Why Dividend Growth Investors Should Choose ConocoPhillips Over Chesapeake Energy

New technology such as hydraulic fracking, horizontal drilling, and enhanced oil recovery is creating a historic energy boom in America. This bonanza is expected to last for decades, and dividend growth investors can cash in on the riches by selecting the right independent E&P (exploration and production) companies. As this article will show, investors seeking stable, secure, and growing dividends should steer clear of Chesapeake Energy (NYSE: CHK  ) and instead choose what is arguably the best independent E&P company in the world -- ConocoPhillips (NYSE: COP  ) . 

What's wrong with Chesapeake?
Aubrey McClendon may have been ousted from the company that he ran as his personal fiefdom (to the detriment of shareholders), but the damage he did continues to haunt the company. Specifically, I am referring to the company's large debt load of $14.7 billion, $1.265 billion of which is coming due within the next ten months.

The company is selling off non-core assets, spinning off its oil services subsidiary, and plans to slash capital expenditure (capex) by 20% in 2014. This is in order to try to close a $1 billion gap between current capex and operating cash flows. 

The bullish case for Chesapeake would be that it is being run more competently (though management underestimated 2013 capex costs by 10%) and LNG exports will cause natural gas prices to increase. This might secure the company's profitability and low, slow-growing dividend. However, there are several major problems with this last thesis. 

LNG exports (out of Cheniere Energy's Sabine Pass terminal) are scheduled to begin in late 2015/2016. This facility will export one billion cubic feet per day, or about 1.5% of national gas production (2013).

Thus, the effect of LNG exports on increasing gas prices will likely be small (at first) and take 18 to 24 months to occur. In the meantime, Chesapeake's Haynesville shale (from which it plans to produce gas for export) is in trouble. 

According to the Energy Information Administration, this shale had remaining reserves of 17.7 Tcf of gas and was producing 2.7 Tcf/year in 2012. 

This means about five years of remaining production. As a gas field becomes depleted the cost of production increases. By the time LNG exports begin, production costs for Chesapeake may be climbing past the current break even price of $4.5/mbtu and make the whole plan uneconomical. 

By the time LNG exports really take off (in 2017), the company's Haynesville shale fields will nearly be empty. Meanwhile $4 billion in debt will come due (through 2017).

ConocoPhillips: firing on all cylinders

Company Yield 20 yr dividend growth (CAGR) 5 yr dividend growth (CAGR) Payout Ratio
COP 3.9% 7.81% 7.17% 37%
CHK 1.3 9.66% 3.13% 48%
IND AVG 2%      

Data from Fastgraphs

Company PE ROA ROE Operating Margin Net Margin
COP 11.5 7.8% 18.3% 25.8% 15.7%
CHK 37.8 1.10% 3.70% 11.80% 2.70%
IND AVG 28.8 3.3% 7.1% 18.7% 9.2%

Data from Morningstar

As seen above, ConocoPhillips is doing phenomenally well. It boasts operating efficiences two or three times that of the industry average (and six to seven times that of Chesapeake) as well as superior profitability. 

Its yield is double the industry average and three times that of Chesapeake; yet its payout ratio is low enough to make the dividend both secure and capable of strong and consistent growth. 

These are two of the three reasons to invest in ConocoPhillips, but there is a third, and it's the most impressive -- the company's growth strategy.

Between 2012 and 2013 ConocoPhillips sold $12 billion in low margin, non-core assets and reinvested it into higher margin (mostly North American) regions such as the Eagle Ford, Bakken, Permian Basin, and Alberta tar sands.

The company is laser-focused on delivering double-digit total returns by delivering three things: 3%-5% production growth, 3%-5% margin growth, and a strong, sustainable dividend.

In 2013 they met these goals with 11% margin growth, a 167% reserve replacement rate, and 4.5% dividend growth. 

The remarkable reserve growth is likely to continue, with the CEO stating that he expects that the company will ultimately book five times the reserves from Bakken and Eagle Ford acreages. 
 
The investments in the prolific Bakken and Eagle Ford regions have yielded spectacular results:
  • 2013 oil production up 24%
  • Bakken production up 60%
  • Eagle Ford production growth from 2013-2017 projected to be 20% CAGR.
  • Eagle Ford reserves increased by 39% in 2013 
Perhaps most exciting is that the fastest growing areas in production (shale oil and tar sands have projected CAGR of 22% and 21% from 2013-2017, respectively) are also the highest margin. The company estimates it will net $40+/barrel from shale oil and $30/barrel-$40/barrel from tar sands over the next four years.

Bottom line
Chesapeake Energy is a value trap but without the value. Its gas assets are aging and its production costs are about to start rising, placing additional stress on a company that's struggling just to break even. The dividend is anything but safe, yet the valuation is pricing in amazing growth that management has no track record of delivering. Meanwhile, ConocoPhillips continues to under-promise and over-deliver (and what they are promising is pretty amazing). With a generous yield and booming production from shale formations, long-term dividend growth should continue near its historical average (6%-7%). This should ensure market-beating returns based on dividends alone. If the valuation expands to match the industry average then patient investors will be richly rewarded indeed. 

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  • Report this Comment On May 08, 2014, at 11:41 AM, Hansen wrote:

    Chesapeake Energy beat revenues and earnings estimates for the quarter and also raised its production outlook for fiscal year 2014 as the stock went up 2% http://goo.gl/GMFmBM

  • Report this Comment On May 12, 2014, at 2:56 PM, AdamGalas wrote:

    True, things are looking better for now, but Conocophillips is still a better company.

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11/26/2014 4:02 PM
CHK $23.04 Down -0.66 -2.78%
Chesapeake Energy CAPS Rating: ****
COP $70.83 Down -0.90 -1.25%
ConocoPhillips CAPS Rating: *****

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