ConocoPhillips Repositioning Its Portfolio

ConocoPhillips (NYSE: COP  ) , the world's largest independent exploration and production company, has the ability to grow production and margins by 3%-5% annually, which should enable the company to self-fund its capital expenditures and grow dividends at a healthy rate. Contrary to what bears would say, the company is proving it can grow production via U.S. legacy unconventional projects and new projects while supporting dividend growth.

Maintaining production without raising guidance
Unlike peers ExxonMobil (NYSE: XOM  ) and Chevron, both of which lowered their production guidance at recent analyst days, Conoco has maintained its long-term production guidance without raising capital expenditures. To support shareholder returns, both Chevron and ExxonMobil are outspending free cash flow by $10 billion to $12 billion per annum. While Conoco maintained its debt level and lowered net debt by $2.3 billion (using proceeds from asset sales) last year, Chevron and ExxonMobil respectively increased their net debt by $13.6 billion and $16 billion.

Repositioning portfolio
Until production and margins expand enough to support capex and returns, Conoco is expected to continue bridging its near-term funding gap with noncore asset sales and cash on hand. Conoco's major portfolio repositioning is driving this positive variance. The company is exiting its lower-return international projects, which are a product of the last cycle and are maturing, and repositioning its portfolio into current-cycle North American assets. The company is investing 95% of its capital in projects that deliver more than $30 per barrel in margins.

Source: Company Documents.

U.S. unconventional driving growth
ConocoPhillips has increased its focus on the North American unconventional resources and is targeting a production compound annual growth rate of 22% through 2017. Moreover, average cash margins of more than $40 per barrel and full-cycle returns of greater than 25% for these plays also exceed those for the rest of the portfolio. The company is in full development phase for the Bakken and Eagle Ford shales, which in the near term will be the biggest drivers of volume growth for ConocoPhillips. It expects to produce 250 million barrels of oil per day by 2017 in the Eagle Ford alone, compared to its first-quarter 2014 exit rate of 160 million barrels per day and fourth-quarter 2013 average rate of 126 million barrels per day .

Permian, Niobrara, and oil sands
In addition to the Eagle Ford and Bakken, production and reserve upside is also expected from the Permian Basin and Niobrara shale. The company is actively testing these plays. It is also targeting 21% production growth through 2017 from its oil sands portfolio, Conoco's second biggest growth driver. Conoco is executing seven major projects and two optimization projects. These low-decline assets should generate more than $1 billion of net cash by 2017.

Source: Company Documents.

Dividend growth
The company remains committed to its stated top priority of dividend growth, having raised its payout by 4.5% last year. Given the company's cash position, A-rated balance sheet, financial flexibility, and expected cash flow growth, Conoco anticipates raising the dividend again this year and should continue to grow the payout through 2017. Management remains confident that the company is nearing a point at which cash flow will fund capital expenditures and dividend growth. ConocoPhillips has a healthy dividend yield of 3.7%.

After 2017
While the company is expected to improve margins and grow production at a CAGR of 3%-5% through 2017, some question Conoco's post-2017 growth potential. However, a deep look finds the company's long-term reserve-to-production ratio remains competitive with its peers. Moreover, Conoco's disciplined portfolio management should pay off in the longer term as the company sells down discoveries, monetizes a growing midstream portfolio, and extends the growth per share potential.

Takeaway
ConocoPhillips is actively taking steps to drive production growth of high-margin barrels. I think the market does not fully appreciate the growth potential of the company's acreage in North American unconventional plays. Conoco remains confident in its ability to meet production targets and eventually generate strong cash flow. While the company should have a strong 2014, Conoco is looking at a stronger 2015 as larger projects come online and the contribution from shale rises.

Conoco also offers better risk-adjusted production and cash flow growth outlook at an inexpensive valuation than peer ExxonMobil. Exxon faces growing challenges to fund its stock buyback program and, compared to Conoco, offers a lack of meaningful production growth outlook and expensive relative valuation.

 


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