ConocoPhillips is one of the world’s leading E&P companies based on both production and reserves with operations and activities in 14 countries. They explore, produce and transport crude oil, bitumen, natural gas, LNG and NGLs. It manages operations through six operating segments, defined by geographic region: Alaska; Lower 48; Canada; Europe, Middle East and North Africa; Asia Pacific; and Other International.
Operating segments and regions
| Segment | Consolidated liquids Production | Natural gas production | Revenue Contribution |
| Lower 48 | 55% | 64% | 60% |
| Alaska | 19% | 1% | 17% |
| Canada | 8% | 4% | 5% |
| Europe, Middle East and North Africa | 12% | 14% | 13% |
| Asia Pacific | 6% | 17% | 5% |
Alaska segment – mainly contributes towards crude oil production. ConocoPhillips is the largest crude oil producer in Alaska and have major ownership interests in the oil fields here (which is also North America’s largest oil field by area). Alaska operations contributed 19 percent of our consolidated liquids production.
Lower 48 segment – include production from western (Permian basin) and southern (Eagle Ford) region of Texas, North Dakota (Bakken) and the Gulf of Mexico. Permian basin in western Texas is the largest oil reserve in North America. This segment is major producer of Crude Oil and natural gas. Lower 48 is the company’s largest segment.
Canada region – is major producer of Bitumen and natural gas.
Europe, Middle East and North Africa segment – consists of the Norwegian Sea; Qatar; Libya.
Asia Pacific segment has production operations in China, Indonesia, Malaysia, and Australia.
Due to nature of the industry, production and revenue contributions will keep on changing from year to year. For example, in 2019 Europe, Middle East and North Africa was the major revenue contributor and prior to that in 2017 it was Canada. Quite simply, this is because any company in this industry needs to replace reserves to show sustained growth or stable production. This is done in couple ways:
- Organically, where new technology or economic conditions make more extraction possible hence increasing reserves from existing assets.
- Or the company goes out and buys assets to add to its reserves.
Production mix
| Average Net Production | 2021 | 2020 | 2019 | 2018 | 2017 | 2016 |
| Crude Oil (MBD) | 829 | 568 | 705 | 653 | 599 | 598 |
| Natural gas liquids (MBD) | 142 | 105 | 115 | 102 | 111 | 145 |
| Bitumen (MBD) | 69 | 55 | 60 | 66 | 122 | 183 |
| Natural gas (MMCFD) | 3162 | 2394 | 2805 | 2774 | 3270 | 3857 |
| Total Production (MBOED) | 1567 | 1127 | 1348 | 1283 | 1377 | 1569 |
MBD – thousands of barrels per day (unit of measurement)
MMCFD – million cubic feet per day (unit of measurement)
MBOED – thousands of barrels of oil equivalent per day (unit of measurement)
A clear trend in the production mix shows a shift in ConocoPhillips’s portfolio toward a higher mix of crude oil and less of bitumen and natural gas. This has resulted in higher annual average realized price.
Reserve Replacement
The reserve-replacement ratio (RRR) is the amount of oil added to a company’s reserves divided by the amount extracted for production. This calculation is a metric used to judge an oil company’s operating performance. A Reserve-replacement ratio of 100% indicates that the company can sustain current production levels i.e., whatever the company produces, it replaces either organically or buys new reserves.
However, RRR cannot be simply interpreted as this value varies considerably year to year contingent upon:
- timing of major projects which may have long lead times between capital investment and production.
- crude prices which dictate on the amount of production that can be done economically.
As seen below, RRR increased 377% in 2021 because major acquisition which increased reserves by 1.1 billion barrels. After excluding net increase from acquisitions, RRR is 189%. This is due to higher crude prices in 2021 (higher crude prices also increases the existing reserves). More on the relation of crude prices and reserves in “Proved Reserves” section below. Access to additional resources may become increasingly difficult as lower commodity prices can make projects uneconomic or unattractive.
| 2021 | 2020 | 2019 | 2018 | 2017 | |
| Reserve Replacement Ratio | 377% | (86) % | 100% | 147% | (168) % |
| Organic Reserve Replacement Ratio | 189% | (84) % | 117% | 109% | 200% |
Note: Organic Reserve Replacement Ratio excludes the impact of sales and purchases.
2017 – reduction of 1.9 billion BOE from dispositions.
2018 – Increased crude oil reserves accounted for over 90 percent of the total change in reserves.
