- ConocoPhillips shows what all the majors must do to weather the oil storm.
- Spending cuts and assets sales more important than production growth under current market conditions.
- Business model changing to match low-price oil environment.
- What the company will spend the most on next year.
source: Stock Photo
It wasn't a surprise to hear the recent announcement from ConocoPhillips (NYSE:COP) that it was going to sell as much of $8 billion in natural gas assets, while at the same time cutting as much as 4 percent from its 2017 budgets. The move will help raise capital to shore up operations, according to company management.
This move, and other steps and changes the company is making, lines up with my thesis that the major oil producers that remove more costs and underperforming assets from its portfolio, will be those that do the best in the continuing low-price-for-longer oil market.
While I see austerity being the most important adaptations to make at this time, there is still room for strategic spending on specific production assets which will allow for at least a maintaining of production levels while improving margins, and eventually starting to generate meaningful and sustainable earnings again.
Chief Executive Officer Ryan Lance recently stated in an interview that the company couldn't sit around and wait for the prices to "bail out your business model." He's right. Companies must aggressive change the model to reflect market realities, which are concerning oil and gas, they're going to take a significant amount of time to reach levels that would have generate a profit under the former business model.
No company can wait for price of oil to recover
As I've proven to all my readers for a long time, the oil sector has been completed disrupted by the success of shale oil producers, which has added supply to the market and driven down the price of oil. Many analysts, pundits, writers and money managers have projected very optimistic outlooks for oil in the near term, which I have said over and over again isn't going to happen; and it hasn't.
Companies like ConocoPhillips can't wait around and hope the prices of oil and gas will recover, overcoming the high costs of extracting them from the ground or ocean floor. It's obvious oil in particular is going to be lower for longer, and that means steps have had to be taken to change the business model companies had used under a much higher oil price.
This is why when Exxon Mobil (XOM) recently announced it had discovered a lot of oil off of Nigeria, it didn't do much to produce a positive outlook. The major reason why is the market intuits the fact the old oil model is no longer profitable, and until global demand rises and the market rebalances, the price of oil will remained subdued. That's the only event to consider for oil concerning supporting a higher price, and until that happens, having more reserves that cost more to produce than can be sold, will result in selling into a loss.
For that reason large energy companies like ConocoPhillips need to increase their exposure to shale oil in the U.S., and to focus most of their production spend there. Lance sees that, and has moved the company in that direction.
Spending cuts and assets sales
Focusing production expenditure on shale is important, but for now, even more important is the strategy to cut spending and sell off assets, and successful implementation of that strategy.
Initially a lot of companies found it easy to shed assets because it was obvious which were lower performers or would recover an enormous amount of investment over a prolonged period of time before they would be brought on line. Even then there was no guarantee money would be made if they developed the assets. That has changed now that the low hanging fruit has been divested of.
Conoco has decided its next divestment would be natural gas assets located in North America, suggesting it sees natural gas having more headwinds and less potential than oil. It is selling off anywhere from $5 billion to $8 billion in North American natural gas assets.
After the company has completed its asset sales and spending cuts, Lance said it should be able to generate a profit with Brent oil at $50 per barrel. That's not too bad, but will be difficult to obtain in the near term if OPEC doesn't reach any meaningful output cut agreement, which is probably how it'll play out.
What I'm looking for now from the oil majors with a lot of upstream exposure is what their strategy is concerning production expenditure. The only thing I care about at this time is if it's primarily increasing shale exposure and production. If that's not the major emphasis of the company, I'm not interested.
Conoco stated that in 2017 most of its budget will be allocated to shale locations in the U.S. A small portion of it will target some projects in Europe and Alaska, along with maintaining some assets that are already operational.
To me this is the only way to do business on the production side of oil, and those companies not doing so will underperform their peers.
It wasn't that long ago that ConocoPhillips had over 28 locations is working in the world, it has slashed the total to about half of that now, which is helping the company better leverage existing assets by targeting fewer locations.
This is why I say smaller is the new big of oil producers. Not only are they getting leaner by removing costs out of the production process, but are also selling off assets that don't have the potential to produce at a high level. Combined with focusing on lower cost shale in the U.S., it's positioning Conoco and its peers engaging in the same practices to perform stronger even if oil remains subdued for a longer period of time than many expect, which is how I see it playing out over at least the next couple of years.
With all the steps it's taking, oil production in 2017 is expected to be in a range of 1.54 million to 1.57 million barrels of oil per day, a little higher than it was in 2016.
To me ConocoPhillips is doing exactly what it needs to do to give it the best chance at long-term success, and when the price of oil eventually does start to climb, it should be very competitive with its large peers on the production side of the business.
It's going to use some of the capital from its asset sale to improve its balance sheet by paying down debt. At the same time it's continuing to lower costs and focus on a smaller number of projects to get the best results from its capital expenditure.
Everything Conoco is doing with its upstream business is what investors should look for with its competitors. Exxon Mobil has for some time been operating under the assumption the price of oil would be at about $55 per barrel. It has done fairly well in that regard, but it's still participating in higher cost projects that require oil to be at a higher price point than $55 per barrel to make a profit. It needs to lower its price assumption closer to the $50 per barrel Brent oil Conoco is using as the target it feels comfortable with.
I think that's closer to what will be required over the next couple of years to at least break even with their performance. Those over that will continue to struggle to generate a profit. I think if oil is able to find support at about $50 per barrel or a little higher, Conoco could at least tread water and buy time until the price of oil moves sustainably up from growing market demand.
At that time it could outperform many of its peers because of the price it can start making a profit.
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