Not Your Daddy’s Conoco

For most of its history, Conoco (COP) had been resistant to the types profit streams that enabled Exxon and Chevron to have better reporting results during the low point in the business cycle. Exxon and Chevron are heavily invested in chemicals and always engage in some transportation work which is only mildly resistant to oil prices (the transportation business is affected by lower prices to the extent that oil companies cut back on production and have less oil available for transportation.)

The reason why Exxon and Chevron are more profitable at low points in the business cycle is because they operate what are called “integrated business models.” That’s jargon for upstream, midstream, and downstream production. Chevron and Exxon do all three. Upstream means you find the oil and sell it, midstream means you transport it, and downstream means you modify it into a final product that it can used in cars, plastics, vaseline, and so on.

Conoco has always been an upstream reliant company. That means, of the three largest oil companies in the United States, Conoco stood to benefit the most as oil prices rise but also was guaranteed to have a rough go of it when oil got cheap. This is why Conoco would freeze its dividend regularly in the 1990s and early 2000s. It did have some midstream and downstream operations, but the bottom of the business cycle ensured that the oil company would barely be able to cover its dividend.

Even that margin of profit safety during the lean years went away after Conoco decided to spin off Phillips 66 in April 2012. That is the business that transports and finishes oil. It is much more resistant to flows in the commodity sector because people are going to get gas whether it costs $2.50 or $4 per gallon, and it gets paid for transporting and finishing it regardless. This has notable consequences when oil is cheap at $50 per barrel: Right now, Conoco is expected to lose $500 million per year. And Phillips 66 is expected to generate $4 billion per year in net profits.

If the spinoff had never happened, the combined Conoco + Phillips 66 entity would make $3.5 billion in total profits. It is on the hook for paying out $3.6 billion in dividends at the current rate. This is why it is nice to have upstream, midstream, and downstream operations together under the same corporate umbrella. While you get less growth when oil rises rapidly, you are able to weather the downturns in the industry much better and that is a necessary condition of being a blue-chip stock for the long run.

Had there not been a spinoff, Conoco would only have to borrow $100 million to fund the dividend. Not a problem. If that’s the worst thing an energy company must get through, it’s a sign of a well run operation (which should really increase your respect for Exxon, which will still manage to have a dividend payout ratio of only 60% if oil remained at $50 per barrel.)

But now, because Conoco is only an upstream company, it will need to borrow about $4.1 billion to fund the current $3.6 billion in dividends plus it is expected to lose a little over $500 million this year.

That’s why the debt burden on the company has climbed from $16 billion to $22 billion in the past year and a half. That $0.74 dividend that investors currently receive will most likely be frozen for awhile, as the fundamentals won’t support another dividend hike unless oil crosses $75 per barrel (at that point, Conoco would be making around $6 billion or so in annual profits.)

If oil stays in the $50s, Conoco certainly has the borrowing capacity to bring the debt burden up to $40 billion or so if it desires to maintain the dividend throughout this period. It would probably take a couple years of oil at $55 or below for a dividend cut to become a likely possibility (all of this depends on how much debt the Board feels comfortable putting on the balance sheet for the sake of satisfying long-term shareholders. If there were no dividends, Conoco would only be borrowing $500 million per year right now, and it would be able to sail through this period with hardly a dent to its balance sheet.

Conoco has been making extensive investments in the Bakken Fields that will be more profitable than its typical costs because: (1) Bakken Fields oil is subject to less costly finishing work, and (2) the drilling costs are lower. An added benefit is that, once the Bakken Projects start becoming a significant part of Conoco’s production in the next three to four years, Conoco will be improving the point at which it becomes profitable in low-priced energy environments.

If you are trying to figure out whether Conoco makes sense for you, there are two primary considerations you should keep in mind.

One, you should figure out how important the current dividend is to your strategy. If you are someone who needs the dividend to be maintained, and even go up every year, you should be looking at Exxon. But maybe you think: “Conoco trades at $62, and will probably pay out $62 in total dividends over the next sixteen years with dividends reinvested”, so I’ll put up with the turbulence. If that describes your thought process, then Conoco would be more appropriate for you.

Two, you should figure out whether you’d rather capitalize on an oil price upswing or protect yourself in the event of prolonged $50 barrel pricing. If you want high dividend growth and capital gains in response to higher oil prices, you will make more money owning Conoco than Exxon or Chevron. But if oil stays low for awhile, you will hold up better with Exxon and Chevron because they make money through transportation of oil, the finishing of oil, and general chemical sales.

On a risk-adjusted basis, I still continue to think that Chevron, followed closely by Exxon, are the best ways to do energy investing. That said, if oil shoots up, Conoco will likely prove to be a superior investment. But it is important to know how the spinoff of the downstream division in 2012 affected Conoco in future business cycles. Everything is more exaggerated with Conoco now–the highs will be higher, and the lows will be lower.