Watch, Don’t Buy, this Fracking Leader

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Monday, April 29, 2013
Dr. Stephen Leeb

Today our spotlight turns onto Continental Resources (CLR), an oil producer that can be seen as the poster company for the resurgence of the U.S. energy industry. Note, though, that we’re not recommending that you buy the company. Rather, we’re featuring it because it’s a critical bellwether of U.S. economic and energy strength.

The company recently reported superb results. While most oil and gas companies are struggling to keep production from declining, Continental Resources reported an exceptional 37 percent increase in fourth-quarter oil and gas (mostly oil) production compared to the like year-earlier period. For the entire year, production increased a whopping 58 percent to the equivalent of nearly 100 million barrels of oil a day. Because of increased costs the gains in profits were a bit less impressive, but at $3.36 a share were still well above 2011’s $2.72 a share. The company projected further production gains of 35 percent for 2013. Not surprisingly, the shares gained on the news.

The rise in production was made possible by the company’s role as the leading U.S. oil fracker. If Continental Resources can keep production growing rapidly, it bodes well for America’s ability to keep energy prices in check, further insulating us from the very volatile sources of oil on which we still depend.

But there’s no guarantee Continental Resources can do this. Fracked wells become depleted much faster than conventional wells. For conventional wells, the depletion rate—the yearly loss in production—is an estimated 5 percent. For fracked wells, depletion in the first year can be as high as 60 percent, meaning that to increase production from fracking, ever more wells must be drilled.

The financial metric that best reflects this imperative to drill ever more is capital expenditures. And for Continental Resources, capital expenditures have been increasing much faster than any other metric. In 2012 they more than doubled from the previous year. Indeed the increase was so great that the company had to come up with a dollar for every dollar of revenue it produced. In other words, every dollar of revenue cost the company $2.
 
Clearly this trend, which applies to fracking companies in general, isn’t sustainable. Does this mean that fracking is destined to be a major disappointment? Not necessarily, but it does mean that for fracking to lead to ever increasing oil and gas production, several heroic assumptions must be met. Among them are major gains in technology and a leveling off of well productivity at a high level. You also have to hope that companies haven’t already exploited all the most productive areas, i.e., the low-hanging fruit—that comparably productive areas remain to be found.

We have our fingers crossed but remain skeptical that all these conditions will be met. The future results posted by Continental Resources will tell us a lot, with big implications for the U.S. economy and markets—making this an important stock to follow.

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