The Dividend Investors' Guide: Part XXI - Petroleum Producers Poised To Produce

|
Includes: APA, COP, MRO
by: Mark Bern, CFA

Back to Part XX - My Favorite General Retailers

By Mark Bern, CPA CFA

If you are joining the series for the first time, you may find it informative to refer to the first article in the series, "The Dividend Investors' Guide to Successful Investing," where I provide more details about my process for selecting companies for my master list and details about why I use the metrics that I do.

As many readers who are familiar with my work know, I expect the price of oil to rise over the next five years. While I do not expect any huge jumps, demand growth seems to be a near certainty by the end of the next five years. There may (and probably will) be multiple dips along the way as new production fields come online and slower global economic growth holds demand at bay at times. But, unless there is a significant change in U.S. drilling policy, I don't expect that the supply will get far enough ahead of demand during the coming five-year period. Even if U.S. policy changes, the time it takes to get through all the bureaucratic red tape (including getting federal permits and processes for bidding on potential tracts in federally controlled regions where most of U.S. oil reserves are located), exploration drilling and analysis, and then building out the infrastructure to get a field into full production is generally longer than five years. I wish it weren't so, but wishing does bring hope or change.

At the same time, many older producing fields are still experiencing declines in production. Technology has brought some new life into gathering more oil from wells and fields that were previously considered uneconomical. But the application of that technology also depends heavily on the price of oil remaining north of $60 or $80 per barrel, depending on where the reserves are located. So, if demand falls enough to cause the price of oil to drop below the magic number for too long, wells will be capped, production will be reduced and exploration drilling will come to a halt in high-cost areas. The result will be an equilibrium between demand and supply that props the price of a barrel of oil back up high enough to reopen wells and restart projects that had been shut down. But the equilibrium won't happen overnight. We would fist need to suffer through much higher prices for a period deemed long enough to make capital investment seem less risky. Our comfort is not the subject of what determines optimal pricing; profit is the goal. It always has been and always will be. Thus, even though there is a risk of dramatic policy changes in the U.S. or global demand shrinking in the near term, I do expect oil to rise in the end and find a price, probably higher than today's prices, that will attract enough risk capital to keep all the millions of cars on roads running. Even though cars of tomorrow will get better mileage than the cars of today, there will be millions more in total, all sipping at the same straw. Technological advances in engines that propel us on our errands will likely not begin to decrease the oil consumption before the end of the decade, if not longer, in my opinion.

We will need to keep an eye on that trend in the future, but I believe that what we buy in the oil patch today will find higher highs at some point over the next five years. With that, let me begin my assessment of the companies in this industry with one of my favorites.

Apache Corporation (NYSE:APA) has exploration and production (E&P) operations in the U.S., Canada, Australia, Argentina, Egypt and the North Sea. The company produces natural gas (32% of 2011 oil equivalent production), oil and natural gas liquids (LNG). One of the moves being made by APA management that I really like is that it is increasing production of LNG to meet the rising demand in Asia where prices are as much as eight times the U.S. price. The company is ramping up production at its coastal operations in British Columbia and at its huge Wheatstone project in Australia. APA's competitor in BC is Royal Dutch Shell (NYSE:RDS.A) which has the capital and Asian partners that give it an edge. But APA only needs to capture a reasonable percentage of this potential high-growth market to gain a significant positive impact on future earnings. APA is well-positioned in terms of reserves and capacity to increase production by around eight percent annually. I also think that APA will continue to acquire additional reserve assets from the likes of Chesapeake (NYSE:CHK) and other struggling companies in the industry while asset prices are reasonable. I like this company's buy low, develop and sell higher strategy. To see what other authors/analysts think about APA consider reading this article or this one. Let's look at the metrics.

Metric

APA

Industry Average

Grade

Dividend Yield

0.8%

0.6%

Pass

Debt-to-Capital Ratio

24.0%

31.6%

Pass

Payout Ratio

8.0%

10.0%

Pass

5-Yr Average Annual Dividend Increase

3.7%

N/A

Neutral

Free Cash Flow

$2.80

N/A

Pass

Net Profit Margin

24.8%

16.8%

Pass

5-Yr Average Annual Growth in EPS

2.1%

-3.0%

Pass

Return on Total Capital

10.0%

6.5%

Pass

5-Yr Average Annual Growth in Revenue

4.8%

-0.6%

Pass

S&P Credit Rating

A-

N/A

Pass

Click to enlarge

While the dividend yield is not exciting for APA, other than one neutral rating because the average dividend increase has been a mediocre 3.7 percent, the pass in nine categories is excellent. What I believe this tells us is that APA management does a great job in more aspects of its operations than do leaders of most companies. My five-year target price for APA is $133 which, if achieved, will result in an average annual total return of about 11 percent.

