ConocoPhillips: This Strategy Shift Makes It An Even Better Pick

| About: ConocoPhillips (COP)

Summary

Clear indication from the management that the focus is on better capital and cost structure.

Targeted cost structure should allow it to pay down debt quickly in the next two years.

Oil prices are expected be around $60 in the next year, according to the industry analysts.

ConocoPhillips (NYSE:COP) has announced a major strategy shift, which will define the future direction of the company. On November 10, the management announced that the capital spending will further go down in 2017. There was an expectation that the rising oil prices will prompt the oil companies to increase capital spending. However, ConocoPhillips management has taken a different route. They are not alone in this decision. The global oil industry is showing a trend where the companies are now focused on having better capital and cost structures. The rise in oil prices might not result in proportionate increase in capital spending.

Wood McKenzie reported in June this year that the slump in oil prices has resulted in a decrease of about $1 trillion in capital spending from the oil companies. Most of the oil producing nations saw some sort of cut backs. US was the most affected where capital spending fell by $125 billion. Analysts believe that these companies will not increase capital spending until oil prices cross $70 per barrel. They are expecting a focus on improving the balance sheets. This is exactly what ConocoPhillips management stressed at the investor meeting.

In addition to a decrease in capital spending, the management also plans to sell natural gas assets worth $5-8 billion. Proceeds from these sales will also be mainly used to enhance the capital structure. ConocoPhillips' debt will be around $27 billion by the end of this year. The management is targeting to bring this figure down to $20 billion by the end of 2019. $3 billion will also be spent on share buybacks and around 30% of the operating cash flows will be dedicated towards dividends. Future dividend growth will have to come from the operating cash flows. ConocoPhillips management wants to be cautious about the dividends. Their previous claim about not cutting the dividends and then slashing it a few days after left a bad taste in mouth. This single event was the reason of a considerable trust deficit between the management and the shareholders. Management needs to be careful regarding the promises about future dividend growth. This further highlights why the management has listed capital spending and production growth as the last item on the list of actions it plans to take in the next two years. More cash will be preserved for future dividend growth.

More and more oil companies are realizing that they cannot depend on oil price recovery and they need to develop a mechanism to tackle the cyclicality in the market. It is surprising that these businesses have taken so long to realize this. Oil price cycles have been a norm and most of these businesses have been exposed due to the reckless spending sprees. In the time of boom, we see a scramble for asset acquisition and all the major oil companies try to hoard as many assets as possible. Even if it is just to block a competitor from entering a specific area. These hawkish strategies have resulted in stretching the capital structures in the past. This slump has entered the third year and it has hit these companies hard. Managements are now looking to capital and cost structure that can generate enough cash flows to meet dividends at $50 per barrel.

This is a challenge in itself as most of the current projects were started when oil prices were around $100 a barrel. However, there is a positive also for these businesses. Wood McKenzie analysts also highlight that the costs fell down by 25% in 2015 and it will further go down by 10%. This should go a long way in helping these companies generate enough cash flows at $50 per barrel. ConocoPhillips has also been able to bring down its operating costs substantially. Year-over-year reduction in operating and exploration expenses was around 33% at the end of the last quarter. For the next year, management is expecting a further decline of 9%. This will help boost the operating cash flows. Keep in mind that current operating cash flows and the ratio of dividends is not in line with the company's target. ConocoPhillips wants to spend 20-30% of the operating cash flows on dividends. However, the current payout is at around 32% of operating cash flows. If we take into account the growth in dividends then the payout will go up further without an increase in cash flows. Most of the industry analysts are adamant that oil prices will go up in 2017, EIA remains a little pessimistic with their estimate of an average price of $51 per barrel in the next year. However, there are many views and majority predictions fall between$60-80 per barrel. Most of these predictions are close to the lower end of the range. Oil prices at $60 per barrel will result in higher cash flows if the costs are kept in check. However, these prices will not be attractive enough to cause a major increase in capital spending.

Prices over $50 will give a choice to the management, Ryan Lance said. This is a clear indication that the management is trying to prepare for any future slump in price. If ConocoPhillips can be cash flow neutral at under $50 per barrel, then the company will have a lot of scope for future strategic moves. This can also allow the management to pay down its debt rather quickly.

It is clear that ConocoPhillips' strategy is to bring its own house in order. Decision to keep production almost flat for the next year is a sign that the dependence on volume for growth is not part of strategy anymore. I like these strategy changes and believe it will make ConocoPhillips a more resilient business. In better times, the company will be able to leverage its low-cost structure to considerably improve its financials. Dividends and the payout ratio is a little stretched at the moment. However, if the cost reductions continue and the price of oil recovers further, then the company will be able to meet its target of 20-30% payout ratio. While the commodity prices are not in control of the management, it is encouraging that the internal changes are wise and take into account the long-term stability and growth.

Disclosure: I/we 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.