On Tuesday, ConocoPhillips (NYSE:COP) held its annual shareholder meeting, and the company delivered more solid news that should please existing shareholders and convince new investors to initiate a position. Thanks to its focus on North American oil and gas, ConocoPhillips will be able to grow revenue and margins far faster than larger integrated peers like Chevron (NYSE:CVX) and Exxon Mobil (NYSE:XOM). While shares do trade at a premium multiple compared to some competitors, COP is the best major oil stock thanks to solid growth prospects and a nice dividend.
The major oil companies have worked tirelessly to grow production for several years to little avail. When it comes to increasing production, ConocoPhillips is without a doubt best in class. For five years, Exxon has actually seen output decline, though in some recent quarters output has shown inconsistent and mild growth (Exxon's operating and financial data can be found here). Given its weak past performance and declines from major existing fields, I am not convinced recent growth is the new trend or merely an aberration from the long-term decline. With some projects coming online though, Exxon could grow production by 0.5-1.5% in 2014 with a similar showing in 2015. Chevron has also been spending billions to grow production with massive projects in Australia and in off-shore wells (Chevron's operating and financial data can be found here). Unfortunately, this capital plan has not been delivering results. Chevron will spend over $40 billion in cap-ex this year but is seeing production declines. Chevron is unlikely to grow production by more than 2% annually over the next three years.
Conversely, ConocoPhillips should be able to grow production by an annual 3-5% over five years. In fact, COP reaffirmed that guidance at Tuesday's meeting (details available here). Conoco has been investing heavily in the oil sands and major U.S. formations like Eagle Ford, the Permian Basin and Bakken, which will drive production growth for years. These areas also deliver strong margins of more than $30/barrel, which will cushion margins even with oil prices struggling in the $90-$105 range. Cap-ex should also stay capped at $16 billion in 2014 and 2015 before dipping a bit in 2016. As a consequence, as volume grows beyond 2015, cap-ex will decline, which leaves the company with a significant amount of free cash flow with which to pay higher dividends and repurchase stock. Over the past three years, the company has been running around the flat line for free cash flow due to expansion projects. As these capital needs decline, I expect annual free cash flow to pass $7 billion in 2016 or 2017. Thanks to major finds in North America, Conoco has been able to fully replace its proven and probable reserves, which Chevron and Exxon have struggled to do. Conoco expects its strategic shift to increase margins by 3-5% per year assuming prices stay flat.
Conoco will also benefit from potential for US LNG exports. Thanks to its domestic abundance, natural gas is much cheaper in the United States than in foreign markets like Europe and Asia. If the US moves to export natural gas, Conoco can sell gas at the international rate while maintaining the lower costs of the US market, which will lead to significantly higher margins. I do not expect significant LNG exports in the near future, especially as they could also push up domestic prices, which is politically unpopular. Over time though, there will be growing exports, which will provide a further tailwind for results.
ConocoPhillips' focus on North America to drive growth is achieving significant results. The company is growing production more rapidly than peers, expanding margins, and growing its reserve base. By 2017, Conoco will deliver more than $20 billion in operating cash flow and $7 billion in free cash flow. In the meantime, Conoco has a pristine balance sheet with a debt to equity ratio of less than 50%, which allows it to run around breakeven on free cash flow while growing the dividend.
COP currently yields 3.6% and should earn at least $6.25 this year, giving it a 12.5x multiple. For comparison, Chevron is trading around 11.7x earnings and Exxon is 13.2x earnings. Given its stronger growth prospects and focus on production rather than refining, I believe Conoco should trade at a premium to its integrated peers. At current prices, I would be a seller of CVX and XOM and rotate into COP. With 3-5% production growth, COP should definitely trade 14x earnings or upwards of $88. With its North American focus and solid production growth that management affirmed at the annual meeting, ConocoPhillips is still a great investment.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.