ConocoPhillips: A Liquids-Focused Growth Story

Having divested some $12.4 billion worth of assets since 2012, ConocoPhillips (NYSE: COP  ) is zeroing in on higher-margin, liquids-rich assets as it attempts to grow both margins and production at a compound annual rate of 3%-5% over the next five years. Fourth-quarter results suggest this production shift is well under way.

Conoco's liquids-led growth
ConocoPhillips last month reported fourth-quarter earnings of $2.5 billion, or $2 per share, up 74% from $1.4 billion, or $1.16 per share, during the same period in 2012. Growth was driven by asset sales in Algeria and the Caspian Sea, which generated combined proceeds of $7 billion.

Meanwhile, fourth-quarter production fell 5.9% to 1.518 million barrels of oil equivalent per day due to abnormally harsh winter weather in the U.S. and the loss of production from Libya due to continued instability in the nation. However, output from the company's three core growth areas -- Texas' Eagle Ford shale, North Dakota's Bakken shale, and Texas' Permian Basin -- surged 31 % year over year, driving a 7% year-over-year increase in the company's production from its Lower 48 program.

More importantly, though, higher-margin oil production from the Lower 48 program grew by an impressive 24% year over year, while total liquids production from the Lower 48 program and Canada increased by 10%. This resulted in the liquids share of the company's production rising from 48% to 52%, reflecting its shift toward liquids-led growth.

Liquids-focused reserve growth
Conoco also added more than 1 billion barrels of reserves organically last year, giving it a superb organic reserve replacement ratio of 179% and an all-in reserve replacement ratio of 147%. That easily bests peers with high reserve replacement ratios such as Statoil (NYSE: STO  ) , which had a 2013 organic reserve replacement ratio of 147% and an all-in ratio of 128%, and even Chevron (NYSE: CVX  ) , which reported a three-year average reserve replacement ratio of 123%.

Crucially, liquids account for roughly 60% of Conoco's reserve additions, while another 15% is tied to liquids pricing through liquefied natural gas. About half of the added reserves came from North American shale plays, primarily the Eagle Ford and Bakken, while a quarter came from Canada's oil sands -- all of which are generating solid returns for the company.

These reserve additions should further improve the liquids share of Conoco's resource base. As of year-end 2012, 69% of the company's resource base of 43 billion barrels of oil equivalent consisted of liquids. That puts it up there with other liquids-levered oil companies such as Hess (NYSE: HES  ) and Occidental Petroleum (NYSE: OXY  ) , which hold reserve bases that are 79% and 72% in liquids, respectively.

Lower 48 program to drive liquids-led growth
Over the next several years, Conoco's production should become even more heavily weighted toward liquids as the company ramps up drilling activity in the Bakken, the Eagle Ford, and the Permian Basin. Over the period 2012-2017, it plans to spend approximately $3 billion in the Permian, $4 billion in the Bakken, and $8 billion in the Eagle Ford to drive annual production growth of 7%, 18%, and 16%, respectively.

The company is already seeing stronger returns in these plays thanks to a shift toward multiwell pad drilling, and it expects to further improve returns in the years ahead as production becomes increasingly oil rich. In the Bakken, for instance, the liquids share of the company's production mix is expected to average more than 90% over the period 2012-2017, up from a Lower 48 average of 45% in 2012.

Stronger margins for years
Over the past few years, ConocoPhillips has refocused its portfolio toward higher-growth, higher-margin liquids-rich assets, while divesting riskier, lower-margin international assets. As a result, investors can expect continued improvements in the company's margins over the next five years, driven by its core assets in the Bakken, Eagle Ford, and Permian Basin, as well as high-margin opportunities in Canada's oil sands, Europe, Malaysia, and the APLNG project in Australia.

Though shares of Conoco look more or less fairly valued based on price-to-earnings and price-to-cash flow metrics, the company's 3.8% dividend yield may be attractive for income-seeking investors, especially given the relatively low payout ratio supporting it and the company's history of consistent dividend increases.

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