ConocoPhillips: More Than Just a Great Stock

It is widely known among investment professionals that the Dow Jones-AIG Commodity Index (“DJP”) is an excellent complement to any portfolio. This index is comprised of a wide variety of commodities that are currently traded on the U.S exchanges. The following sub-indexes of the DJ-AGI are represented by the major commodity sectors within the broad index: Energy, Petroleum, Precious Metals, Industrial Metals, Grains, Livestock, Softs, Agriculture and ExEnergy. Thus, the DJ-AGI is a broadly diversified index across various sectors that in effect will smooth out the volatility risk and risk-return payoff (Sharpe Ratio), as opposed to investing in a single commodity sector.

In terms of portfolio diversification, it is academically and statistically proven that the DJ-AGI is quite beneficial to any portfolio/investor. When the DJ-AGI is added to a balanced portfolio of equities and bonds, the Sharpe Ratio will increase due to the DJ-AGI having a similar volatility to the S&P 500, as well as higher returns than bonds. The exposure and diversification in commodities along with reducing a portfolio's market risk and increased returns comparable to bonds will create an outstanding complement to any portfolio.

The advantages of adding the DJP to a portfolio can be further enhanced by adding ConocoPhillips (COP). As shown below, ConocoPhillips is closely correlated with the DJP. In my view, this correlation can be exploited by holding COP instead of the DJP for diversification in the commodity sector. One key advantage is the annual yield that COP offers. COP is currently yielding 3.40% as of the close on Tuesday January 6, 2009. The difference in yield between COP (3.4%) vs. DJP (0%) can benefit investors greatly by offering an additional source of income – especially in depressed markets. Another advantage of COP is the outperformance relative to the S&P 500 over the past two years.

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Even during the worst sell-off since the Great Depression, the outperformance to date further illustrates why COP is a great way to increase alpha and decrease market risk relative to the S&P 500. Lastly, the three oil giants, Exxon Mobil (XOM), Chevron Corp. (CVX) and ConocoPhillips (COP) have been trading in close tandem/correlation over the past two years until May 2008.

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In May 2008, XOM drifted to the downside leaving COP and CVX still highly correlated. Then in October 2008, XOM became re-correlated with CVX and this time COP drifted further to the downside. As of yesterday's close, COP has remained in a trading range since its low in November. On the other hand, XOM and CVX have continued to trade higher in close correlation with one another, leaving COP behind. With this being said, I believe that COP could eventually trade alongside XOM and CVX again, which leads to greater upside potential to be achieved by owning COP.

Thus ConocoPhillips is an excellent way to diversify a portfolio as an alternative to owning the DJ-AIG Index, as well as the additional income being produced from dividends. In addition, the upside potential (stock price) and the probability that COP will once again trade in correlation with XOM and CVX is probable due to their trading history. Also, if you like whale watching – Warren Buffett has been adding to his already healthy position in ConocoPhillips. Is this a co-incidence?

For more information on the DJ-AIG Index see here. Information from the aforementioned website was used in this article.

Disclosure: Author holds positions in COP, BRK.B

Comments

[Michael Fit...:]

i agree, it's seldom you can buy a company of COP's quality when the PE damn near equals the dividend yield. in the longer term, the America has no alternative but to migrate transportation solutions toward US produced natural gas. that said, the American gov, media, and people (outside of picken's following) have yet to figure this out, however, within the next few years, it will become ever more apparent that we have no choice but to leverage US natural gas production. when we DO figure it out, COP's value will also become more apparent as the US's second largest natural gas producer.

Jan 07 10:27 AM

[Itsonlymoney:]

Why do you think COP does not currently trade in correlation to XOM and CVX?

Jan 07 11:41 AM

[Kevin B.:]

See the second chart - since Oct 2008 COP has de-pegged itsself in a range from XOM and CVX. If they were trading in correlation after Oct 2008 they would be trading along side eachother - which they are not. Thus a potential opportunity refrenced in the article.

Jan 07 11:50 AM

[123:]

Does it bother noone that COP's capex goes up as high or higher than its profits?

Jan 07 10:00 PM

[Norman Lepo...:]

Good Article.

