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Investment Overview for ConocoPhillips (NYSE:COP)
WHAT HAS CHANGED?
- Declining Crude Oil Prices
Over the last one year, global crude oil prices have plummeted close to 60%, falling from over $110 per barrel in July 2014, to less than $40 per barrel in March 2016. This steep decline was driven by the mismatch in the demand-supply of crude oil worldwide, caused by the following factors:
- Weakness in global demand for oil, primarily due to slower growth in the Chinese economy
- Excess oil production because of the rise in the tight oil production in the US
- Organization of Petroleum Exporting Countries (OPEC) maintaining high production rates to defend their market share
The weakness in crude oil prices has resulted in a sharp drop in the price realizations for all the oil and gas companies, including ConocoPhillips. As a result, their revenues have plunged drastically. In addition, these companies have been forced to pull back their capital spending on drilling activities, leading to a slowdown in their exploration and production activity. While the outlook for crude oil prices is uncertain, the following developments are likely to delay the recovery of oil prices at least to the next year:
- Iranian nuclear agreement, which is likely to waive all international sanctions on Iran's oil production, is expected to result in an additional supply of oil in early 2016.
- Weakness in the Latin American market is expected to drive down the demand for oil in the near future.
As OPEC continues to maintain its high production levels, the recovery in oil prices is expected to take longer than expected. In such a challenging oil price environment, we expect to see a further fall in ConocoPhillips' top line at least over the next few quarters.
- Increased Focus On Cost Optimization In A Weak Oil Price Environment
Capital expenditure is the biggest single cash expense item for the oil and gas industry, and is the primary driver for future production and earnings growth. Thus, the capex budget of independent exploration and production companies is highly dependent on the short to medium term outlook for global crude oil prices. Due to the steep fall in oil prices, ConocoPhillips was forced to significantly cut its capital expenditures in 2015. Since the commodity markets have not recovered, the company expects to invest $6.4 billion in capital spending (including capitalized interest) during 2016, which is 20% lower than last year.
Lower capital expenditures mean lower investment in future production growth. Therefore, while lower capital spending will improve the free cash flows to the firm, we believe it will also slow down the company’s short to medium-term production growth. For example, in 2015, ConocoPhillips’ production fell by 1% y-o-y due to the pull back in exploration and production activities during the year. Consequently, we expect production to decline further by around 3% this year, followed by a 3.5% average annual growth beyond that.
Below are the key drivers for ConocoPhillips which present opportunities for upside or downside to the current Trefis price estimate for ConocoPhillips.
- Crude Oil Price: ConocoPhillips' stock price is highly sensitive to crude oil prices as the company derives more than 60% of its total value, by our estimates, from the sale of crude oil. We believe that the recent decline in oil prices could sustain for a longer period amid slower demand growth and the diminishing price-controlling power of the OPEC. According to our estimates, annual average crude oil prices (Brent) could average at around $50 per barrel this year and rise back to around $90 per barrel by 2022. However, if oil prices remain depressed for longer than what we currently expect, and increase only to around $70 per barrel by the end of our forecast period, there could be almost 15% downside to our current price estimate for ConocoPhillips.
- Price of Natural Gas: ConocoPhillips' average selling price of natural gas increased from $5.06 per million cubic feet (Mcf) in 2010 to $5.64/Mcf in 2011 before plummeting in 2012 amidst an oversupply in the market due to the increased availability of shale gas. In 2010, approximately 1% of natural gas production came from shale sources. By 2014, this figure had increased to nearly 25%. Technological improvements have helped improve the ability of companies to discover these new resources. As a result of new discoveries of shale gas, there has been a decoupling between the prices of crude oil and natural gas. In 2014, the company's natural gas price realization increased on higher commodity prices in North America. We expect natural gas prices in North America to recover, albeit gradually, to $5 per mcf by the end of the Trefis forecast period as additional demand comes from the power generation sector (which is switching to gas from coal) and other sources. However, if demand picks up further and prices rise above $7.20 per mcf there could be an upside of about 6% to our price estimate.
