Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: ConocoPhillips

ConocoPhillips disappointed income-oriented investors when it cut its payout back in early 2016, a situation that was predictable given the company’s weakened Dividend Cushion ratio. However, a lot has changed since then. Now, ConocoPhillips’ Dividend Cushion ratio has climbed back to 3.5, and it’s likely the turnaround strategy launched by management several years ago will enable ConocoPhillips to reclaim its status as an income growth idea in the future. We continue to watch the company closely.

By Callum Turcan

The two parts of the storied energy giant, ConocoPhillips (COP) split back in 2012, with Phillips 66 (PSX), its downstream operations, performing markedly better in terms of dividend growth and capital appreciation than ConocoPhillips, the upstream super-independent, since then. ConocoPhillips, the focus entity of this article, continues to be highly exposed to movements in raw energy resource prices without the natural hedge that its downstream division, now Phillips 66, used to provide. Phillips 66, however, remains exposed to variations in crack spreads, too, perhaps revealing that investing in energy is never easy.

We think followers of Valuentum should know the ConocoPhillips’ dividend story well. In February 2016, ConocoPhillips cut its quarterly payout to $0.25 per share from $0.74 per share, shocking the E&P market at the time. This wasn’t too big of a surprise to us, however. From early 2012 to early 2013, ConocoPhillips’ Dividend Cushion ratio dropped from over 1.5 to below zero (cutting through 1 in late 2012). As ConocoPhillips’ Dividend Cushion ratio continued to fall further into negative territory, it became increasingly apparent to us that its dividend payouts weren’t safe. Here’s what we wrote in the company’s Dividend Report at the time, in February 2016:

“We're going to call it how it is: ConocoPhillips' dividend is not safe. Though the company continues to slash capital spending, the collapse in energy resource pricing is hurting operating performance in a big way. Having spun off its downstream assets, ConocoPhillips now more than ever is exposed to volatile commodity prices. For a dollar change in Brent crude, net income is impacted by nearly $100 million. Though ConocoPhillips may increase the dividend in the near term, it will be some time before the company closes the gap to free cash flow neutrality. A prolonged period of low energy resource pricing could result in a dividend cut. A negative Dividend Cushion ratio is a clear warning sign.”

For those that may not know, the Dividend Cushion ratio is Valuentum’s dividend-health evaluation metric that makes use of the future forecast free cash flows in our enterprise discounted cash flow model and compares those to expected dividends to be paid over a five-year time period in the context of net balance sheet health. Things were looking quite grim in early 2016 for Conoco, but a lot has changed since then. ConocoPhillips currently yields 1.8% as of this writing after increasing its dividend and is in the process of potentially reclaiming its status as an income growth story, which will be the primary focus of this piece.

Major Restructuring

During the past few years, ConocoPhillips shed the vast majority of its uneconomical oil sands and Western Canadian gas assets, its very uneconomical gas-heavy Barnett shale assets, its sleepy gas-rich San Juan Basin assets, and other upstream operations deemed undesirable or non-core. While some upstream oil sands assets could be considered valuable on a long-term basis, a firm must have a downstream presence in Western Canada (or nearby) that can process those heavy sour bitumen volumes in order to consistently realize that upside. As a pure upstream player, that strategy doesn’t apply to ConocoPhillips so these assets had to go.

Upstream oil sands operators without this natural downstream hedge run the risk of generating negative operating cash flow from those assets if the Western Canadian Select to West Texas Intermediate differential were to ever blow out again. There is also always the risk that WTI drops precipitously and takes WCS with it, regardless of the differential paradigm at the time. Note that even after serious operating expense reductions (as highlighted by research firm Rystad Energy), the ongoing cash costs associated with oil sands production is still relatively high.

Natural gas prices in Western Canada are very low and upstream returns in the region’s gas-rich plays aren’t competitive. Alberta’s AECO natural gas pricing benchmark consistently trades well below Louisiana-based Henry Hub. The Barnett shale play in Texas simply isn’t productive enough to earn even a modest return on investment due to high cash operating costs and the low-value nature of North American gas production in general. For Conoco’s gas-rich San Juan Basin operations, that sleepy conventional asset simply couldn’t compete for capital in its portfolio so the firm decided to frontload its expected future cash flows in the form of a sale. Many of Conoco’s recent North American divestments have a common theme, the company wanted out of upstream assets with gas-rich production streams.

