COP: High-cost producer in competitive energy field

With a market cap of $61 billion, ConocoPhillips (COP) ranks as the largest independent U.S. crude oil producer.  It announced preliminary 2017 proved reserves of 5.038 billion barrels of oil equivalent after asset sales of 1.904 billion barrels of oil equivalents during the year. Reserves are widely scattered in Alaska, the lower 48 states, Canada (mostly oil sands), the Asia Pacific Middle East region focused on liquefied natural gas, and in the North Sea and Libya. 

Last March, COP announced the sale of its 50% interest in the Foster Creek/Christina Lake oil sands project in Canada, which produced 148,000 barrels net bitumen in 2016 (81% of its total oil sands production). The deal also included the majority of its western Canadian natural gas assets. The sale to its joint venture partner, Cenovus, closed in Q2 2017. COP received cash proceeds of
$10.6 billion, 206 million Cenovus shares, and a contingent payment related to the amount that Western Canadian Select crude prices exceed $52 per barrel, less customary adjustments.

Last April, it announced the sale of its interests in the San Juan Basin, which accounted for 46% of its U.S. gas production and 10% of its U.S. liquids production. The deal closed in Q3 2017. It received proceeds of $2.7 billion in cash and a contingent payment up to $300 million, less customary adjustments.

It used proceeds from both transactions to reduce debt from $26.4 billion in Q1 2017 to less than $20 billion at the end of the year. Its debt to equity ratio improved from 46% in Q1 2017 to 39%, compared to a peer group average of 43%. 

Capital spending in 2017 was $4.6 billion, down 6% year-over-year following a 52% decline in 2016. It was funded by cash flow from operations of $7.1 billion and $13.9 billion in asset sales. In addition to its sizable debt reduction, COP also paid $1.3 billion in dividends and repurchased $3.0 billion of its common stock.

Guidance indicates 2018 capital spending will increase to about $5.5 billion with projected cash flow from operations of $8.3 billion, assuming a $59 per barrel WTI oil price. Only $3.5 billion capital expenditures are needed to hold production flat. It plans to repurchase $2 billion in stock during the year and it just announced a dividend increase of 7.5%.

If oil prices remain supportive, COP anticipates a further debt reduction to $15 billion by 2020 and a 25% reduction in common shares outstanding from a share repurchase program. Its target is a return on capital employed in 2020 of more than 20% based on a $45 to $55 per barrel crude oil price range.

During the last 12 months, COP is up 20% compared with an 11% decline in the SPDR S&P Oil & Gas Explore & Production exchange-traded fund (XOP), and a 22% increase in the S&P 500. It reached a high of $87 per share in 2014 and a cyclical low $32 per share in 2016. 

COP’s 2017 asset sales improved its competitive position, but its growth potential and cost structure is still inferior to industry leaders. The stock has a value of $50 per share (-15%) over the next 12 months, assuming $59 WTI in 2018 with a $3.50 Brent discount, a $3 Nymex gas price and its seven-year average 7.1x cash flow multiple on 2018 estimated cash flow of $6.98 per share. 

With the sale of 27% of its reserves last year, it has significantly improved its competitive position but it still remains a higher cost producer than its major competitors and is, in our mind, a sell. 

It has the resources to sustain 5% production growth, predominantly from its the major U.S. resource plays. Industry leaders are capable of growing faster because of greater exposure. Its dividend yield is inferior to BP, Royal Dutch Shell (RDS/A), Total (TOT), Occidental Petroleum (OXY), Chevron (CVX) and Exxon Mobil (XOM).

COP’s 2017 production declined 15%. Future production growth at a 5% rate to 2020 is anticipated, derived predominantly from its three major Lower 48 resource plays. They will represent about 21% of total 2018 production, increasing to about 29% in 2020. Its major competitors have much larger exposure. Outside the Lower 48, COP expects to hold its production flat through 2020, as various drilling programs offset the losses from natural decline.

Adjusted operating costs in 2018 are expected to be $5.7 billion, up around 8% year-over-year with service cost inflation. After 2017 asset sales, depreciation charges are expected to decline 21% to $5.9 billion this year.