ConocoPhillips Stock: Delaware, Willow And The Decade Of Low-Risk Growth (NYSE:COP)

ConocoPhillips (NYSE:COP) is the largest independent oil and gas producer in North America. Unlike its major integrated peers, the company has no downstream processing capacity which exposes it to the whims of energy markets to a great degree. During periods of commodity price strength COP is expected to do particularly well and underperform when the markets turn, just like we have seen over the past month. This business is risky you might conclude, but for those seeking to hold their stocks long-term, – risk is not defined by volatility.

Yes, COP might be volatile over the shorter holding periods. Over the past three years, oil prices have been appreciating and, as could be expected, the stock has outperformed the integrated majors. Short-term traders should sell COP and buy integrated majors if they expect oil prices to continue going down. Unfortunately, we do not have a crystal ball to tell us where oil prices are going within the next few months, and therefore we choose to ignore the short-term volatility and focus on structural long-term value growth drivers and fundamental risk factors.

Over longer periods, oil prices tend to fluctuate around the so-called mid-cycle price, which is the oil price based on which oil companies make capacity investment decisions. Oil prices can move up and down considerably in the short to medium term due to demand shocks or capacity bottlenecks, but over a longer period, the capacity addition decisions drive oil markets. Oil will not stay at say 30 dollars for a long time if producers are only willing to add capacity at a 60-dollar mark. If we are willing to hold oil stocks for a long period, say 10 years or so, we are likely to experience both positive and negative price surprises which will cancel each other out. Over long holding periods, the price volatility stops being a risk factor.

In this article, we take a view from the perspective of a long-term investor. We do not consider the short-term oil price volatility to be a meaningful risk factor. We focus instead on structural business value growth and fundamental risks surrounding investment plans. We do like the market-leading position that COP has in the Permian basin and the capital allocation decisions implemented by the company’s CEO Ryan Lance. We see COP as a rather low-risk investment over a longer investment horizon.

Oil as a long-term investment

We are long-term investors, with a limited appetite for churning our portfolio or predicting movements of the markets over the short term. We look for long-term buy-and-hold investments that could deliver us rather predictable returns over the long holding periods. Industry cycles do not concern us much as long as we can ride significant positive structural trends. We do not follow the “all eggs in one basket” approach and therefore we are ready to experience even prolonged periods of underperformance in any one of our holdings. Having said this, long periods of pain can only be sustained if we are positively confident of the ability of the investment to eventually turn the corner and deliver positive returns in the end. We thus look for high-conviction ideas.

On the oil patch, the price is the biggest unknown that can deliver a lot of pain in the short term. We are confident though, that over the long term, the mid-cycle oil price will continue trending up. New oil production capacity will be needed as the global population grows and old oil fields continue depleting. It will also become ever more expensive to develop and operate new production capacity as companies are having to tap ever less favourable reserves. Inflation is also a factor driving mid-cycle prices, as labour and materials cost appreciation is making it more expensive to produce even from prime acreage.

E&P, on the other hand, is quite a technologically intensive industry, where continuous innovation is dragging down the cost of production. When we have several factors working against one another it is quite difficult to tell which one will prevail, and therefore we cannot know the pace of future mid-cycle growth trends. Over the last 70 years, WTI has appreciated by a rate of about 2%, in nominal dollars. During the last 60 years, the average rate of inflation in the US has been 3.8%. Long term, oil prices have grown below the rate of inflation even though ever less favourable drilling locations had to be accessed, and this is mainly due to technological development. We expect the technological development to continue offsetting the inflationary impacts.

Considering this rather pedestrian mid-cycle oil price growth rate and the very substantial short to midterm volatility in the markets, we would argue that the long-term trend growth rate of oil prices is actually irrelevant. When the underlying commodity can move up and down by a factor of 3x within a year or two, the slow underlying appreciation trend does not matter since timing is everything. If one buys oil at the wrong end of the cycle, the minuscule underlying price growth will not help recoup our initial investment even over an extended holding period. Based on this we argue against a long-term buy-and-hold strategy for oil.

Oil companies as long-term investments

We thus ask ourselves where the value of COP comes from. If we see it as a landowner sitting on oil-rich acreage, we should probably not invest in its long-term, as the mineral rights will not appreciate much over the decades to come. We could only trade it, based on short-term oil price movement expectations.

Looking at a short-term price correlation chart, the connection between COP and oil is quite apparent, as COP tracks the movements of the Brent Oil Fund (BNO) quite closely. However, over the longer periods, this correlation breaks. Compared to 2014, when oil prices peaked at $140, the BNO is still down 30% as the oil prices have not recovered to these high levels yet. The share price of COP, on the other hand, is up and they have also paid dividends over these 10 years. The company has grown capital value and been paying out dividends and in total delivered TSR of about 5.6% on average per annum, even when the price of oil declined 45%.

