An oil company's production volumes and reserve base are among the two most critical metrics in measuring its worth. But more often than not, we fail to check whether the company is growing its production volumes in an economical manner. Understandably, this isn't an easy task for oil and gas companies. Even though Whiting Petroleum (NYSE: WLL ) recently became the single largest player in the Bakken by acquiring Kodiak Oil & Gas, there are serious doubts about its profitability. However, one company that appears to meet this criterion is ConocoPhillips (NYSE: COP ) .
So what should investors be on the lookout for when the world's largest independent exploration and production company reports its second-quarter results on July 31? Let's take a look.
Management's main motto
ConocoPhillips' central focus is to drive sustainable double-digit returns to shareholders through cash flow, as well as dividend growth. Specifically, management aims to obtain a higher margin per produced barrel of oil equivalent, or BOE. That should eventually drive cash margins higher.
It's of significant importance to find out whether a company is earning more than it spends on capital expenditures and acquisitions. And so far, Conoco has been delivering on its promises and creating value. This is exactly what investors should look for in an exploration and production company.
How does ConocoPhillips plan to achieve its goal?
Management has a clear strategy for the next five years, starting with 2014. With a diversified portfolio of North American and international assets, capital allocation plays a critical role here. As it turns out, 95% of the capital has been allocated to production of oil and gas that will generate a margin greater than $30 per BOE. Higher margins enhance cash flow in the long run.
3 things investors need to watch closely
In tune with this, there are three things investors should watch closely when Conoco reports its second-quarter results.
1. Growing production from North American unconventional drilling
Conoco should be reporting healthy growth in production from the North American unconventional segment, for the simple reason that this segment is slated to carry a cash margin of over $40 per BOE, the highest across the company's diverse asset portfolio. Management expects a 22% annual production growth rate till 2017.
According to Conoco's investor presentation, its 221,000 net acres in the Eagle Ford lie in the sweet spot, with over 3,000 drilling locations. The company enjoys the highest net present value per acre among its peers -- even better than EOG Resources (NYSE: EOG ) -- with an estimated ultimate recovery of 2.5 billion BOE. Closely complementing this acreage are the company's Bakken properties. With an estimated ultimate recovery of 600 million BOE and 83% oil mix, the Bakken has among the lowest cost of supply.
2. A healthy growth in operating cash flows
Somewhere, these higher margins -- driven by growing production volumes -- must get reflected, and I'm betting on solid growth in operational cash flows. Conoco's first-quarter cash flow from operations managed an impressive 34% growth year-on-year despite a severe winter. I'm expecting similar rates in the second quarter as well. A higher operational cash flow truly reflects the company's commitment to profitability.
3. Higher capital allocation to development programs
Between 2013 and 2017, management expects to see 60% growth in development program spending, while effectively reducing capital allocated to major projects.
Apart from spending for North American oil, Conoco will be pushing hard for the completion of the Australia Pacific LNG program, as well as the Surmont oil sands project in Canada. Both these projects are expected to come online by mid-2015, thereby substantially lifting average production volumes.
Keeping these three points in mind, you can test whether Conoco is delivering the goods. Thanks to management's relentless focus on higher margins and greater cash flows, the dividends are not only safe, but should keep increasing as well. There is an assurance that ConocoPhillips is creating value as it further grows its operations.
More from The Motley Fool: Warren Buffett Tells You How to Turn $40 Into $10 Million