Goodbye Deepwater Exploration

Conoco did more than just shed uneconomical assets. The firm also stopped pursuing deepwater exploration programs at the end of 2017. No longer spending hundreds of millions of dollars on wells that would penetrate through 10,000 feet of water and another 20,000 feet of the Earth’s surface in the hope of proving an emerging offshore play is saving the firm a small fortune.

This strategic decision freed up $0.8 billion per year for ConocoPhillips, and that figure rises when including the cost of acquiring exploration licenses. Keep in mind that exploration programs, save for the rare success that can be quickly monetized through some sort of farm-out arrangement, take years and years and billions of dollars in investment to eventually become cash flow generating properties.

However, this doesn’t mean Conoco isn’t still searching for new discoveries as the firm recently entered Louisiana’s emerging Austin Chalk play and has had great success locating additional low-cost oil resources in Alaska. Here is a key excerpt from ConocoPhillips’ fourth quarter press release (we double checked Conoco’s 2018 10-K filing and its year-end net proved reserves figure remained the same);

“Preliminary 2018 year-end proved reserves are 5.3 billion barrels of oil equivalent (BOE). The total reserve replacement ratio, including a net increase of 0.2 billion BOE from closed acquisitions and dispositions (A&D), is expected to be 147 percent. Increased crude oil reserves accounted for over 90 percent of the total change in reserves.

Excluding A&D impacts, the organic reserve replacement ratio is expected to be 109 percent. Approximately 33 percent of organic reserve additions are from Lower 48 unconventional assets, 29 percent from Alaska and 22 percent from Asia Pacific and Middle East.”

Significantly Stronger Financial Performance

This corporate revamp has had a powerful impact on Conoco’s financial performance. For comparison purposes, note ConocoPhillips generated $13.9 billion in net operating cash flow on 1.6 million barrels of oil equivalent per day in net upstream production (including its net Libyan output) when its average realized oil price was $106 per barrel back in 2012. By 2016, Conoco was pumping out 1.6 million BOE/d net yet generated just $4.4 billion in net operating cash flow as its average realized oil prices came crashing down towards $41 per barrel.

After shedding uneconomical and unwanted assets, after removing risky deepwater offshore exploration spending from its cost structure, and in light of major improvements to its balance sheet, which we will address later on, ConocoPhillips emerged from the oil pricing downturn as a rebuilt enterprise. In 2018, the company generated $12.9 billion in net operating cash flow while its production base came in at 1.3 million BOE/d net (1.2 million BOE/d net when excluding its Libyan production due to ongoing tensions in the country putting future operational performance into question), largely due to its average realized oil price firming up to $68 per barrel but keep in mind its turnaround strategy was also key here.

If Conoco hadn’t divested most of its oil sands assets, it would have been heavily exposed to the precipitous drop in Western Canadian Select pricing for its heavy oil output during the second half of 2018. ConocoPhillips retains a 50% stake in the Surmont oil sands joint-venture with Total (TOT), and its bitumen realizations during 2018 were roughly a third of its company-wide crude oil realizations excluding bitumen sales. In the event Conoco hadn’t divested many of its upstream natural gas assets in North America, the firm would have been heavily exposed to the continent’s gas pricing benchmarks treading water below $3 per million British thermal units over a multi-year period (note natural gas prices in Europe are two to three times as high).

Debt Burden Coming Down Behooves Dividend Cushion Ratio

Conoco’s management team made sure to allocate divestment proceeds and when possible, free cash flow, towards debt reduction efforts. Conoco generated $12.9 billion in net operating cash flow and spent $6.8 billion on capital expenditures last year, which included $0.6 billion in cash outlays for acquisitions. The company was able to use a combination of free cash flow, cash on hand, and divestment proceeds to pay off $5.0 billion of its debt load in 2018.