We find this chart to be quite instrumental in understanding the value drivers of E&P companies. COP is not just a passive holder of mineral rights, it is a developer, operator and capital allocator. Oil and Gas exploration and production is a risky business, as the operators are uncertain about the eventual oil production output of a reserve and face technical and operational project issues and therefore have to be rewarded for grappling with this uncertainty. This active operational management is the secret source that differentiates E&P companies from passive mineral rights holders. On top of this, the management of E&P companies can strategically take advantage of the oil market volatility by implementing contrarian capital allocation strategies. When the markets are strong E&P companies can maximise production and return proceeds to shareholders, during the market weakness they do have the ability to mitigate production and possibly acquire additional reserves at attractive prices. As we are sceptical about the long-term buy-and-hold strategy for oil reserves, the only reason for investing in an oil company long-term is the operational and capital allocation acumen of the operator. We should therefore buy and hold the best operators and capital allocators in the industry.

Having said that operational excellence is not easily measurable, especially when it comes to shale oil. A well-operated E&P is not necessarily the one with the most efficient wells or highest profit margins in any one year. Reservoir management strategies can and should span long-term, to maximise overall recovery over many years and do it cost-effectively and safely. It’s rather a qualitative judgment, which is likely to be reflected in longer-term value appreciation and shareholder return ratios. Using share price as a proxy for long-term value creation, it would appear that COP has outperformed most of the major independent and integrated industry peers. Several other factors could have contributed to this outperformance, but operation performance has likely been solid.

Countercyclical and long-term-oriented capital allocation is also a very significant ingredient of the secret sauce. E&P companies tend to jump on any hot new play even as acreage and service costs are escalating, out of the fear of missing out and underperforming their main industry peers. It is easy to grow when shareholder returns are of no concern. We are therefore confident that over the long term, the winners in this capital-intensive industry will be the ones willing to take a long-term view and make countercyclical investment decisions. Why would that be difficult you may ask, investing in oil acreage when everybody is screaming that the world will no longer need oil? These types of countercyclical bets tend to require significant shareholder trust, and if they go south, the careers of these bold risk-taking executives can be destroyed. It’s a lot safer for the executives to run with the herd, in the short term at least.

COP has initially caught our attention as the largest producer and one of the largest acreage holders in the prolific Permian basin. What intrigued us even more was that the company acquired the Permian business during the post-COVID oil price crash, when the “experts” were screaming that the world would not need more oil production capacity. And most importantly, the guy who has made these contrarian moves is still running the show today, as he has been since 2012. Ryan Lance is one of the longest-serving CEOs in the industry, and the most profitable division of the company is essentially his baby. Mr Lance was a big reason for the outperformance of COP and we expect him to continue delivering.

Track record of Mr Lance

Today COP is one of the most profitable O&G companies, during FY2023 they generated a return on capital above 20%, they are also one of the largest Delaware acreage holders with ambitious plans to expand production in this prolific basin. Not only is COP profitable, but it also has a long-term plan and a clear strategic direction.

Mr Lance took COP over in 2012, just as it was emerging as a fully independent producer after the separation of Phillips66. The new CEO wasted no time and put Kazakh, Nigerian as well as many smaller interests up for sale. The business generated more than $12 billion in divestment proceeds and also went on the offensive with its investments in the US, Australia, Europe and Canada. These markets make up the foundation of COP until today. The table below illustrates the rising capital spending as well as the main areas of investment.

The next round of big strategic moves came in 2017 when Mr Lance decided to reduce exposure to North American natural gas and oil sands and generated asset disposal proceeds of ~$14 billion. The assets sold included the 50% non-operated interest in the Foster Creek Christina Lake Partnership, as well as the majority of western Canada gas acreage, and the interest in the San Juan Basin gas asset. These assets were sold during a period of market weakness as Henry Hub averaged $2.7 per Mcf while WTI was selling for $48. It is not obvious that the timing of this sale was good, on the other hand, Cenovus, which acquired FCCL has subsequently underperformed COP by a wide margin. COP used the proceeds to strengthen its balance sheet which gave it strategic optionality further down the road. The business has also initiated buybacks as the stock was underperforming peers back in 2017-2018.

The most significant move of Mr Lance came in 2020-2021 when COP significantly expanded their presence in the US with shale oil asset acquisitions. First COP acquired Concho Resource, the fifth-largest producer by volume in the Permian that held half a million acres. This deal was implemented via an all-cash offer, having said it the premium paid was small. A year later, the Permian assets of Shell were acquired. Shell has 225K acres and a production output of 175 m BOED. Overall, COP created a Permian business with close to 1 mm of acres and 500 m BOED of output, while spending only $22 billion. To put this into context, XOM has recently paid $60 billion to acquire Pioneer, – a business of comparable size.

