Short ConocoPhillips Now

| About: ConocoPhillips (COP)

Summary

Cash flow could decrease significantly in the new year to $4 billion with the decrease in commodity pricing.

The proposed budget for 2016 was obsolete before it was ever presented to shareholders.

Management cut the dividend but failed to plan to support the new dividend rate in the current market conditions. In fact its assumptions of WTI pricing are extremely high.

Management failed to answer some direct questions about the future dividend from analysts given current commodity pricing and budget demands.

The company hopes to hold production flat.

ConocoPhillips (NYSE:COP) recently reported the annual results for the fiscal year of 2015. Management cut the dividend but sought to assure analysts that the new rate would hold.

Source: ConocoPhillips Fourth Quarter, 2015, Conference Call Slide

Showing this slide not long after management made the statement about assuring investors that the new dividend rate would hold does not inspire a lot of confidence in management. Notice that the slide has no numbers on it to measure the dividend expense as well as the predicted cash flows.

First of all a casual observer could easily conclude that oil prices are a good deal lower than the assumption used here. In fact, during the question and answer session there was a very interesting exchange.

"Roger Read - Wells Fargo Securities, LLC -Analyst

Okay. Great. Thanks.

And then as a follow-up, well it's not a cash flow, it's a net income-driven adjustment for the change in oil prices to the change in net income. Just a quick back-of-the-envelope look at it, and I'm talking about the slide here towards the end. It looks like about a $5 difference in oil is how you cover the dividend, if I assume net income as a good proxy for cash flow. So at roughly $40, you're having to lean on the balance sheet for the dividend, and at $45 is the way we should think about the company being balanced along with that $5.5 billion capex number?

Jeff Sheets - ConocoPhillips - EVP of Finance and CFO

Yes, I think we're -- we'll repeat a couple of things we said today is some calibration points for you on that. If you just look at 2016, where we said we will be balanced in terms of not needing to have additional debt, with a price that's kind of in the low $40s, but that assumes that we reduce our cash balances. That's one point."

This exchange occurred during the question and answer session of the conference call. The analyst hit the problem on the head directly, which is very unusual for analysts. Normally analysts ask "safe" questions as they don't want to disturb their employer's ability to do business with the company in the future. However, if the analyst and his bosses feel that there is little chance of doing business with the company in the future, usually due to upcoming financial difficulties, then the analyst gets braver. The above question by the analyst in the quote was a very brave exchange in my book.

Notice that management did not directly answer the question. They instead redirected the question to previously vague statements. When combined with a bar graph that has no cash flow and no cash use numbers, one has to wonder just what this management is up to. However, the fact remains that oil prices are a good deal below the average realized price in the fourth quarter and below the assumptions used for this budget.

The company realized average oil prices of $40.35 per barrel in the fourth quarter. Looking on Yahoo Finance on February 11, 2015, the price of oil was $27.52 per barrel. That price is nearly 30% lower than the price realized in the fourth quarter and the price has yet to bottom. The analyst above noted that the company would have to loan money to pay the dividend if oil prices dropped $5 per barrel, well now oil prices are on the verge of dropping three times that amount and company management really had no concrete answer as to how they would make the new dividend rate work with the new lower commodity pricing.

Source: ConocoPhillips Fourth Quarter, 2015, Conference Call Slide

This slide from the conference call actually made things worse. The company shows a reduced budget of $6.4 billion of capital spending for next year, plus dividends as the primary monetary expenditures. But first the company needs to make that money to give it back to shareholders or allocate it to the capital budget.

To give the impression that the new budget was realistic, management spent a fair amount of time mentioning that the cash flow in fiscal year 2015 was roughly $7.6 billion. However, in the fourth quarter, cash flow was roughly $1.6 billion, which annualizes out to a cash flow of $6.4 billion before the recent oil price decreases. That is more than one billion dollars lower than the number that management kept emphasizing.

Plus the only number on that chart that really increases cash flow is the amount of operating expense savings that are projected to be about one billion dollars. As much as management liked to include the capital budget cuts into increasing cash flow, they never mentioned the deficit that they started with. If the cash flow was not there to spend to start with, then the capital budget has to decrease until it is realistic and corresponds with cash inflow.

The company will produce roughly 600 MBO in the first quarter and earn approximately $12 per barrel of oil less than the fourth quarter selling price. Those two numbers equate to a $7.2 million loss per day just for oil revenue. Given a 90 day quarter, the loss of cash flow would be approximately $650 million.

There is a similar story for both the natural gas liquids and the natural gas. Cash flow decreased $500 million, roughly, in the fourth quarter from the third quarter, and frankly, the first quarter does not look much better.

Management committed to operating cost savings of about one billion for the new year. But those savings will not offset the continuing commodity price declines. They will only cushion those effects a little bit. Many in the industry are looking for much larger operating savings, and cutting general and administrative costs significantly as well. This company did not even mention general and administrative costs during the conference call, so it may not have the will power to cut those costs.

Source: ConocoPhillips Fourth Quarter, 2015, Conference Call Slide

This slide from the conference call reiterates what has already basically been stated. That is that the company needs a WTI of at least $40/BBL (maybe a little more) to avoid adding more debt. But the problem is that should the WTI stay where it is now, the company may not have the ability to add more debt because it won't have the cash flow to support that debt.

