The last two months have been a bit of a rollercoaster ride for the oil and gas industry. The Energy Select Sector Index hit a 52 week high of 772.91 in September after International Energy Agency (IEA) increased its forecast of crude oil by 100,000 barrels per day (bpd). Since then, mounting pessimism over global economic outlook and a 300,000 bpd reduction in the IEA's Q4 crude oil demand forecast has sent the IXE down 11% to 688.80.
Energy Select Sector Index 3 month year performance
The short term depression, which should rebound as confidence is restored in the global economy and tension in the Middle East creates fear of a disruption in crude oil supply, gives you the opportunity to purchase energy stocks, which typically have a high dividend yield, at a discount. The two companies we looked at were ConocoPhillips (COP) and Royal Dutch Shell (RDS.A), which had dividend yields of 4.80% and 5.29%.
In May of 2012, ConocoPhillips sold off its downstream segment in order to focus solely on its upstream oil segment that was responsible for 66% of 2011 earnings. The new ConocoPhillips generates revenues by bringing to market crude oil, natural gas, natural gas liquids, liquefied natural gas, and bitumen. In 2011, ConocoPhillips had total confirmed reserves of 8.4 Billion Barrels Oil Equivalent (BOE) composed of 43% natural gas, 40% liquids, and 17% bitumen. During 2011, the company produced 1.6 MBOE per day, of which 47% was gas, 49% was liquids, and 4% was bitumen. Exploration and production revenues for COP in 2011 were balanced between domestic and international exposure, with 49% of revenue being generated in the United States and 51% being generated internationally.
Royal Dutch Shell operates its business in three segments: Upstream, Downstream and Corporate. Upstream combines the operating segments Upstream International and Upstream Americas, which generate revenue by bringing recovered crude oil, natural gas, liquefied natural gas and bitumen to market. Downstream generates revenue through the manufacturing and distribution oil byproducts and chemicals. The corporate function provides key support to the functions.
RDS is heavily dependent on international markets, with over 80% of 2011 revenues being generated outside the US; nearly 40% came from Europe. While only 18% of the revenues were generated through upstream activities, the segment accounted for 85% of the earnings.
In 2011, Royal Dutch Shell had confirmed reserves of 14.2 BBOE and produced a total of 3.2 MBOE per day.
Both these companies are attractive for their high dividends, especially in a world where the 10-year treasury is a dismal 1.5%. However, that means nothing if the companies can't afford to pay them, so two things were looked at: 1) short term cash flow, 2) long term growth potential.
Last quarter ConocoPhillips and Royal Dutch Shell produced revenues of $15B and $120B resulting in net incomes of $1.8B and $4.1B respectively. Total dividend payments for the quarter were $800M and $2.2B yielding payout ratios of 44% for COP and 54% for RSD. These payout ratios are high relative to the rest of the peer group; ExxonMobil (XOM), Chevron (CVX), BP (BP), and Schlumberger (SLB) have payout ratios of 22%, 28%, 30%, and 26% respectively. To confirm the companies could meet their dividend payments at the current payout ratio we looked at cash and operating income relative to current portion of long term debt, long term debt, and capital expenditures. The first chart is RDS, and the second is COP.
Both ConocoPhillips and Royal Dutch Shell have cash positions large enough to pay off their current portions of long term
debt. Royal Dutch Shell is in a better position with its debt being only 2.3 times current operating income compared to COP which as a multiple of 4.11. While the multiple is higher than the 5 year average for both companies (COP's was 1.1, RDS's was 0.7), most likely due to the low interest rates on treasuries, further decline in COP's operating income would require ConocoPhillips' management to either reduce capital expenditures and risk long term growth or issue debt to meet its dividend obligation.
Although ConocoPhillips has had to issue $7B in debt (approximately 39% of the total long term debt) in the two quarters since its divestiture of the downstream segment, it gives the company a considerable advantage over Royal Dutch Shell. If we look at the gross margin, net margin, and the ratio of SGA, R&D expense, depreciation and amortization and capital expenditures to operating margin, we can see the short term benefits of ConocoPhillips decision.
COP Last QTR
RDS.A Last QTR
COP 5 Year Avg.
RSD.A 5 Year Avg.
SGA to Operating Income
R&D to Operating Income
Depreciation & Amortization to Operating Income
Capital Expenditures to Operating Income
Calculated based on financial data from YCharts.com
By getting rid of the downstream segment, ConocoPhillips was able to increase its gross margin and net margin, while cutting back on SGA. Royal Dutch Shell's last quarter compared to the five year average, shows considerable decline in the gross and net margin. In look at the average growth rate from 2007 to 2011, we can see that although RDS's revenue grew earnings were flat. This is largely because the downstream segment for RDS which in 2011 generated $427B in revenue only produced approximately $4B in earnings, for a net margin of 1%. The book value decline for COP is largely due to the repositioning of COP to an upstream focused company.
5 Year Growth Rate
5 Year Growth Rate
Calculated based on financial data from YCharts.com
An accurate valuation of these two stocks is difficult for two reasons: 1) COP just started as a stand-alone oil and gas exploration company, making the history of the company a less reliable indicator of future returns, and 2) there isn't one metric that is relevant for both companies to project future price on.
Therefore, the an easier way to approximate if COP and RDS.A are fairly priced at $55 per share, and $65 per share, is to look at the current P/E see how they compare to historical averages. According to YCharts.com, COP has a current P/E of 6.8 and in the past 5 years has been as high as 17.4 and as low as 6.0. As for RDS.A, the current P/E is 7.7, and the high and low in the past 5 years are 22.3 and 6.1 respectively. ConocoPhillips carries slightly less risk of being overpriced as it is closer to its five year lows than Royal Dutch Shell.
While both companies have attractive dividends and seem to be priced cheaply, the underlying fundamentals in both are questionable. Royal Dutch Shell has high revenues, largely driven by sales in its downstream segment, but just doesn't have a strong margin. While this might be okay in companies requiring small capital expenditures, it poses significant risk for Royal Dutch Shell. With almost 40% of its revenue coming from Europe, continued economic pressure could further cut the margin and force the company to take on debt to finance operations or reduce their dividend.
As for ConocoPhillips, the company is just too young to tell. While it looks like it has healthy margins and healthy financing, two quarters of data isn't enough to predict long term results on. The shares seem fairly priced at P/E of 6.8, but, if short term tail winds continue to cut into revenues, operating income could drop to levels that would require management to reduce the dividend. If that happens, the share price will drop and the capital loss will surely outweigh the dividend payments.
My recommendation for both stocks would be to hold and watch to see how the economic landscape improves. I believe ConocoPhillips is a stronger investment, but want to see how the company operates over the next two quarters and see the debt to operating income ratio decline to three or lower.