2019 – Increased crude oil reserves accounted for approximately 55 percent of the total change in reserves.
2020 – reflecting the impact of lower commodity prices
Factors needed for success
A successful business strategy in the E&P industry must be resilient in lower price environments while also retaining upside during periods of higher prices. Must remain highly disciplined in investment decisions and continually monitor market fundamentals, including OPEC Plus updates regarding supply guidance and inventory levels.
This is supported by financial principles and capital allocation priorities that allows to deliver superior returns through the prices cycles. Financial principles consist of maintaining balance sheet strength, providing peer-leading distributions and making disciplined investments.
A peek into volatility
Two recent examples:
- In mid 2014 to 2016, booming U.S. oil production (due to efficiency gains in the sector) lowered break-even prices considerably that caused one of the largest oil price declines in modern history. The 70% price drop during that period was one of the three biggest declines since World War II. This crash was caused due to an oversupply of oil production
- A more recent experience would be due to the covid-19 pandemic. The energy landscape changed dramatically in 2020 with simultaneous demand and supply shocks that drove the industry into a severe downturn. The demand shock was triggered by the COVID-19 pandemic and the supply shock was triggered by disagreements between OPEC and Russia, beginning in early March 2020, which resulted in significant supply coming onto the 38 market and an oil price war. These dual demand and supply shocks caused oil prices to collapse in the first quarter of 2020. There were planned production decrease eventually from all the oil producing nations but the delay in action caused crude oil prices to reach negative territory.
To say the least, oil & gas industry is inherently quite volatile with wild swings in both directions. The direction of the swing is controlled by supply and demand dynamics which is frequently affected by geopolitical conditions of the time.
Requirement of strong balance sheet
Due to the apparent nature of the industry, it is important that in distressed markets, company can put in place production curtailments when there is weakness in oil prices and strong balance sheet will enable the company to forgo some production and cash flow in anticipation of receiving higher cash flows for those volumes in the future.
ConocoPhilips plans to reduce gross debt by $5 billion over the next five years. This will reduce interest expense and provide resilience in periods of volatility.
Proved Reserves
Reserve estimates are based on geological and engineering assessments of in-place hydrocarbon volumes, the production plan, historical extraction recovery and processing yield factors, installed plant operating capacity and approved operating limits. The reliability of these estimates at any point in time depends on both the quality and quantity of the technical and economic data and the efficiency of extracting and processing the hydrocarbons. Despite the inherent imprecision in these engineering estimates, accounting rules require disclosure of “proved” reserve estimates due to the importance of these estimates to better understand the perceived value and future cash flows of a company’s operations.
As prices and cost levels change from year to year, the estimate of proved reserves also changes. Generally, a company’s proved reserves decrease as prices decline and increase as prices rise.
Source of Growth
Growth prospects for E&P company is not very straightforward. At a high level, growth for ConocoPhillips mean more production output year over year, that means to maintain or grow production volumes on an ongoing basis, they must continue to add to their proved reserve base. Proved reserves generally increase as prices rise and decrease as prices decline. So crude prices ultimately control everything and is completely out of control of any single company. All a company can do is to position itself such that the company is able to sustain depressed prices by maintaining a strong balance sheet and at the same time be ready to take full advantage of the prices when they are high.
Return of Capital Program
This includes three-tier return of capital framework as described by ConocoPhilips: delivered through dividends, share repurchases and VROC (Variable Return of Capital). The VROC (introduced in Dec 2021) provides a way for returning greater than 30% of cash from operating activities to the shareholders during periods where commodity prices are higher than planned price range
| 2021 | 2020 | 2019 | 2018 | 2017 | |
| Dividends per share | $1.75 | $1.69 | $1.34 | 1.16 | 1.06 |
| Share repurchase (billion) | $3.6 | $0.9 | $3.5 | $3.0 | $3.06 |
Annual highlights
2021
Acquisitions:
– Concho Resources Inc., an independent oil & gas exploration and production company with operations in New Mexico and West Texas focused on the Permian Basin.
– Shell Enterprises LLC’s assets in the Delaware Basin. Assets acquired include approximately 225,000 net acres of producing properties located entirely in Texas.
Announcement to reduce the company’s gross debt by $5 billion over five years..
Announced an increase to expected 2022 return of capital to shareholders to a total of $8 billion, with the incremental $1 billion to be distributed through share repurchases and VROC tiers.