I am a long-term owner of ConocoPhillips (NYSE:COP) and now own shares in both companies after the split. I haven't decided what I will do with my Phillips 66 (NYSE:PSX) shares yet. The PSX shares have provided some nice appreciation but the COP shares provide the yield I like. COP has E&P operations in nearly 30 countries around the globe. The company had 8.4 billion barrels of oil equivalent (BOE) in proven reserves at the end of 2011. That amounts to over 13 years of reserves at current production levels. The profit margin should expand significantly since the downstream operations have been split off since margins on those operations tend to be much slimmer. COP is also investing heavily in operations to increase future production. If you are interested in my views regarding the benefits of the split, please consider reading "ConocoPhillips - Reducing Risk and Enhancing Shareholder Value." For those interested in the most recent earnings call, here is a link. Please also consider this article by another author for another perspective. Let's see how COP fared against the metrics.

Metric

COP

Industry Average

Grade

Dividend Yield

4.6%

0.6%

Pass

Debt-to-Capital Ratio

25.0%

31.6%

Pass

Payout Ratio

30.0%

10.0%

Fail

5-Yr Average Annual Dividend Increase

16.4%

N/A

Pass

Free Cash Flow

$0.34

N/A

Pass

Net Profit Margin

5.0%

16.8%

Fail

5-Yr Average Annual Growth in EPS

-2.6%

-3.0%

Neutral

Return on Total Capital

15.0%

6.5%

Pass

5-Yr Average Annual Growth in Revenue

14.3%

-0.6%

Pass

S&P Credit Rating

A

N/A

Pass

Click to enlarge

One neutral and two fail ratings to go along with seven passes is a decent showing. Unfortunately, the metrics and growth rates are muddled from results that occurred prior to the recent split. I am working from pro forma statements until we have a few quarters of SEC filings to use. But COP was a great company with great management before the split, and I expect it will continue to remain a leader within this new category. I do expect the net margin to improve in 2013 as production expands. My five-year price target for COP is $89 which would result, if attained, to an average annual total return of over 15 percent.

I decided to include Marathon Oil (NYSE:MRO) in this discussion with a metrics table because pre-split the company was on my list. The company did not make the list again at this time due to the unknowns. I realize that COP seems to have a similar situation but its size, diversity and leadership give me greater comfort. Plus, the company provided pro forma data making assessment of its past and future less cloudy. For a different perspective on MRO by another author consider this article.

Metric

MRO

Industry Average

Grade

Dividend Yield

2.5%

0.6%

Pass

Debt-to-Capital Ratio

22.0%

31.6%

Pass

Payout Ratio

29.0%

10.0%

Fail

5-Yr Average Annual Dividend Increase

N/A

N/A

Neutral

Free Cash Flow

$0.68

N/A

Pass

Net Profit Margin

14.8%

16.8%

Neutral

5-Yr Average Annual Growth in EPS

N/A

-3.0%

Neutral

Return on Total Capital

15.0%

6.5%

Pass

5-Yr Average Annual Growth in Revenue

N/A

-0.6%

Neutral

S&P Credit Rating

BBB

N/A

Pass

Click to enlarge

I really wanted MRO to do better because it has been one of my favorites over the years. But, with only five passes due to lack of available data (could not locate pro forma reports from company going back before 2009), the company ends up with four neutral rankings. The one fail came in area that I often overlook it not too egregious, payout ratio. This ratio is not outrageously high, but it is high for its industry. I expect that after a couple more years of results after the split, I'll be able to take another look at MRO for list contention. I do expect MRO to do very well, but just cannot recommend the company at the present time.

As for those other companies that did not make the list, I will remind readers that I do not include a company unless it pays a dividend, and I also do not include companies that have negative free cash flow. These two exclusionary conditions were present in every other company in the industry that I follow. I also do not follow companies that are not listed on U.S. exchanges.

Disclosure:

I am long COP, PSX.