The Chorus Of People Criticizing Conoco Phillips

Here is a quick piece of information that will help you funnel oil-related news better. Whenever you hear people talk about current production in the Bakken oil fields, that usually refers to Exxon Mobil and Marathon Oil (the smaller players in the Bakken fields are Whiting Petroleum, Continental, and Hess, and this is why these smaller companies are frequently linked in discussions about mergers with Exxon and Marathon). Whenever you hear people talk about Eagle Ford oil field, the big players are BHP Billiton, Conoco, and Marathon Oil (Chesapeake and Anadarko are the smaller players there that often get brought up in the merger talks).

As a general rule, the production costs per barrel of oil are higher in the Bakken Fields than the Eagle Ford fields because the technology is more sophisticated and the drilling is deeper. Normally, this is not an issue because most of the time Bakken oil field production is very profitable. But this is not most of the time. With oil in the $50s, many of the projects in the Bakken fields make little economic sense at current prices (though some companies, like Whiting Petroleum, only have to pay around $18 in production costs per barrel, so there are clearly exceptions to these general rules).

But as things stand now, production in the Bakken Fields is expected to decline by about 50% over the course of 2015 (compared to 2014) with the lower production expected to continue until the price of oil rises. If you expect lower oil prices to remain low for an extended period of time, your first bet is to buy something diversified like Exxon and Chevron that have the economies of scale and diversity of production sources to survive pessimistic scenarios for the energy sector. After that, your best bet is to focus on companies that do their drilling and production in the Eagle Ford, Woodford, Utica, and Haynesville basins because those are the areas where oil production remains profitable and oil companies in those areas are expected to have the smallest amount of idling rigs and production declines because the access tends to be cheaper.

This is why I do not join the chorus of people that have been eager of late to criticize Conoco Phillips. The people who criticize the company for not raising the dividend every year are correct when they claim that the dividend growth from Conoco in the bad times won’t be as good as what you’d get from Exxon and Conoco. Heck, the dividend growth from Conoco isn’t even guaranteed during the bad times, as the company has frozen its dividend at several different points over the past generation. Heck, the dividend froze at $0.68 per share throughout the late 1990s until the quarterly dividend finally went up half a cent in 2001.

Why are analysts then so quick to lambast Conoco? Because Conoco is only cutting its capital spending by 33% (compared to industry peers that are cutting spending by 50% or more) to $11.5 billion because it intends to develop $4 billion worth of oil projects in the Eagle Ford fields, spend $4.8 billion developing new oil projects in Alaska, Europe, and Malaysia, and spend a little over $1 billion this year in exploration for new oil. The remaining $1.7 billion will go towards basic maintenance expenditures on existing projects.

The consequence of this course of action for Conoco is that short-term earnings results for the company will look ugly. The price of oil is down significantly, and the company is continuing to spend heavily (on a relative basis to other peers) on future projects. Those $4.60 you see in trailing profits per share are about to go out the window. My guess is that, based on current oil prices and management’s intent for capital expenditure plans, Conoco will make $1.40 per share in profits this year. The $0.73 dividend puts Conoco on the hook for $2.92 per share in cash payments to shareholders while only generating earnings of $1.40 on behalf of shareholders. This mismatch between dividend payments and capital spending objectives compared to short-term profits is why the company is so roundly criticized of late.

The big-picture, though, is that Conoco generates $8 per share in cash, and could easily pay its dividend based on current profits if it were not investing so heavily for future growth and taking certain impairments to existing projects in the Gulf. Most likely, what will happen is this: Conoco will freeze or negligibly raise its dividend for the next few years, borrowing as necessary to fund it (debt only stands at 24% of capital), and people will be hollowering that the dividend cannot be covered by current profits. Then, at some point in the future, the price will of oil will cross the $75 threshold, and the dividend ratio will be well covered as the production improves and the cost of the commodity advances. It is the nature of cyclical investing.

That said, even though I think the criticism of Conoco is often over-exaggerated, this does not that I consider Conoco to be the optimum oil supermajor investment right. I think it is very hard, on a risk-adjusted basis, to beat Chevron. Chevron’s 4.1% dividend yield is rather close to Conoco’s 4.6% dividend yield, and Chevron’s current profits ought to continue to cover the dividend even in worst-case scenarios. Even though Conoco will be able to get through a medium-term period of dividends not covering earnings, Chevron investors do not face this risk as the current dividend payment is lower than profits even with oil in the $50 range. Given that Chevron provides so much protection in the event that oil stays in the $40s or $50s, I would be hesitant to look at anything else (especially when the tradeoff of taking additional risk is only an extra half point of yield). In short, my opinion is: Buy Chevron first, then Exxon second, and the conditions at Conoco aren’t as bad as projected right now but that doesn’t mean I would elevate the company above either Chevron or Exxon if looking to make substantial, fresh investments in the energy sector.