The Permian acquisitions were great strategic moves, and these could not have been implemented without the divestments in the prior years. Mr Lance seems to have followed a consistent and coherent strategy through the decade at the helm of COP and this consistency as well as countercyclical moves have rewarded shareholders handsomely.

Where next Mr Lance?

COP has largely shied away from the recent M&A frenzy of the shale oil patch and instead is focussed on low-risk organic expansion projects where the company already has established operations. The Delaware basin of the Permian and as well as Willow are the most significant capacity expansion areas. The company already has significant production and infrastructure in the Permian, while Willow is adjacent to the current Alaskan operations and can utilise some of the existing infrastructure. The growth strategy of COP is rather boring. It is not betting on some technologically challenging new reserve plays, instead it will continue building on the foundation Mr Lance has created over the decade in charge. We are fans of this boring, low-risk growth strategy.

The Permian is expected to be the greatest contributor to growth over the next 10 years, with overall production growth projected at 7% per annum. If these production growth expectations are met, Permian production is expected to almost double to about 1,2 MM BOED and plateau at this level.

COP is also projecting that it can achieve this growth by reinvesting merely 50% of the cash flow generated in the patch. The realisation of these assumptions would enable the business to generate significant amounts of Free Cash Flow with $60 oil even as the production capacity doubles. It is really helpful to have these growth expectations laid out in front of investors’ eyes, as it illustrates clearly the direction that the business is taking which helps shareholders decide if they are happy to hold the stock long term. It is also comforting to see that the business is betting the future on a well-known large-scale basin which is located very favourably. On the other hand, we have to take into consideration that there is significant uncertainty surrounding these forecasts and they might not come to fruition. They are just one illustrated example of a possible future.

Alaska is the second most important growth area for the business. The existing legacy operations are expected to deliver gradual growth, but the most significant upside lies in the Willow project. The new field is conveniently located adjacent to the legacy production infrastructure of COP, enabling the business to leverage some of the infrastructure that is already in place. Willow is also expected to produce mainly oil and is deemed to be quite cost-competitive.

In both of these projects, COP can utilise existing geological data, infrastructure and drilling and completion techniques optimised for these individual geologies. The business is unlikely to incur any significant technical “surprises”.

Permian – the lowest-risk production region

Despite growth in other fields, Permian is expected to increase its COP output share to close to 50%. The company’s results will depend to a great degree on performance in this one area. We believe it is a good exposure to have.

First, the Permian is one of the largest oil fields in the world. Enormous resources are being thrown into geology mapping, drilling and completion techniques and infrastructure construction by numerous market participants. Whatever technical issue the basin faces, it is likely to be resolved given the enormous resources that are being invested. E&P is a business of scale, and Permian definitely has the scale. It is also located close to existing oil and natural gas hubs of a major market as well as export infrastructure.

Second, Permian output is a significant factor in determining the oil prices globally, at least in the mid-term. This influence on global prices will help the Permian producers protect their margins and returns on investment.

There has been a lot of commentary in the markets that the Permian will plateau soon as ever poorer quality rock will start being drilled and the cost of production will increase. While we are not in a position to make or refute these claims we do realise that technological development of the future is hard to predict and that it is reasonable to expect the producers to start drilling less favourable rock eventually. This would imply that given stagnating oil prices, higher production costs will eventually lead to lower profit margins and returns for Permian producers. This could be a significant future risk.

However, the potential cost escalation in the Permian might not be such a big problem. If technology does not develop fast enough higher prices might be needed to incentivise producers to drill. Permian is a particularly strategic asset as the oil output of the region is close to 6 mm BOED and it is well connected to major demand centres and export infrastructure. Permian has grown to be an indispensable source of global supply and these 6 mm of barrels cannot be easily replaced.

If Permian producers start incurring ever higher production costs, the inventories of commercial wells will be reduced and production will decline. As Permian production goes down, the global supply of oil will decline considerably, as shale oil wells have rather rapid depletion rates. This reduced supply is likely to push the global prices up, to the levels needed to incentivise higher drilling and production in Permian. This means that Permian producers do not have to worry about escalating costs, as long as oil demand does not collapse and no other low-cost mega field is found.

Overall, it is highly likely that Permian operations of COP will be able to generate attractive or at least commercial rates of return, as Permian output is essentially irreplaceable. As long as the business stays competitive operationally with other players it should do all right.

Operational and Financial Performance during FY2023

ConocoPhillips has 6.8 billion BOE of proved reserves and also claims to have about 20 billion BOE of recoverable resources. 46% of the proved reserves are made up of oil. Lower 48 is the largest production region with a total output of ~1 mm BOED. Permian and Eagle Ford are the key production areas. It is also the key profit driver for the group. Overall group output has been ~1.8mm BOED during FY2023. At the current rate of production, COP has close to 10 years’ worth of proved reserves.