Distributed $6.0 billion to shareholders through $2.4 billion in dividends and $3.6 billion of share repurchases, representing over 30 percent return of cash provided by operating activities to shareholders.
Brent crude oil prices averaged $71 per barrel in 2021, compared with $42 per barrel in 2020.
2020
Adopted a Paris-aligned climate risk framework to achieve net-zero operated emissions by 2050.
Asset sales of Australia-West in Asia Pacific segment and Niobrara and Waddell Ranch in the Lower 48. Sales generated $1.3 billion of proceeds. Purchases of increased interests in existing fields in the second half of 2020 after commodity prices had dropped.
Paid dividends of approximately $1.8 billion and repurchased $0.9 billion of common stock.
Lower “Total production” in 2020 because The divestiture of our U.K. assets in the third quarter of 2019 and our Australia-West assets in the second quarter of 2020. Production curtailments of approximately 80 MBOED, primarily from North American operated assets and Malaysia, in response to the low crude oil price environment.
In 2020, we invested $4.7 billion in capital expenditures, of which $0.5 billion consisted of strategic acquisitions, including additional Montney acreage.
2019
- Financial achievements
- Cash from operations of $11.7 billion
- Free cash flow of over $5 billion.
- Balance sheet
- Lowered asset retirement obligations by almost 30 percent, largely through asset dispositions.
- Achieved an 11% return on capital, which ConocoPhilips considers it’s North Star.
- Achieved 5% growth in underlying production.
- Generated $3 billion of disposition proceeds, with another $2 billion of announced dispositions expected to close in early 2020.
- Added low cost of supply resources to the portfolio, which allowed to exit the year with resources of about 15 billion barrels of oil equivalent in our investment inventory with a cost of supply less than $40 per barrel.
- Return to shareholders:
- Returned 43 percent of cash from operations to our shareholders, which represented nearly all free cash flow.
- Paid $1.5 billion in dividends, repurchased $3.5 billion of shares.
2018
Financial returns surpassed returns from a few years ago when Brent prices averaged more than 50 percent higher.
Debt reduction of $4.7 billion, thus achieving our $15 billion total debt target 18 months early
35 percent payout of cash from operations to shareholders via our dividend and $3 billion of share buybacks.
Portfolio enhancements through exploration success and acquisitions in Alaska, acreage additions in the Lower 48 and Canada, and proceeds from non-core asset dispositions of $1.1 billion.
A shift in portfolio toward a higher mix of crude oil and less of bitumen and natural gas which contribute to higher annual average realized price of $53.88 per BOE in 2018, an increase of 37 percent compared with $39.19 per BOE in 2017
Fundamentals
Working Capital Position
| Value | Median | Industry Median | |
| Current ratio | 1.54 | 1.05 | 1.35 |
| Cash ratio | 0.67 | 0.12 | 0.43 |
| Cash-to-Debt | 0.48 | 0.1 | 0.50 |
| Debt-to-Equity | 0.34 | 0.6 | 0.48 |
| Interest Coverage | 19.6 | 8.4 | 10.77 |
Cash ratio is below 1 but if we consider total liquidity, which also includes $6 billion line of credit available, is sufficient to fund near and long-term requirements, including capital spending program, dividend payments and required debt payments.
Returns
| 2017 | 2018 | 2019 | 2020 | 2021 | |
| Return on Equity (RoE) | -2.61% | 20% | 21.49% | -8.33% | 21.47% |
| Return on Invested Capital (RoIC) | 1.04% | 9.81% | 9.61% | -2.87% | 11.95% |
| Return on Asset (RoA) | -1.05% | 8.73% | 10.23% | -4.06% | 10.54% |
High RoE and low RoIC & low RoA indicate that growth is funded by debt.
| 2017 | 2018 | 2019 | 2020 | 2021 | |
| Debt to Equity | 0.64 | 0.47 | 0.43 | 0.52 | 0.44 |
Debt-to-Equity in most recent quarter is 0.34 which indicates that ConocoPhilips is paying down its debt which good as it strengthens its balance sheet.
Valuations
DCF Valuations
Valuing commodity companies is challenging because of two main factors:
– Commodity companies are cyclical and where we are in the price cycle is hard to determine
– Commodity prices are not in control of the companies.
In valuing these companies, we can make two mistakes; first, ignore the economic and commodity price cycles and assume that current year’s earnings and cash flows will continue forever; second, we try to forecast the cycle in the long term.
