ConocoPhillips (COP) announced on Wednesday this week that it planned to sell 86,000 acres of Bakken oil fields to Denbury (DNR) for an estimated $1.05 billion. This all comes after just last month when the company announced that it had made $3.5 billion in assets sales. Conoco over the last year has been involved in a strategic asset selling program that the company hopes will allow its oil production to grow at a rate of 3% - 5% per year. After this week's sale, the company announced that in the past year it has raised nearly $12 billion from its asset sale program. This surpasses the firm's goal of generating $8 - $10 billion in cash for this year.
Conoco's ultimate goal is to consistently maintain a 3% - 5% output rate while still being able to pay a 4.5% dividend. These goals are very aggressive especially compared to the firm's main competitors like Exxon Mobil (XOM), Chevron (CVX), BP plc. (BP), Total (TOT), and Royal Dutch Shell (RDS.A). These aggressive growth rates do come at a cost to the company, especially a large oil company. Oil reserves are essentially the life blood of any oil company and as reserves decrease new reserves must be continually discovered to replace old and retired ones.
In 2011, Conoco's reserve ratio was around 14.2. Most major oil companies target a replacement rate of 90% - 100% per year. Factoring in Conoco's growth goals of increasing output by 3%, the low end of its goal, reserves would need to be replaced at a rate of 126% per year. Examining the higher end of Conoco's goal, a 5% increase in output would require a 148% replacement rate each year.
In order for Conoco to maintain this projected high replacement rate, it requires a great deal of capital infusion. Capital expenditures for the company last quarter topped $15 billion, while operating income came in at $10.05 billion. That still doesn't take into account that the company currently pays out roughly $3.2 billion in dividends. The $5 billion (excluding dividends) spending gap can only be covered by asset sales for so long. The current $12 billion that Conoco has sold this year technically should hold it over for the next two years, but eventually production efficiencies need to be made to further offset this gap.
The shortfall that Conoco currently is experiencing in its cash flow could also be offset by higher Brent crude prices. In Conoco's case, those prices would need to top roughly $125 per barrel. With prices of Brent currently trading at $110.30 per barrel, pinning the company's cash flow on a sustainable long-term jump of 14% in Brent is not extremely likely or a good long-term business practice.
Conoco is also targeting margin growth as way to increase its overall operating income by trying to close its $5 billion spending gap. The company believes that if it shifts its production mix, it will allow it to increase its production growth. The firm is projecting that by 2016 this production shift will add $3 billion of annual positive cash flow to its bottom line. This is based on the assumption that Brent crude oil remains at or above $85 per barrel.
Even with all of these headwinds, the stock has still been able to rise almost 10% in the past year. The stock has seen its P/E multiples rise from around 8 time earnings at the beginning of last year, to its current multiple of 10.6. Conoco's ability to execute on its increased output plan is still very dependent on energy prices remaining high, with no unforeseen supply distributions in the immediate future that would further offset cash flow. The main positive for Conoco is that the company has an extremely diverse portfolio of assets that can continue to be sold to help bridge the firm's cash flow gap.
On the bright side, I tend to believe that Conoco's bullish projections on the price of energy are accurate long term and will pay off for the company. I have outlined below several reasons why I believe that high energy prices will remain, even with the newly discovered oil in the U.S.
· As the U.S. economy and the Chinese economies start to regain steam, their demand will once again push prices up. If demand picks up enough, I could see Brent crude oil prices once again topping the $140 - $150 per barrel level.
· Even with the large amount of newly discovered (I use that term loosely) oil reserves in the U.S., the cost in extraction is still very high, causing the need for prices to remain high for oil companies to be able to economically extract the oil and refine it.
· As much as I hate to say it, the Middle East will still play a large role in determining the direction of oil prices. If for some reason, the price of oil were to get to low, I won't put it past OPEC to simply cut supply, which would instantly cause prices to shoot back up until a new equilibrium was met.
Overall, Conoco may have a bit of a tough road ahead of it in the short term, but if management is able to continue to strategically sell off non-performing assets for a premium price, while still working to increase output each year by 3% - 5%, I feel that any major sell-off in the stock price presents a significant buying opportunity for long-term holders.