I haven't bought any Conoco (NYSE:COP) stock since August. Since that time, the share price of the stock has gone up 17%. When you pick up almost two years worth of anticipated capital appreciation in under three months, it is probably time to pause and assess whether the stock has crossed the threshold of "high fair value" and entered the realm of "modest overvaluation", given that it is unlikely that Conoco's long-term earnings power has increased by more than 17% in the last three months.
When I think big picture about Conoco's next fifty months or so, I see three big things:
First of all, I see a company that is shedding low-margin assets to tighten the business operations around more lucrative profit sources, and the important thing to remember is that some of the figures that you see in the earnings reports are related to one-time divestments. For instance, in 2012, Conoco made $1.40 per share in profits. This year, it seemingly scooted up to $1.96 per share. But once you remove non-recurring events, we are looking at $1.60-$1.65 in profits going forward. Oil and gas earnings are volatile enough as it is due to the cyclical nature of the business, but Conoco's earnings performance will likely be extra-volatile over the coming years due to the company's asset shedding program. That puts the obligation on you the investor to single out individual events from the earnings that truly represent the company's long-term earnings power going forward.
Secondly, the daily earnings production of oil and oil equivalents, which had been declining in some areas and stagnating in others, should start making important strides 36-48 months from now. To be direct about it, I hold Conoco stock with the expectation that growth in the Eagle Ford and other as yet unfilled U.S. projects will get Conoco's production up from the 1.4-1.5 million barrels per day now to somewhere north of 1.8 million barrels per day by this time in 2016. The reason I expect the production growth to take a couple of years is because the company is currently unloading $7-$10 billion worth of assets, and that should temporarily stunt current production from going much above the 1.4-1.5 million barrel per day mark.
And lastly, the combination of asset shedding with production growth that will take a few years to materialize, leads me to conclude that the earnings per share will fluctuate between the $6.50 and $7.50 mark over the next three years. That's why I don't consider this company a buy at current prices-during stable energy prices (that is to say, when you are not at either extreme of the cycle), you want to buy an oil major around 8x earnings or so. Right now, Conoco is noticeably above 10x earnings for my expectations during the next three or so years, and that is what has prevented me from buying.
Now, of course, I should cover the side that explains why I do not consider Conoco a sell right now. Some of it relates to my orientation in portfolio construction. I regard portfolio construction as something akin to laying the bricks for a fortress, and that is accomplished by owning the most dominant companies in the country, and letting the dividend checks stack up while looking for other excellent companies trading at reasonable (or ideally, cheap) prices that have yet to be purchased.
In the case of Conoco, there is no doubt that the current shareholders find themselves being in the quite nice plan of owning one of the world's pre-eminent business enterprises. Conoco is pumping out almost $10 billion in annual profits that originate in over 25 countries. In terms of proven reserves, the company is now approaching almost 9 billion barrels of proven oil and oil equivalents. Operating margins are approaching 50%. The dividend should grow nearly every year, and when energy prices become unseasonably low like 2008-2009, shareholders only have to make peace with a dividend that holds steady and does not increase (given the very volatile nature of energy profits, a frozen dividend is something of an accomplishment when you make decisions based on 20+ year time frames).
There are two justifiable reasons to pay up for a stock like Conoco today. If you conclude that energy prices are going to increase more than 15% over the medium term, or if you think that Conoco's asset reshuffling will take place quicker than predicted, then the $72 may be justified. But based on present known factors, the stock seems to be a hold at $72 per share. Patient investors almost always get their price, and that aphorism is especially true in the volatile oil industry.
For shareholders that already own the stock, the prudent course of action is to keep cashing the $2.76 annual dividend checks and wait for a more opportunistic share price to add shares. Conoco's trading history is littered with periods of time where the stock traded around 7x normalized earnings or so. You don't even have to wait for a pricing bust to buy more shares-two or three years of patience ought to be able to get you an initial price at least 20% below today's current price of $72 per share, if historical pricing patterns for the oil majors portend anything about the future. Until then, current shareholders collect $0.69 per share every ninety days to wait out a better entry point.