Hence there are two ways to value these companies:
– We look past the cycle using normalized earnings, growth and cash flow.
– We still assume normalization, but only for the long term. In the near term, we forecast earnings, growth and cash flow based on where we are in the commodity price cycle.
| (in millions) | Operating Income | Tax Rate | Perpetual growth rate | Cost of Capital(3) | Reinvestment rate(4) | Value of Op. assets(5) | Enterprise Value(6) | Share price(7) |
| Avg operating income for 10 years. (inflation adjusted)(2) | $4349 | 25%(1) | 4% | 11.65% | 33.48% | $29140 | $21026 | $16.29 |
| Latest year operating income | $10200 | 45% | 4% | 11.65% | 33.48% | $50030 | $41916 | $32.49 |
| Forecast year operating income | $9844(8) | 45% | 4% | 11.65% | 33.48% | $48288 | $40174 | $31.14 |
| long-term normalize short-term forecast | See below | See below | 4% | 11.65% | 33.48% | $82395 | $70301(9) | $54.49 |
(1) Tax rate of 25% is the average of tax rate of last 10 years. This accounts for tax benefits during years where operating income is negative.
(2) Inflation rate is taken as 3.3%
(3) value of Cost of Capital taken from gurufocus.com
(4) Reinvestment rate calculated using formula, perpetual growth rate / cost of capital
(5) Calculated using formula
(6) Enterprise value = value of operating assets + cash & cash equivalents + marketable securities – Long term debt + capital obligations
(7) Share price = Enterprise value / total shares outstanding
Total shares outstanding is 1290 million as of June 2022
(8) Forecast year operating income calculated using same average BOE of $54 but higher capex of $7.20 billion as outlined by the latest annual report by ConocoPhilips.
(9) Forecast details below
Market based Valuations
Market based valuations is done using current earnings of the company and the current average PE ratio of other companies in the same industry.
– Earnings: Trailing twelve month EPS of ConocoPhilips is $12.16.
– PE ratio: Using PE ratio of 11 which is the average PE ratio of the industry.
Share price of ConocoPhilips is:
EPS x Industry PE = $133.76.
Advantage of using market based valuation is that this assumes that market has already done major calculations and assumptions and so we can have good faith in our calculation that it is near to the real fair value of the company.
We can also determine price of ConocoPhilips using average earning per share. I have calculated average eps for ConocoPhilips for past 9 years which approximately covers an entire price cycle for crude oil. This average is $2.14 which is inflation adjusted to current value of $2.52. Using the same industry average PE ratio, share price of ConocoPhilips is $30.64.
| 2013 | 2014 | 2015 | 2016 | 2017 | 2018 | 2019 | 2020 | 2021 | |
| Earning EPS | 6.47 | 4.63 | (3.58) | (2.91) | (0.70) | 5.36 | 6.43 | (2.51) | 6.09 |
| Dividends per share | 2.70 | 2.84 | 2.94 | 1.00 | 1.06 | 1.16 | 1.34 | 1.69 | 1.75 |
Valuation conclusion
Using DCF and market based valuation, we have determined 6 different values for ConocoPhilips which one reflects the real fair value of the company? The market based valuation of $133.76 is wildly different from $54.49. As stated earlier, market based valuation gives that advantage that market has already done most of the research so we can in fact safely rely on this value.
DCF valuation is limited by our assumption of crude price futures. For the valuation above I made a very conservative assumption that the average price of crude for year 2022 and 2023 will be same as 2021 (i.e. $71) which most probably will not be the case of 2022 and may or may not be for 2023. As of writing this article, average crude price YTD for 2022 is $98 (~40% higher than 2021) and I am fairly confident that the average will probably stay at $90 range by the end of the year.
The operating income for any commodity company, no matter how big or established, are highly dependent on the crude prices and it fluctuations.
Based on this, we can determine value of ConocoPhilips at different crude price levels. Hence, depending on how optimistic/pessimistic your are on the futures of oil market you will come at a different value for ConocoPhilips.
Thank you for reading all the way through!! Hope you enjoyed it as much as I did writing.
Disclaimer
The opinions expressed in the Blog are for general informational purposes only and are not intended to provide specific advice or recommendations for any individual or on any specific security or investment product. It is only intended to provide education about the financial industry. The views reflected in the commentary are subject to change at any time without notice.
This was a very informative analysis, and I felt the author did a great job in explaining each section. Overall, this was a very articulated post and research was very well done. Good job!