Permian Basin: Is ConocoPhillips' Position Being Overlooked?

Oct.17.13 | About: ConocoPhillips (COP)

Click to enlargeThere has been much discussion recently about the oil riches contained in the Permian Basin. The stock of Pioneer Resources (NYSE:PXD) has taken off like a rocket on its drilling results in the Spraberry/Wolfcamp play and the prospect for big gains in proven reserves growth in the coming years. One company which has a big acreage position in the Permian Basin appears to be overlooked: ConocoPhillips (NYSE:COP). While COP may not be able to match the overall production growth of PXD, there are other reasons why COP represents great value at current levels. The stock could easily return 15% over the next 12 months. Add to that a fat dividend near 4% and you've got close to a 20% annual return.

Conoco's Permian Basin Holdings

At the September Barclay's CEO Energy Conference, ConocoPhillips CEO Ryan Lance's presentation included a slide summarizing the company's legacy position in the Permian Basin of over 1 million net acres:

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While most of COP's acreage is generally west of PXD's prolific Spraberry acreage, I believe COP's current estimate of 800 million barrels of resource could be low for a number of reasons. One, it would appear most of the Permian Basin contains stacked acreage, which for decades has been tapped by vertical wells. As the full benefits of horizontal fracking are focused on the company's Permian leases, odds are in favor of a potential upside in reserves. Secondly, as I discussed in my last article on COP, the company owns 89,000 acres in the prolific Ozona Arch region of the Wolfcamp play. Lastly, in Texas Conoco has been focused primarily on exploiting the Eagle Ford shale - and who can blame the company? The Eagle Ford has arguably the best economics of any US shale. But Conoco is reaching the full development phase (~130,000 boe/day) in the Eagle Ford and soon will be able to shift more attention to exploiting its Permian acreage. As shown from the slide above, the company plans to add roughly 40,000 boe/day of Permian production to its mix by 2017. Note also the incremental finding costs of ~$15/boe. And as Jim Cramer recently pointed out, one of the nice things about the Permian Basin is its fully developed pipeline takeaway infrastructure.

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In Q2 2013 Seeking Alpha conference call transcript, Matt Fox, ConocoPhillips Executive VP E&P, said:

We expect to see production to continue to grow in the Eagle Ford, the Bakken and the Permian over the next few years. The Permian from an unconventional perspective, and we've seen a lot of potential there. We are seeing probably at least two producing wells in the Avalon, two or three in the Wolfcamp. So we continue to be encouraged by the unconventionals in the Permian.

In Q2, combined production from the Eagle Ford, Bakken and Permian Basin averaged 203,000 boe/day -- up 47% from a year ago. These shale plays made up less than 9% of COP's production a year ago and today they comprise 13% of total company production. Currently, COP only has three rigs running in the Permian and is using them to test the Delaware and Midland basins. I don't have any specific drilling results and all the company has said is that they are "encouraging." I remember years ago hearing the same word used to describe the Eagle Ford...

In this fairly comprehensive Howard Weil report on the Permian Basin, we find that COP has 2,627 active wells in the Permian. My guess is that most of these wells are either vertical or water floods. In other words, the Permian is a legacy asset for COP and new horizontal fracking techniques have not been fully implemented in the play. Although the report is over a year old, on page 1 it lists Conoco as the third largest acreage holder in the Permian after Occidental Petroleum (NYSE:OXY) and Apache (NYSE:APA).

With respect to the Delaware Basin region of the Permian, the report says:

Sweet Spot #1 - The State Line: Currently, the area offering the most consistent and prodigious results on a return basis is centered around the New Mexico/Texas state line. This area is a 2nd and 3rd Bone Spring play spread between south-central Eddy
and Lea counties in New Mexico. We have seen multiple operators within our coverage universe-like CXO and XEC-report very strong wells here. The Bone Spring is not the only prodigious horizon in this sweet spot, as Wolfcamp and Avalon wells have also
yielded generous returns here. We conservatively model horizontals in this area to yield a median 30-day IP rate of 700 Boe/d with over 70% crude. Many wells here have averaged IP rates well in excess of 1,000 Boe/d.

The sweet spot curve in the report (Figure 14) shows EUR estimates in the range of 5-600,000 boe. COP does indeed have some leases along this state line area, as well as the second sweet spot in central Eddy and Lea counties.

Summary and Conclusion

While ConocoPhillips may not have as much premium acreage in the Spraberry as does Pioneer Natural Resouces, it is the third largest acreage holder in the Permian Basin and does have some sweet spot leases in the Bone Springs/Wolfcamp play. But the jury is really out on COP's prospects in the Permian as the company has been focusing in Texas on exploiting the Eagle Ford. My guess is the company has a lot of upside potential in the Permian as it moves rigs to the region and begins hitting the stacked play with horizontal fracking techniques. While the company's production growth plans in the Permian are modest, the chances for significant proven reserves increases appear high.

COP currently has a P/E=12.2. In contrast, PXD has a P/E=59. As I mentioned before, COP's overall production growth will not keep pace with Pioneer. However, the company does have some advantages over PXD: it pays a dividend of 3.8% compared to an insignificant PXD payout. COP also has very profitable legacy production in Alaska and overseas - production that garners Brent prices over WTI. In addition, COP is a much more diversified producer with operations in China, the North Sea, the Gulf of Mexico, the Canadian oil sands, Australian LNG, and of course it is the #2 producer in the prolific Eagle Ford shale. As such, COP is much less exposed to a possible dip in WTI prices as is PXD. I am not knocking PXD, in fact I recently recommended the stock and predicted it could double over the next 3 years. Yet, meantime, investors should consider giving some love to Conoco as a larger, lower risk, dividend paying company.

Bottom line: Despite COP's nice run year-to-date, and the fact it is hitting new highs on a daily basis, the company is still attractively valued. It's legacy position in the Permian is just one more reason to like the stock. Another is COP's commitment to growing both production and margins by 5% over the coming years. COP could easily go up 15% over the next 12 months. Add in the 3.8% dividend and you'll get a pretty low-risk return approaching 20%. COP is a BUY.

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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.

Additional disclosure: I am an engineer, not a CFA. The information and data presented in this article was obtained from company documents and/or sources believed to be reliable, but has not been independently verified. Therefore, the author cannot guarantee its accuracy. Please do your own research and contact a qualified investment advisor. I am not responsible for investment decisions you make. Thanks for reading and good luck!