Insanely Undervalued Stock Could Rebound 50% When Oil Stabilizes

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When stocks or commodities are tumbling, traders start to prepare for "capitulation." That's typically the final phase in a sell-off, characterized by a complete absence of buyers and one last massive exit by sellers.

Investors are hoping we are nearing the capitulation phase in oil prices and related stocks. First, an increasing number of hedge funds are using options contracts to position their portfolios for an imminent rebound in crude prices. Second, oil industry insiders have tacitly declared a bottom by embarking on a large-scale wave of insider buying.

There is good reason to believe that oil prices have come close to a bottom, and it's known in economic circles as "supply destruction." More and more oil exploration projects are being cancelled as $65 oil makes these efforts much less feasible. There's no way to precisely correlate supply cuts with price support, but the longer-term impact is undeniable: Energy producers will pump less oil out of the ground in 2015 and 2016 than they had planned to just six months ago.

Assuming oil prices find a floor near current levels, a number of energy stocks are poised to stage a relief rally. The key is to identify what shares are likely worth at current oil prices, and then determine potential upside when oil prices rebound to $75 or $80 a barrel. That's the price that many strategists peg as a breakeven rate for most U.S. oil producers.

To be sure, almost every type of energy-related stock should bounce once oil prices stabilize and reverse course simply because of the sidelined buyers that are merely waiting for the bottom to be put in. But few offer as much upside potential as Continental Resources (NYSE: CLR ) .

Continental has surely been impacted by the plunge in oil prices, with shares losing more than half of their value since Labor Day.

Management announced in November that the company would cut capital spending by $600 million to $4.6 billion in 2015 from a prior estimate of $5.2 billion. That new figure is flat with 2014 spending levels.

Still, flat capital spending should enable Continental to boost production by more than 20% next year. That's because the company's newest oil wells are more productive than legacy wells.

Although management has been discussing cash flow scenarios at $70 or $80 oil in recent weeks, we don't yet know what the company's cash flow profile looks like with oil trading at $65. But we can connect some dots.

On Nov. 7, with crude oil already below $80 per barrel, analysts at Merrill Lynch noted: "At current levels, we view CLR as oversold, discounting long-term oil prices around $65 per barrel in perpetuity."

At that time, CLR was trading in the low $50s, down from an all-time high above $80, made in late summer. Since then, shares plunged to a 52-week low of $33 on Wednesday. In effect, we know that by this analysis, fair value should be closer to $50.

Next, we want to figure out what fair value would be if oil rebounded to $70 or $80 a barrel. According to the company, at $70 oil, Continental would generate a 30% rate of return on each of its wells in the Bakken Shale, which accounts for more than half of the company's total output. At $80 oil, that figure rises to 40%, meaning for every $1 in drilling expenses, the company would make $1.40 in cash flow.

Merrill's analysts project that the company will generate $2.75 billion in 2015 cash flow, assuming oil prices average $72 a barrel.

Yet these analysts don't expect oil prices to stay in that range, and instead think oil will rebound to $90 by later this decade. In that context, they peg fair value for CLR at $74, which is more than twice the current share price.

Even if oil prices remain range bound in coming months, CLR is trading well below fair value, which appears to be north of $50.

CEO Harold Hamm already assumed that oil prices would find a floor when they were trading at $70 a barrel, which led him to cash in some hedges that netted the company a $433 million profit. Continental would have earned more on those liquidated hedges had he waited a bit longer, but his instincts are likely correct that $60 or $70 oil sets the stage for enough supply destruction to foment an eventual rebound in oil prices.

William Berry, a company director, isn't afraid to commit to shares. On Dec. 3, he spent $603,000 to acquire 15,000 shares at around $40 a share. CLR has fallen more than 15% from there, but unless oil prices completely collapse from here, they are unlikely to fall much further.

In short, the potential reward in CLR clearly outweighs the risk at these levels.

Recommended Trade Setup:

-- Buy CLR at the market price
-- Set stop-loss at $28
-- Set initial price target at $50 for a potential 50% gain in six months

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This article was originally published on ProfitableTrading.com: Insanely Undervalued Stock Could Rebound 50% When Oil Stabilizes

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing , Investing Ideas , Stocks

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