The oil and gas sector is a volatile place right now. There are opportunities if you know where to look, but there's also a lot of danger.
Here's what separates ConocoPhillips (COP 0.16%) from Occidental Petroleum (OXY 0.22%), and why ConocoPhillips is the better oil producer stock to buy right now.
A change in sentiment
From wellhead to gas station, the oil business has seen its fair share of volatility over the past few decades. The upstream sector, which partially consists of the companies that drill for and produce oil, is one that offers the highest risk and the highest reward.
For a while, investors accepted volatility as an inherent part of a cyclical commodity business. But financial markets are now tiring of an investment thesis that basically says the more money you spend, the lower the break-even price per barrel of oil. While there are advantages to this strategy, excess spending can leave a company with an unhealthy amount of debt, even if they are able to break even at $5 less per barrel than their competitor. This change in sentiment is one reason why we are seeing investment in upstream oil and gas fall to a 15-year low.
Few companies embody the dangers of high investment/high efficiency more than Occidental Petroleum. The company's acquisition of Anadarko Petroleum, which was finalized in August 2019, could not have come at a worse time. Anadarko's enterprise value was around the same as Occidental's, so Occidental had to increase its debt load to pull off the deal. Shortly after, the pandemic hit, and oil prices briefly went negative before rebounding to the current price of around $40 per barrel. This price is still unprofitable, or barely profitable, for many oil and gas producers.
Occidental's logic in acquiring Anadarko was that their businesses aligned in many ways, most notably the shale plays that have made the U.S. energy-independent with horizontal drilling and hydraulic fracturing. Occidental CEO Vicki Hollub claimed that Occidental is the best shale operator from an efficiency standpoint, so Anadarko's rich portfolio of assets would fit nicely into Occidental's business.
The deal sounds good until you realize the kind of financial shape it has left the company in. Occidental's strained balance sheet has pressured the company to try and sell some of its assets, but there are few buyers in today's weak market. In its first-quarter 2020 earnings call, Occidental noted that it's having trouble selling assets, so it will take on debt and cut its dividend. Occidental was one of the first cash-strapped oil producers to cut its dividend. ConocoPhillips yields 4% and Occidental Petroleum yields 0.2% at the time of this writing.
ConocoPhillips is the largest independent oil and gas producer. The company's patient, yet deliberate growth strategy has driven its selectiveness when it comes to new investments.
ConocoPhillips has funded its growth with solid cash flow and less debt than Occidental. Although it's a larger company, it has just one-sixth the net total long-term debt of Occidental.
ConocoPhillips also has healthy debt-to-capital and debt-to-equity ratios, signaling it is more reliant on cash flow than debt to fund its business.
ConocoPhillips has consistently managed to keep a strong balance, but it isn't immune to the challenges of lower oil and gas prices. On March 18, ConocoPhillips invited analysts to a conference call that outlined the measures the company is taking in response to the current market. The measures included cuts to spending and production, as well as raising liquidity without cutting the dividend. ConocoPhillips noted that it can achieve at least a 10% return on its Lower 48 assets even when oil is in the high $20s, which indicates that the company's portfolio is strong.
The advantage for ConocoPhillips over Occidental is that it can handle more debt without straining its balance sheet or having to cut its dividend. It can also afford to bring back some of its production as prices rise. ConocoPhillips had shut down around a third of its production in May and June, but CEO Ryan Lance hinted that the company might restore some of its curtailed production in July if prices stabilize.
Even with production cuts, ConocoPhillips is still producing just 5% less than the first quarter and around the same as it was in the second quarter of 2019.
The advantages of time
The main difference between ConocoPhillips and competitors like Occidental Petroleum is that ConocoPhillips has time on its side. Instead of selling oil on razor-thin margins or selling assets for a fraction of what they were worth a year ago, ConocoPhillips can simply take out a few loans and spend less money. In a $40 oil market, what matters more than anything is the health of a company's balance sheet.
Comparing Occidental to ConocoPhillips frames the contrast well, but the same logic extends across the industry.
ConocoPhillips is a good starter energy stock to add to your portfolio. There's arguably already enough risk in upstream to venture much further than that, especially with the uncertainty surrounding transportation demand for gasoline, diesel, and jet fuel. But if you decide to venture further, check that the company can handle quarter after quarter of low oil and gas prices without drowning in debt or cutting its dividend.