Any fall in price for ConocoPhillips (NYSE:COP) should be treated as a buying opportunity. Especially, if that pullback brings the stock price to below $50. For investors looking at long-term investment options, ConocoPhillips is a great choice due to the expected strength in the oil market and the company's ability to leverage its leaner structure to gain higher returns.
The oil price slump in the last two years, while challenging for the whole industry, has also proved to be a blessing in disguise for some. ConocoPhillips is one of these businesses that have used this period to enhance the structure as well as the business strategy. Price cycles are a norm for the oil and gas companies but this particular cycle has had a profound effect on ConocoPhillips' strategy.
Normally, in oil price down cycles, these companies just focus on preserving cash by cutting capital spending and reducing operating expenses. However, ConocoPhillips has gone one step further and the management has been working towards bringing down the breakeven cost. This has involved managing the capital budget, operating expenses, exploration costs, production and operating expenses and efficient technology management. All these factors have contributed towards bringing the breakeven cost below $50 per barrel. Exiting the deep-water market was also a factor in bringing down the overall breakeven cost. Deep-water production typically comes at a higher cost than the conventional on-shore oil production. All these measures have helped the management bring down breakeven cost down by around 55-60%.
Production growth has also been managed wisely. As the oil price recovered in the last few months, ConocoPhillips also decided to increase its output. However, asset sales brought down the year end production figures to around 1535-40 thousand barrels per day. Keep in mind that the asset sales will continue in the next 18-24 months as the company still wants to sell assets worth around $8 billion. These sales will mainly come from North American natural gas assets. ConocoPhillips wants to bring down its natural gas contribution to less than 10% of total production. At the moment, this figure is around 20%. Personally, I believe that natural gas assets will likely yield more in the next few months due to the increased exports of LNG and reduction in local stockpiles. These factors should push natural gas prices higher in the next 12-18 months. However, the management clearly believes that they stand to gain more from oil as the oil price recovers.
Bringing down the breakeven cost positions the company to grow its margins as the oil prices start a sustained recovery. I looked at the trend in gross and operating margins in the last seven quarters in order to see any improvements. The table below shows the trend.
Source: SEC Filings
Gross margin took a hit in the last quarter of 2015 and the first quarter of 2016. The figure was actually negative in the fourth quarter of 2015, but that was mainly due to a special non-cash impairment charge of$2.7 billion from APLNG in Australia. Adjusting for this non-cash charge will result in a positive gross margin number of around 15%, which is still the lowest among the group. Operating margin is negative throughout the period. However, a look at the last four quarters shows that it is improving. Other operating expenses also include non-cash impairment charge. Adjusting for this non-cash charge will further enhance the operating margin slightly as these impairments charges have not been substantial.
Production and operating expenses are around 23% of total revenues at the moment. This figure will likely go down as the oil prices go up. These are the direct production costs which have come down considerably. At the end of 2014, ConocoPhillips' full year production costs were over$8.9 billion. This figure came down to $7.01 billion by the end of 2015 and the first 9-months figure for 2016 was $4.325 billion. Average quarterly figure has been around $1.44 billion, and extrapolating it will give us a full year cost figure of less than $6 billion. This is a huge achievement as the direct production costs have come down by around $3 billion in two years. Revenue figure will be slightly lower than the full year figures of 2015 due to the lower commodity prices at the start of the year and also asset sales. However, the magnitude of decline in production costs will be far greater than the decline in revenues.
These changes in the cost structure have positioned the company to thrive as the oil prices recover in the next few months. The reports coming out of OPEC are encouraging as there are suggestions that the productions cuts are being implemented religiously. Investors are becoming bullish as the bets on oil price recovery are touching the highest in the recent history. Funds are taking long positions while the independent sources are verifying decreased shipments. This points towards a supply-demand balance in the next few months and a sustained rise in oil price. If the oil price touches $60 in the next twelve months, then ConocoPhillips' earnings and cash flows will get a huge boost due to the efficient cost structure. The company will certainly look to grow production which might result in some rise in costs. However, a lower cost base will give it a lot of room to grow its production.
Sustained recovery in oil prices will help the company meet its target of $20 billion in debt in the next three years. Asset sales plus increased cash flows from operations will result in lower leverage for ConocoPhillips in the next three years. This should strengthen the credit profile as well as the free cash flows available for shareholders. Higher free cash flows for shareholders mean better dividend growth and a possible increase in share repurchases. Overall, it points towards better returns for shareholders. In the last two years, ConocoPhillips has become an extremely efficient business with a leaner capital structure. I expect the company to further improve capital structure in the next three years. Leaner and efficient capital structure, lower cost base, potential for further improvement in capital structure, dividend growth and improving market conditions make ConocoPhillips one of the best buys in the oil and gas industry. This has the potential to yield some serious returns in the next 3-5 years.
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.