Oscar Wilde famously quipped that "imitation is the sincerest form of flattery that mediocrity can pay to greatness." That sums up what we've witnessed in the oil patch over the past year as a growing number of exploration and production companies (E&Ps) have copied the playbook developed by leading U.S. E&P ConocoPhillips (COP +0.10%) in the fall of 2016. That strategy, which included increasing its dividend and buying back stock, has been instrumental in creating value for its shareholders, evidenced by the fact its stock is up nearly 70% since that time.
However, while many rivals are trying out the company's playbook, "not everyone can do it," according to CEO Ryan Lance. ConocoPhillips has four unique characteristics that Lance stated "are necessary to execute and win in a value proposition like ours." He detailed what sets the company apart at a recent industry conference.
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The four pillars
ConocoPhillips spent the bulk of the recent downturn in the oil market reshaping its portfolio so that it could firm up its foundation. The company sold high-cost assets to pay down debt and reduce its oil break-even level, which is the oil price at which the company will produce enough cash to fund its dividend and the capital spending required to keep production flat. Those actions enabled the company to rebuild its foundation on the following four pillars:
- A strong balance sheet with a low debt level and ample cash.
- A diverse portfolio of assets with an average cost of supply of less than $35 a barrel, which is the price where new investments will generate at least a 10% after-tax return.
- A low oil break-even level of less than $50 a barrel.
- Capital flexibility so that it can ramp spending up or down depending on commodity prices.
While many of its peers share some of these foundational pillars, few boast all four.
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An unrivaled portfolio
One of the main differentiators between ConocoPhillips and its peers is its diversified portfolio of low-cost oil and gas resources, which includes conventional assets (traditional onshore and offshore oil and gas wells), LNG and oil sands facilities, and unconventionals (i.e., shale plays). The base layer of the company's portfolio is formed by its LNG assets in Australia and Qatar, as well as its oil sands facilities in Canada, because they produce at a very steady rate for years. As a result, the company doesn't need to invest very much capital in maintaining its production rate, which increases its capital flexibility and reduces its oil break-even level.
The next layer is made up of the company's conventional assets, which include its positions in Alaska and the North Sea. Production from these assets declines at a low rate, which means the company only needs to invest a moderate amount of capital to maintain its production pace. The final component of ConocoPhillips' portfolio is its unconventional collection of shale assets, led by the Bakken, Eagle Ford, and Permian Basin. While production from wells drilled in these regions declines at a more rapid rate -- which requires a higher level of capital investment to maintain a consistent output level -- these assets provide the company with more flexibility and growth potential than conventional, LNG, and oil sands assets.
Contrast that portfolio with those of its peers, many of which have sold off their non-shale assets in recent years in favor of focusing solely on shale plays. While that gives them lots of flexibility and growth potential, it comes with higher decline and capital investment rates. That led Lance to conclude that "a pure-play portfolio might struggle to [deliver on a company's strategic goals] because of the higher capital intensity [and] the lack of diversification." By contrast, he said, ConocoPhillips' "three classes comprise what we believe is an unrivaled E&P portfolio. ... That's why we believe our portfolio has an advantage."
Imitation only works if you have great resources
ConocoPhillips' differentiated portfolio enables the company to generate more cash than it needs to run its business, which has allowed it to grow its dividend and spend billions of dollars in buying back its stock. Those cash returns have been one of the key factors driving its outperformance in recent years, which is leading rivals to imitate its strategy by increasing the amount of cash they send back to their investors.
So far, they've been able to copy that part of ConocoPhillips' strategy primarily because oil prices have been on the rise, which has given them more cash to send back to investors. If prices fall, however, those companies might not be able to continue with their shareholder returns. That's when ConocoPhillips' uniquely diversified portfolio will give it a competitive advantage since it doesn't need to invest as much money in maintaining its production rate -- which will enable it to continue returning cash to investors. It's that ability to generate more consistent returns in both good times and bad that sets ConocoPhillips apart from most of its E&P peers and makes it an excellent oil stock to buy for the long haul.