The business does not hedge commodity prices and therefore is fully exposed to upside as well as downside. As of late, natural gas as well as NGL prices in the US have experienced weakness, reducing the profitability of the Lower 48 division along with lower oil price realisations. Recovery in associated product prices would improve the profitability of the operation even with stagnant oil prices. We do not expect gas prices to stay at these low levels for long.

Last financial year the business generated ~$20 billion in Operating Cash Flow and invested ~$11 billion in maintenance and production growth. The largest destination for capital spending was the USA, which is the key growth region for the business. Europe, the Middle East and Africa are also receiving more capital investment due to projected growth from LNG projects.

During FY2023, COP has produced about ~$9 billion of free cash flow. The business has also returned close to ~$11 billion to shareholders through dividends and buybacks throughout the year. Based on a market cap of ~$140 billion, Cop trades at a free cash flow yield of 6.4%, which is in line with industry peers. The business generated very attractive returns to shareholders last year, with dividends and buybacks amounting to a 7.8% yield. The generous shareholder returns were significantly higher than the minimum 30% CFO return promised by the management. The returns are unlikely to continue at such a high level unless commodity prices appreciate markedly.

The leverage of the business looks to be at manageable levels. However one does have to point out that COP is an independent E&P that does not hedge commodity prices. The business should be expected to be exposed to higher levels of volatility as compared to integrated majors and therefore should have a lower financial leverage. The business is not as leveraged as Occidental, on the other hand, it lags behind some independent peers as well as integrated peers. The chart below indicates the Net Debt/EBITDA of market participants.

Having said that, the large Permian acreage position and production growth might help the business to deleverage over the next few years. COP expects to generate on average about ~$9 billion of Free Cash Flow per annum over the next 5 years even in a $60 WTI price environment. Considering that the overall Net Debt of the business stands at $13 billion, if the business performs according to plan it should be able to reduce debt with no difficulties. Overall, we consider the debt levels of COP to be manageable.

Conoco expects to grow cash flows above production output and revenue growth, in a $60 WTI environment. Free cash flow is expected to grow even faster than the CFO, as business is expected to leverage existing pre-production investments and become less capital-intensive. We are somewhat sceptical about the ability of COP to reduce their capital intensity going forward, as these assumptions rely on many uncertain factors, such as technological development.

However, even if the business fails to reduce the capital intensity over the next 10 years, and grows FCF and shareholder returns at the rate of CFO growth of 6%, it could still be an attractive investment. Reduced shareholder’s return yield of say 6% combined with annual growth of 6% would deliver average annual Total Shareholder Returns of 12% for long-term holders.

This return might not be particularly appealing in an industry as volatile as oil. But assuming that oil fluctuates around a rather stable mid-cycle price, over longer holding periods the upward and downward oil price movements would cancel out. COP also seems to have quite a low-risk profile given its focus on Permian production and other well-established production regions. We are therefore bullish on COP, as a long-term holding.

Conclusions

ConocoPhillips is the largest independent oil producer in North America with an enviable position in the Permian basin. The company began its strategic realignment in 2012 when downstream activities were separated. The newly independent oil producer headed by Ryan Lance has set out to streamline operations and exit smaller positions, especially in politically unstable regions. The disposal proceeds were used for investments in the Lower 48, Alaska, Canada, Australia and Norway. The company later reduced its exposure to oil sands as well as natural gas and most notably acquired its market-leading Permian business during the post-COVID distress at attractive prices.

The strategic realignment is now finished and the business is focused on building upon the positions that it has. COP wants to expand already significant production from the Permian, they are also growing in Alaska. COP is not targeting any new and risky frontiers, it’s just continuing with its established strategy and building on the existing expertise. COP is rather boring and consistent, and that is what we like about this business.

The current ~6% FCF yield, that COP currently sells at, does look somewhat mediocre considering the volatility that independent E&P producers are exposed to. However, the significant growth potential of COP as well as the low-risk nature of its operations make the stock attractive even at this price level.

Risk Factors

1. Commodity Price Volatility: COP’s profitability is influenced by oil and gas prices, which can fluctuate widely. US natural gas prices are currently affected by oversupply and we believe the market can stay out of balance for an extended period.
2. Operational Challenges: Extracting oil and gas from unconventional shale formations involves complex drilling and completion techniques. Operational issues such as well productivity declines, can reduce the profitability of oil production activities even in an environment with stable prices.
3. Regulatory and Environmental Risks: The oil and gas industry is subject to extensive regulation, including environmental regulations, land use restrictions, and safety standards. Changes in regulations or legal challenges could increase compliance costs or restrict EOG’s ability to operate.