At the end of 2012, Conoco had a total debt load of $21.7 billion. By the end of last year, that number had fallen down to $15.0 billion. Reducing this burden frees up cash flow in the form of reduced interest payments and firms up Conoco’s Dividend Cushion ratio by improving its net cash/debt position. Conoco had a combined $6.2 billion in cash and short-term investments on its balance sheet at the end of 2018.

A Recent Gift

In some ways, Conoco was given a gift by Exxon Mobil Corporation (XOM) and state-run Qatar Petroleum when those two companies decided to move forward with the Golden Pass LNG development. America has plenty of competitive advantages when it comes to liquefied natural gas exports (surging domestic production, extensive low-cost resources, ample midstream infrastructure), which is largely why the country’s LNG export capacity is expected to double this year according to the EIA.

The Golden Pass LNG terminal as it stands today can only import liquified natural gas, so Exxon Mobil and Qatar Petroleum plan to add export capabilities to the facility in light of ongoing market dynamics. Located along the Gulf of Mexico in Texas, ConocoPhillips owns just over 12% of the import terminal and the related Golden Pass Pipeline. As Conoco’s management has opted not to pursue this expensive long-cycle endeavor, the company is selling its stake in the asset. Reuters reported that Exxon Mobil was likely the acquirer of that stake. At the end of 2018, both assets had a combined net book value of $0.2 billion for Conoco.

Here is a key excerpt from ConocoPhillips’ 2018 10-K filing (emphasis added);

“Utilization of the terminal has been and is expected to be limited, as market conditions currently favor the flow of LNG to European and Asian markets. In January 2019, we entered into agreements to sell our 12.4 percent ownership interest in Golden Pass LNG Terminal and the affiliated Golden Pass Pipeline. We have also entered into agreements to amend our contractual obligations for remaining use of the facilities. Completion of the sale is subject to regulatory approval.”

A purchase price wasn’t publicly given. Effectively, Exxon Mobil and Qatar Petroleum’s decision to move forward with the Golden Pass LNG import-to-export conversion project removed a stranded asset from ConocoPhillips’ portfolio while also generating a nice bit of cash in the process. Not necessarily needle-moving by itself, but this ties in with the bigger picture of Conoco further optimizing its asset base to improve its financials along the margin. It’s possible some of those proceeds may go towards Conoco’s $15.0 billion share buyback program, of which $9.0 billion in repurchasing authority remained at the end of last year. That is equal to 11% of its market capitalization as of this writing. Last year, ConocoPhillips spent $3.0 billion buying back its stock.

Concluding Thoughts

Management has set ConocoPhillips’ 2019 capital expenditure budget at $6.1 billion, keeping in mind the firm spent $1.4 billion on dividends last year. That budget is forecasted to grow its upstream production to 1.3 – 1.4 million BOE/d net in 2019, excluding Libyan volumes, which is good for 7% organic annual growth at the midpoint. However, WTI and Brent imply its oil realizations are likely between $55–$65 per barrel as of this writing, which will put downward pressure on ConocoPhillips’ operating cash flow relative to its 2018 performance unless global oil prices move higher.

By fundamentally changing its cost structure and asset base, ConocoPhillips has been able to slowly stage a turnaround in both its operational and financial performance over the past few years. The company is growing its dividend once again as its quarterly payouts have climbed back up to 30.5 cents per share, good for an annualized payout of $1.22. As of this writing, ConocoPhillips yields 1.8% and its Dividend Cushion ratio sits at 3.5. We give the company a GOOD Dividend Safety rating (in light of the ratio), even though its Dividend Growth rating remains POOR (mostly because of management’s decision to cut the payout a couple years ago).

Though we only view the highest and lowest rungs of the Valuentum Buying Index rating system as material, ConocoPhillips carries a Valuentum Buying Index rating of 3 at the time of this writing and is currently trading at the upper end of its fair value range. A key catalyst for ConocoPhillips would be to reclaim its status as a dividend growth investment, a task made possible by its corporate revamp and reduced debt burden. That strategy entails allocating more cash flow towards growing the dividend, and likely less towards share buybacks. Until then, the company is simply on our radar, but we aren’t making any new decisions today.

Oil & Gas - Major: BP, COP, CVX, RDS, TOT, XOM

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The author owns shares of ConocoPhillips through a small family fund and a short-term position in DGAZ. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.