The 2 Potential Paths Of Conoco's Dividend

| About: ConocoPhillips (COP)

For long-term investors of ConocoPhillips (NYSE:COP) stock, the 2001-2011 stretch was a good decade stretch of time, indeed. The earnings per share for the company's operations grew from $2.90 per share to $8.76 per share, and the dividend grew every year during that time frame from an annual payout of $0.70 in 2001 to $2.64 in 2011 before spinning off Phillips 66 (NYSE:PSX) to the existing shareholders.

That's what the good side of dividend growth investing looks like: you quadrupled your overall dividend income in less than ten years while getting annual raises and growing your paper wealth by 12.9% annually.

Many of you Conoco shareholders reading this may have noticed the announced dividend increase today from $0.66 to $0.69 per share, for an increase of 4.5%. As a shareholder of Conoco with a 20+ year time horizon in mind, I am interested in setting my expectations for Conoco's dividend now that I need to adjust for the Phillips 66 spinoff in addition to the asset shedding that has taken place in the past two years.

The general trend with Conoco is that it is moving in the direction of becoming a pure earnings and exploration company. That is not a bad place to be: this is a company pumping out about 1.5 million barrels of oil and oil equivalents per day, and has an estimated 9 billion barrels of oil and oil equivalents in proven reserves.

Furthermore, we can see where the company is investing its money: high-margin projects in the Gulf. Continued strength in the Permian Basin. Increased investment at Eagle Ford.

Forbes gave a great synopsis to investors at the end of April, describing the direction that Conoco management will be taking the company:

ConocoPhillips is at the forefront of the debate in the oil industry, having decided to get rid of its lower-margin downstream business and concentrate on exploration and production…

Still in the process of selling assets and streamlining its operations, Conoco's total revenue fell 10% to $14.65 billion, but still beat the estimate which called for $12.79 billion in sales. The company is betting on the U.S. energy miracle, investing $1.28 billion (38% of total quarterly capex) in the liquids-rich Eagle Ford, Bakken Field, and Permian Basin; production there was up 42%. Part of that spending also went to Columbia, where Conoco is expected to begin drilling at the La Luna shale field in the second quarter.

Conoco's asset optimization should benefit long-term shareholders in two meaningful ways: the volume will increase 4-5% annually, but more importantly, the profits that Conoco generates should be higher because the company has been switching to higher-margin opportunities while selling the low-margin cash cows.

The implications of Conoco's spinoff of Phillips 66 and general asset shedding is that a focus on upstream production ties earnings closer to the price of the underlying commodities, and thus makes the earnings more volatile (that is because you focus on making capital expenditures to find new wells and get the energy from the ground, rather than transporting them or processing them). The good news for Conoco shareholders is that the upstream opportunities are where the fast growth is at, particularly in times of decent or high energy pricing. The bad news is that, at the bottom of an energy cycle, the profits at Conoco are likely to be lower.

If low energy prices persist for a long time, upstream companies usually look to merge so that they can rely on midstream and downstream profits to fund the capital expenditures necessary to find new wells (the best case studies of this are the low energy prices that drove Exxon to merge with Mobil, BP to merge with Amoco, and even Conoco to merge with Phillips in the first place).

In terms of dividend policy, it seems that Conoco management has two options going forward:

1. Either establish dividend policy that reflects business performance, meaning sharp dividend hikes during periods of rising prices and high volume production (and consequently dividend freezes or token dividend growth during periods of low asset pricing or asset reshuffling)

2. Or establish a policy of moderate annual dividend growth in the 4-7% annual range that smoothes out the earnings experience for shareholders, softening their income gains in good years but providing them the psychological support and sustained income growth during the lean years.

From 2001 to 2011, the growth of the dividend played a large part in Conoco's story as it increased from $0.70 to $2.64. Conoco is now pursuing more volatile, but likely more lucrative, paths to creating wealth. That means that the total returns experienced by investors over the coming years is likely to be due to the current dividend payout plus the growth in retained earnings (namely, the market multiple placed on those earnings) instead of the growth of the dividend itself. In short, long-term profits should continue to grow substantially but less linearly, and as a result, the growth of the dividend will play a meaningful but less lucrative role in the story of Conoco going forward.

Disclosure: I am long COP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.