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ConocoPhillips (NYSE: COP) is in the midst of reinventing itself and is attempting a transformation into a pure E&P company that will exchange downstream refinery and chemical segments for accelerated organic growth in its North American holdings. Refocused capital spending and emphasis will be on developing the acreage they have in US shale, Gulf of Mexico and Canadian properties. To that end they spun out Phillips 66 in a tax-free distribution and are divesting oil and gas and infrastructure assets that are not core to high margin operations. By the end of the third quarter, COP had divested $2.1 billion in assets. There are agreements to sell Nigerian, Algerian and the Kashga interests by the end of 2013 for approximately $8.5 billion exceeding by $600 million their top-end estimates of $10 billion in asset sales. The proceeds are being used for share repurchases and dividends with restricted cash used to pay down debt. They will need to divert some of the asset sale income to pay the over $3 billion in annual dividend payments as cash flow falls short of covering the payout.
ExxonMobil (NYSE: XOM) is the biggest US integrated oil company with revenues of $434 billion and 24.9 billion barrels of oil equivalent proved reserves. Exxon earned (after tax) $34 billion from upstream production and $4.5 billion from the downstream segment. The dividend yield is currently less than COP at 2.5%, but is well covered by their prodigious free cash flow of nearly $20 billion in the first nine months 0f 2012. Chevron (NYSE: CVX) is paying a 3.2% yield, but with $5.1 billion paid in nine months (2012) on free cash flow of $5.6 billion, is not quite as solid a payer as XOM.
Conoco’s cash flow from operations (CFFO) in Q3 2012 fell well below Q3 of 2011 and for nine months was $10.1 billion compared $13.8 billion one year ago. Part of this is the loss of Phillips 66 as of April 30. Even though Phillips 66 was almost 80% of revenue, with 2% margins (2011 full year) it was only 30% of total net income. Through March, refining added $452 million to net and the spin off in April would not have accounted for more than $500 million in lost CFFO. Cash flow from operations was down $3.7 billion on weak gas prices, the WTI crude differential, turnaround and maintenance operations, and asset sales. CFFO didn’t cover year-to-date capex of over $11 billion. It should begin to increase when Conoco accelerates production in the lower 48 and ease pressure on covering expenditures. Improvement is already underway and Conoco has started producing a higher percentage of oil in the lower 48 in Q3.
The company’s earnings by region depend heavily on Alaska and Asia Pacific/ Middle East -- the lower 48 makes a small contribution to net income. Total net income for 3 months in Q3 was $1.8 billion with 66% of that from Alaska and Asia Pacific/Middle East. Conoco does not earn much in the lower 48 due to underdevelopment, the WTI discount and natural gas selling at low prices that don’t relent. The longstanding underperformance can be reversed and provide a catalyst in margin expansion and growth when they begin to develop their lower 48 acreage. Approximately 40% of the $15 billion in 2013 capex spending will be in North America with 2/3 of that in the US. The improved production and move to oil is underway with better numbers in the third quarter.
From the 2012 Q3 conference call:
Production was 76,000 per day at Eagle Ford with 79% liquids, and 26,000 BOE per day in the Bakken with 88% liquids. Total production of 102,000 BOE per day from these two plays has doubled compared to the same period last year. Compared to the second quarter, the increased liquids production along with the 26% increase in realized gas prices contributed positively to earnings in this segment, while continued declines in NGL prices negatively impacted earnings. Despite the sequential increase in natural gas prices, the segment earnings continue to be impacted by generally weak natural gas prices.
Conoco is one of the largest owners of shale acreage, but has not invested extensively in exploration and production. They will be redirecting funds in the future to these fields. The company lags its peers in development and production of shale and in moving from dry gas to liquid reserves. With over 21 million acres in North America and 15 million acres in the lower 48, their holdings include high production fields in Eagle Ford, Bakken and the Permian and are an opportunity to increase production and margins when the company begins to increase spending on shale. At present capex is stretched largely due to the Australia Pacific LNG project joint venture and the capex spending needed to maintain a large base of properties. Analysts estimate as this winds down and as less profitable assets are sold off, around $5 billion in capex spending will be freed up for investment in shale, creating higher margins, bigger oil reserves and increased production.
The company is committed to giving shareholders 20% to 25% of cash flows. Cash flows currently don’t pay capex and dividends and they will continue to use divestitures to pay the dividend rather than cut it. Beyond 2014, when the asset sales are finished, we should see some improvement in cash flow as they begin to profit from the lower 48 fields, making the dividend safer.
- The WTI discount will disappear as additional pipelines start to reverse the flow bringing the price per barrel up
- Natural gas might recover but should not be counted on
- Conoco is producing a larger percentage of oil and liquids from Eagle Ford and Bakken already and that will continue
- Capex going into APLNG and divested properties can be diverted to other capex projects that are more profitable
- Production growth is targeted at 3%-5% mainly on the strength of their shale holdings
- Margins will expand as they turn low cash margin barrels of oil into higher margin by divesting unprofitable assets
Credit Suisse analysts estimate that the net asset value for proved developed and undeveloped assets after deducting liabilities is $42 per share. That increases to $65 when probable reserves are added. Valuing Conoco on proved reserves only would make it overvalued at the recent $59 per share. As of 2011, the PV10 was $72.2 billion with 1.2 billion shares-- value $60 per share. Subtract the debt and that decreases to $42—close to the Credit Suisse number for proved reserve value.
With a number of catalysts to be realized in the future, they have the ability to pay the dividend with continuing divestitures in 2013, and management’s intention to keep paying shareholders is clear. Conoco’s dividend can be paid from asset sales for now and while COP may not see much share price appreciation, the 4.5% yield puts a floor under share huge price declines. It will pay you to wait and relatively safely.
Last word is from Conoco’s CEO
Ryan M. Lance - Chairman and CEO
So Paul, what we are talking about is that what we said we'll allocate 20% to 25% of our cash flows on an ongoing basis back to the shareholder and we'll do that primarily through the ordinary dividend.
We expect over time as our production grows and our margins grow that our cash flows are going to grow as well. So, I think what we say is we ought to expect modest increases in the dividend as we go forward over the next five years and deliver on the as fast as what the dividend has grown over the last 10 program that we've outlined to the market.
It probably won't grow [ as quickly as it did] in the integrated company, but as we look forward over the next five years as our cash flows grow and our margins grow, so shall our cash flows grow and our commitment to the shareholders remains the same. We are going to distribute that percentage of our cash back to them. And the yield and the share price will increase with the yield down a little bit [as share price increases outstrip dividend increases].
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