Between Conoco and Exxon, What Should Dividend Investors Prefer?

I own shares of both Conoco and Exxon stock—I expect to be a great income holding over the next ten to fifteen years. But what I do not expect is for the company to give smooth, linear annual increases in their dividend each year. With a company like Coca-Cola, you know what you are getting: a dividend every ninety days that eventually gets raised each February and then the process repeats itself until the next February. That is not what you should expect with upstream oil MLPs and corporations.

Because of the spinoff of Phillips 66 and a series of divestitures thereafter, Conoco Phillips is probably the biggest example of an upstream company that often shows up in defensive and conservative portfolios across the country. Now that Conoco is solely an upstream company, it can be useful to understand the implications of its business model if you want to own it for 10+ years.

By focusing on assets in the Bakken and Permian fields as well as at Eagle Ford (in addition to shedding Phillips 66 and other “non-core” assets),Conoco is working on improving its profit margins over the long term.

Let’s take a quick “before and after” look at Conoco’s net profit margins before and after becoming an upstream company. In 2008, Conoco’s profit margins came in at 6.6%. In 2010, they were at 4.7%. And in 2011, they were at 5.0%. Since becoming an upstream company, Conoco posted net profit margins of 12.0% in 2012 and 12.2% so far in 2013. Over the long-term, this means that Conoco should make more money for shareholders.

So what is the catch? When the price of oil and natural gas declines, Conoco will become much more volatile than it was before spinning off Phillips 66. If you are an upstream company, your business results are strongly tied to the price of oil and natural gas because upstream companies are the ones that find oil and natural gas and pump it from the ground.

As a consequence of this fact, it is necessary for investors in a company like Conoco to monitor two things:

(1) Firstly, the replacement rate. For a company like Conoco, you want to see a replacement rate above 100% because anything less than 100% indicates that resources are being depleted. As of early 2013, Conoco was pumping out 1.5 million barrels of oil and oil equivalents per day. That works out to about 547.5 million barrels of oil and oil equivalents per year. Conoco currently has 8.6 billion barrels of oil and oil equivalents in proven reserves. That means that, if Conoco never dug up any new oil finds, they would be able to exist for another 16 years or so at current production rates. Over the past five years, Conoco has been replacing reserves at 108%, indicating that it is adding new oil to its reserves than it is consuming.

(2) Secondly, there will not much (if any) dividend growth during times of low oil prices. That is because an upstream company like Conoco needs to continue to keep its reserve replacement rate above 100%, and requires constant capital expenditures to achieve this. But when oil prices are low, profits shrink, and capital expenditures consume a large portion of the company’s retained earnings, which places a strain on the ability to increase the dividend payout.

But, when oil prices are high, a company like Conoco should see its earnings per share increase 10-15%, and this should give the stock price a nice boost. Over a ten-to-fifteen year period, this works out well for shareholders, but you must be aware that you will experience significant lows along the way.

If you want to avoid those lows, you should stick with a company like Exxon Mobil that generates $35+ billion in profits across 38 countries. It has upstream, downstream, and chemical operations. The company has its corporate hands in every cookie jar. When oil prices fall, it can rely on strong amounts of natural gas, its transporting division, and its chemical division to provide the profits to continue the dividend growth. Exxon has been raising its dividend every year for three decades (which is unusual for a commodities company), and the company’s diversified revenue streams can explain the financial flexibility that has made this possible.

The one catch with a company like Exxon is that if we experience high oil prices for an extended period of time, a pure-play E&P company like Conoco will create more wealth for shareholders.

If you are debating an investment between Conoco and Exxon, you should ask yourself:

Do you think oil prices will be high over the coming decade, and would you be affected by the potential to experience extended periods of no dividend growth?

If you think prices will be high and you can handle periods of no dividend growth, then Conoco is the right investment for you. If you think oil prices will be low, Exxon is the right investment for you. If you can’t handle periods of low dividend growth, Exxon is the right investment for you. That’s how I’d work my through deciding whether Conoco or Exxon better served my needs as a long-term investment.