Contrast this stance with the latest actions of Murphy Oil (NYSE:MUR). The senior management of Murphy Oil has stated that they need to be able to "live with" or make money when WTI has pricing in the mid-thirty dollar range. That is a far safer assumption for budgeting than the assumptions that this company made. Murphy Oil is not the only company in the industry making those assumptions, but is meant to be a significant example. Plus Murphy made an acquisition with locations that have a return at WTI $30.

Whereas ConocoPhillips proposed budget makes absolutely no sense when looking at current pricing of oil and gas, Murphy Oil, on the other hand is using figures that are much closer to the realized current pricing, and is emphasizing cost cutting to close the gap. Plus Murphy Oil reports significant expenses (such as lease operating expense) by major project. ConocoPhillips does not break out their costs for the investor to review. That should imply that ConocoPhillips costs are not the best. In fact, based upon their breakeven price of WTI low forty dollar range, ConocoPhillips is probably a good six months behind in cost cutting and needs to figure out a way to catch up before prices decline some more.

With a market value of roughly $40 billion on February 11, 2016, and debt of another $25 billion. The ratio of market value plus debt to cash flow (annualizing the fourth quarter figure) is nearly ten-to-one. That is an extremely high figure to pay for a company that does not have the best costs in the industry, and makes a presentation that is completely obsolete the day it was presented to investors.

The long term debt to cash flow ratio is a little more than four-to-one. While that figure is ok, it would not take much more of a decrease in commodity pricing to make this company financially uncomfortable. The company really needs to grow its cash flow considerably and make itself a financial cushion. It did have about $2 billion on hand and a total of $8 billion in liquidity.

But this company has the kind of cost figures that will make bankers nervous. If the company will not disclose specific cost figures to investors, then investors should expect some bad news on the cost front. This company needs a rally in oil prices to help it out. The problem is that drilling costs have declined so dramatically in the industry over the last year or so, and resource recovery has increased so dramatically, that the potential rally in oil pricing keeps changing (usually by going down). Costs are now so low, that oil probably will not go over $50 per barrel for the foreseeable future. And costs to produce oil are still dropping. The company admitted that supply resilience has stumped a lot of analysts. Especially frustrating to analysts has been the change in costs that has enabled the supply oil and gas to remain stable at sharply lower pricing. No one really expected that dramatic a change at the start of the price decline.

Source: ConocoPhillips Fourth Quarter, 2015, Conference Call Slide

This slide from the conference call shows the big challenge facing the company for this year. Cash flow already dropped about $500 million in the fourth quarter with prices falling throughout the quarter. With pricing lower the full quarter, cash flow will probably drop more. There are some major projects coming on during the year, but right now it looks as though the company have slightly decreased production for the year, and not enough cash flow to do its bare bones projects and pay the dividend without adding to its long term debt. Plus this is one company that can probably expect a substantial decrease in its credit lines this year until it can demonstrate considerably improved operating efficiencies.

Current pricing is about 40% below the average pricing for last year. Before cost savings, it would not be unreasonable for cash flow to drop at least forty percent from last year's figures. That would a cash flow of about $4 billion doing some very quick figuring provided oil prices remain at current levels for the rest of the quarter. During the conference call, management stated they had about $4 billion in cash flow improvements, however, a fair amount of that was the dividend cut and other capital expenditures cuts. Really, management only committed to about a billion dollars of operational improvements.

From the calculation above, cash flow looks to drop about $400 million in the first quarter (from the fourth quarter) just from the oil price drop ($650 million) less one quarter (about $250 million) of the operational savings estimated by the company. That calculates to a first quarter cash flow of about $1.1 billion, and would really indicate that the company would need to borrow a few billion to complete some of its long term projects. However, at the same time, the long term debt to cash flow ratio would be stretched, and the value of future oil produced (the company's reserve calculation) would also be reduced. Both of these make a significant reduction in the liquidity of the company all but certain.

Annualizing that cash flow of $1.1 billion for the quarter and multiplying by eight (a typical multiple for many oil and gas companies) gives a total value for debt and equity of $35.2 billion. That figure, however, would only leave about $10 billion for shareholders. With about 1.241 billion shares outstanding, the going forward value for this stock is about $8 per share. Management could improve on that projected stock value by coming up with considerably more operating improvements than they have already admitted to and by lowering general and administrative costs significantly (those costs were really not mentioned much in the budget). Many companies that I have already written about have much greater cost cutting ambitions than this company and several have lower costs to start with.

Between the inability to demonstrate any kind of support for the dividend in the current commodity pricing environment, and the fairly high amount that an investor would pay for substandard cash flow, this company is a clear short, and will remain a short until the company demonstrates a convincing plan to survive the current downturn. Currently it has a dividend rate ($1.2 billion annually), and a capital budget ($6.4 billion annually) that together comfortably exceed cash flow of about $4.4 billion annually. Yet the company states it will not increase its long term debt. That math does not work. It also needs to show operating improvements that are substantial enough to enable the company to survive the current downturn, and a probably very small commodity price rise. Plus management needs to be very specific in their communication with shareholders about how they will cut costs to make the numbers work. Until that happens, this stock is an easy short.

Disclaimer: I am not an investment advisor and this is not a recommendation to buy or sell a security. Investors are recommended to read all of the company's filings and press releases as well as do their own research to determine if the company fits their own investment objectives and risk portfolios.

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.

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