How Can ConocoPhillips Deliver More Long-Term Value?

Focused high-margin cash investments do not appear to be reflected in the current pricing of ConocoPhillips. Strong earnings potential from focused shale gas and high-margin volume plays in liquids should fuel growth and mitigate low natural gas price cycles.

Jan 9, 2014 at 1:47PM

ConocoPhillips (NYSE:COP) is now the largest independent oil and gas exploration and development pure-play company in the world with over 1.5 billion barrels of oil equivalent per day of production, or boe/d, and growing.

Last year ConocoPhillips shareholders enjoyed a 21% gain in stock value along with a 3.92% dividend yield. Yet this stock still looks undervalued for at least three major reasons.

Reason #1: unpriced cash investment
The company plows cash back into operations and new fields to fuel volume growth by 3% and margins by 5%. Yet it still knows it needs to reward shareholder confidence and does this with a consistent and growing dividend of $2 per share.

This year the company intends to increase capital expenditure from $14.17 to over $16 billion for new oil and gas fields, pipelines, and liquefied natural gas facilities. It just sold off all of its Nigerian assets and is disposing of assets in Russia and Trinidad and Tobago. With the disposal proceeds the company is focusing on its North American properties, including shale gas in North America, as well as its Chinese ventures. Included are the beginnings of a $50 billion joint venture investment in Alaskan LNG.

ConocoPhillips does not use cash to cover its dividends. As of the third quarter 2013 the company generated operating cash flow net of working capital changes of $13.9 billion. It invested $11.6 billion cash in capital. Free cash flow available to investors netted to $2.3 billion. The company paid a dividend of nearly $3.3 billion. It covered the $1 billion cash shortfall using its commercial paper program.

This results in a low price to cash flow of 9.3 relative to the industry median of over 30. The cash is there and being put to strong and productive use through new investments in conventional and unconventional oil and gas plays. But it doesn't show up in the stock price.

Reason #2: unreflected but strong earnings potential
The margin consistency can be seen in the past quarter. Libyan production dropped so that volumes of 1.5 billion boe/d remained flat. The company eliminated security related volume issues in Nigeria by getting out of that play entirely. In spite of Nigerian and Libyan disruptions last year operating margins rose from 24% to 28%. Growth in volumes in 2014 will come from shale gas and oil sands plays in the continental U.S. as well in China's Sichuan Basin.

By September 2013 ConocoPhillips had reached 500,000 boe/d production, mainly from the Bakken and Eagle Ford shale plays. It plans on another 400,000 boe/d by 2020. These volumes are from liquids-rich oil and natural gas wells. They also produce higher value ethane, propane, and butane. If natural gas prices rise to about $5 per million British thermal units, or mmBTU, then further natural gas production will be feasible.

ConocoPhillips is pushing production to higher margin productions and taking advantage of higher liquids prices in the U.S. Even so, the price to earnings ratio remains low at about 10, relative to the industry average of about 13.

Reason #3: low price to book
Over the past five years ConocoPhillips' share price has gained over 28%, topped only by Chevron at over 63%. In contrast BP and ExxonMobil returned less than 1% and 23% respectively. Long-term shareholders will expect steady appreciation, and they get that from ConocoPhillips along with a growing dividend.

ConocoPhillips' price-to-book equity remains a solid 1.79. This is in line with Chevron's 1.78 p/b and low relative to ExxonMobil's 2.74. More importantly, ConocoPhillips' p/b is consistent over the past five years.

The book equity in this ratio reflects additions to retained earnings. These are earnings plowed back into investments. Those plowbacks are made with cash that does not show up directly in booked equity growth. So this ratio is beginning to look low as well.

Bottom line thoughts
ConocoPhillips' strong earning potential is fueled by its focus on new high-margin plays in North American and Chinese shale liquids and associated gas. ConocoPhillips' policy of investing operational cash in high-volume assets in secure regions will help mitigate low price oil scenarios and maintain margins. Strong focused investments that generate good earnings potential with cash from operations are the recipe for value success.

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