As the downturn in the crude market enters its second year, oil companies are beginning to retrench in order to strengthen their businesses just in case weak commodity prices continue to persist. Among those making retrenching moves is ConocoPhillips (COP +0.65%), which recently announced it was cutting spending on future deepwater exploration. Instead, the company is shifting its focus to develop less risky, faster payback projects in an effort to keep its costs low and its returns high.
Reducing risk while visibility is weak
ConocoPhillips' most recent retrenching is hitting its deepwater exploration program. While the company didn't put a dollar figure on the cut, it did say it intends to reduce future deepwater spending, while virtually pulling the plug on its operated Gulf of Mexico program, which is highlighted on the slide below.
Source: ConocoPhillips Investor Presentation
As a result of this change the company announced it was terminating its contract for Ensco's (ESV +0.00%) DS-9 deepwater drillship. The Ensco vessel was scheduled to be delivered late this year and begin drilling on ConocoPhillips' operated deepwater inventory as part of a three-year contract. Instead, ConocoPhillips will pay Ensco a hefty termination fee to get out of the contract, which Ensco states is equal to two years of the $550,000 operating dayrate. As a result, the termination won't have any negative impact on Ensco's financial operations, though it will result in ConocoPhillips taking a large one-time charge.
Focusing on what drives returns
ConocoPhillips would rather eat that contract than invest even more money into its own operated deepwater drilling program at a time when it has other opportunities for that capital. The company has a number of recent deepwater discoveries that it would like to turn into production first. In addition to that, the company has an enormous shale resource base, which would earn it a much faster payback than it would see from offshore development, which can take up to a decade to go from discovery to production.
This most recent retrenchment is just the latest one to ConocoPhillips' capital budget, which has undergone several reiterations over the past year. The original plan called for the company to spend $16 billion per year in order to fuel 3%-5% annual growth in both production and margins. But with commodity prices now meaningfully lower, the company has reduced its investment to $11.5 billion per year and reallocated that capital away from major projects and exploration and into development drilling. It's a shift that will become even more noticeable in the years ahead as major projects will see a 45% spending cut, while development drilling will be boosted by 50% as the slide below notes.
Source: ConocoPhillips Investor Presentation
In a sense, what the company is doing is moving away from projects that won't deliver returns for a couple of years while redoubling its efforts on near-term development projects, such as shale drilling, that will turn capital expenditures into cash flow much faster. It's why the company still expects to deliver production growth, albeit at a slower pace of 2%-3% per year.
Investor takeaway
The downturn in the oil market is forcing oil companies to make tough decisions, which is why ConocoPhillips is now axing its operated exploration drilling program in the Gulf of Mexico. It's a hard decision to make as it will cost the company a hefty termination fee to be paid to Ensco. That said, the company is much better positioned than many of its peers as its vast resource base provides it with a lot of flexibility. It's now using that flexibility to shift away from riskier, longer term prospects and instead focusing on developing known commodities.