Jan 08 08:23 AM

[BlueOkie:]

I own COP and think it is a great company. Its price is tied to oil which has gone from $147 to $39 in six months. Run comparisons for 5 to 10 years if you really want to do it right.

Jan 08 08:42 AM

[Tim Scott:]

The problem with COP vs. XOM and CVX is COP has a mountain of debt ( @ $1B cash $22B debt) while XOM and CVX are sitting on piles of cash.

IMHO this is the reason and COP is trading at a deserved lower level.

Jan 08 08:50 AM

[Kevin B.:]

Well i dont think debt is of great concern for these oil giants. They generate enough revenues/profits in any given quarter to cover the entire debt on the balance sheet. Debt could be due to growth and expansion of the company - XOM and CVX are at least twice the size in market cap. So the growth of COP would be in direct correlation with higher debt. Debt is not always a bad thing. Its only bad if you cant pay it off - in which COP will have no problems.

Jan 08 09:15 AM

[RSiva42:]

Interesting bit from a Heard on the Street article yesterday: "Another is ConocoPhillips' 20% stake in Russian oil major Lukoil. Public markets indicate a value of $6.2 billion. The book value of Conoco's investment was $12.9 billion at the end of the third quarter."

Jan 08 11:17 AM

[searcher:]

Political risk ignored, the mark to market of the Lukoil stake is of no concern unless immediate liquidation were needed to service debt due to declining revenues. Clearly, debt is the relevant variable in comparison to the other two. A safer way to go might be to play the diminishing spread of the laggard with an average of the relative out performers.

Jan 08 11:45 AM

[BrotherMaynard:]

"In terms of portfolio diversification, it is academically and statistically proven that the DJ-AGI is quite beneficial to any portfolio/investor"

So were asset backed securities and CDSes. My point being, everything looks good on paper, simply because on paper, its doesnt interact with anything. As we saw during 2008 -- all asset class correlations converge at 1 during a crisis. Corporate bonds tanked, commodities tanked, stocks tanked, real estate tanked...you name it and it tanked. So just a word of caution...just diversifying doesn't do you any good. Correlations can be broken or reversed, sometimes permanently, without a moments notice. What should you do? I'm not 100% sure, but just because something is empirically tested doesn't mean that the statistical sample is a complete descriptor of the statistical population.

Jan 08 01:19 PM

[Kevin B.:]

Corelations did not converge at 1. If you notice for the two year holding peroid the DJ-AGI out performed the S&P500. So in terms of portfolio diversification by holding the DJ-AGI you beat the market which is mentioned in the article by "When the DJ-AGI is added to a balanced portfolio of equities and bonds, the Sharpe Ratio will increase due to the DJ-AGI having a similar volatility to the S&P 500, as well as higher returns than bonds. The exposure and diversification in commodities along with reducing a portfolio's market risk and increased returns comparable to bonds will create an outstanding complement to any portfolio"

Just because things fall in price together does not mean they are correlated at 1. Nothing is perfectly correlated - ther will always be some error in statistics. You would be up on the market by about 8%+ with a 50% - 50% mix of stocks and the DJ-Index. So diversification is quite benneficial.

Jan 08 01:47 PM

[ustaad:]

Where do I begin....

Let's think logically here for a minute. Commodities are good diversifiers because inordinate increase in commodity prices typically means bad things for consumers and the economy and by that token stock prices and vice versa. (Think 70s, 80s and 2000s). Also, commodity prices typically follow long supply demand based cycles.

Two of the components of the commodity index are oil and natural gas. To me, it makes logical sense that the stock performance of any oil and gas E&P company (esp. in bubble periods) would tend to move in lock-step with commodity price changes. Since, we had a bubble in pretty much all commodities, we had a short term phenomenon where the fortunes of some of these E&P companies moved in sync with actual commodity prices.

Stocks prices are a function of long term cash flows while commodities prices are largely driven by supply demand imbalances. A 3% delta in returns over a long period of time would add up, not sure how it'll make a great difference here.

Remember, we got to the current crisis by assuming that the future will very much resemble the past. Analyses (if I can call it that) like this proves that we don't really learn, do we?

Jan 08 08:09 PM

[T.Stamps:]

Good reading. Good stock

Jan 08 10:08 PM