he said, pointing out that some companies have already indicated plans to reduce 2015 capex spending and cut production guidance. "US LTO producers have blinked first," he said, decreasing the likelihood that OPEC will announce a production cut at its November 27 meeting.

In the event OPEC does cut production and prices rebound, Otto questions the timing of the monetization given the downside risk for prices prior to the meeting. "If management is deviating from its business strategy of increasing "shareholder value by finding and developing crude oil and natural gas reserves at costs that provide an attractive rate of return on our investment," and now focusing on oil markets, then we believe they have left money on the table due to sub-optimal timing with the trade," he said.

Counter to CFO Hart’s assertion that the hedge removal adds strength to the balance sheet, and Wunderlich Securities analysts' view that said s balance sheet can support continued oil weakness, Otto questions management’s risk practice.

"Monetizing hedges doesn't bolster the company's balance sheet to a point where it becomes a "fortress" (pro forma net debt/NTM Ebitdax of 1.5x) and it also adds an increased amount of volatility to earnings," he said, estimating that despite the 2015 capex reduction, Continental will outspend quarterly operating cash flow by 1.5x.

"Ultimately, we believe shareholders would have been better served if the company had left its hedges in place and sought an alternative source of additional capital to bolster its balance sheet from either an asset sale or an offering of debt or equity," he concluded.

 

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