ConocoPhillips is the third largest oil producing company in the world. After the spin-off of its midstream and downstream businesses into an independent company, Phillips 66, ConocoPhillips has become a pure-play exploration & production company. The company conducts exploration activities in 19 countries and supplements its income with equity stakes in other oil & gas and chemical companies. About 56% of its production consists of liquids and about 44% consists of natural gas. Of the 56% that are liquids, about 45% is tied to Brent or international prices. The remaining 11% of liquids is tied to North American crude markers, NGL, or bitumen prices. On the natural gas side, comprising about 44% of its portfolio, roughly 45% consists of international gas. Price differentials between Brent and West Texas Intermediate (WTI), a widely used North American crude marker, have been narrowing of late. This has reduced the disparity in realized prices for crude oil in domestic and international markets. Price realized by the company on domestic and international sale of natural gas is also different.
Crude oil exploration and production is the most valuable segment for ConocoPhillips for the following reasons:
Large base of proven reserves
The amount of proved hydrocarbon reserves is an extremely critical metric for any oil and gas exploration and production company. It directly impacts the company’s production growth outlook, as it represents the total quantity of technically and economically recoverable oil and gas reserves owned by the company at a given point in time. ConocoPhillips’ total proved hydrocarbon reserves stood at 8,180 million barrels of oil equivalent at the end of 2015. This implies that the company held enough reserves at the end of 2015 to be able to produce oil and gas for more than 17 years at 2015 production rates.
More importantly, ConocoPhillips has reported a greater than 100% reserve replacement ratio for the last five years. This shows that the company has been able to consistently grow its reserve base through a successful exploration program. Its average reserve replacement ratio for the last five years (excluding asset disposition) has been over 117%.
Enviable acreage position in the Lower 48 states
ConocoPhillips holds 12.4 million net acres of onshore conventional and unconventional acreage in the Lower 48 states. The company’s unconventional holdings total 2.6 million net acres and include approximately 617,000 net acres in the Bakken, 216,000 net acres in the Eagle Ford, 102,000 net acres in Permian, 109,000 net acres in Niobrara, 900,000 net acres in the San Juan Basin, and nearly 553,000 net acres in other unconventional exploration plays. Currently, ConocoPhillips’ activities in this region are mostly centered on continued optimization and development of existing and emerging assets, with particular focus on areas with higher liquids production.
Improving drilling efficiencies
Most of the improvement in ConocoPhillips' price-adjusted cash operating margins over the last couple of years has come from better sales volume-mix, and continuous improvements in drilling and completion cost efficiencies. Over the last four years, the company has been able to achieve drilling and completion cost efficiency improvements of 37% and 41%, respectively, in the development of its acreage in the Eagle Ford tight oil play. A large part of this efficiency improvement can be attributed to the increased use of multi-pad well drilling. ConocoPhillips plans to further reduce its average total cost per well by using multi-well pad drilling techniques in 75% of all the wells drilled in the Eagle Ford play this year.
ConocoPhillips’ price-adjusted cash operating margins have also been helped over the past few years by the continuous improvement in its sales volume-mix, which is primarily being driven by the development of its assets in the Lower 48 states. Liquids (crude oil and natural gas liquids) now represent 55% of the total hydrocarbons produced by ConocoPhillips from the Lower 48 states, compared to just over 45% at the end of 2012, and their production has been growing rapidly over the last few quarters.
During 2015, the company’s crude oil production from the Lower 48 states grew by 9.6% y-o-y, while total hydrocarbon production from the region increased by just around 2.3%. This is significant because natural gas volumes are not as lucrative in the U.S. owing to lower commodity prices. In 2015, ConocoPhillips sold crude oil at an average price of almost $45.50 per barrel, while the company realized average prices of just around $22.62 per BOE of natural gas.
It is estimated that a large part of the world's oil reserves have already been discovered. Recent statistics have indicated that global consumption has been outpacing reserve additions. Peak oil is a commonly used term to describe the point at which world oil output will reach a maximum and decline afterward.
However, many institutions such as the International Energy Agency (IEA) believe that peak oil will not occur for another 25 years at the very least. Many governments across the world are promoting alternative energy measures to ensure that the supply and demand of energy will be met at all times to come.
How Does Trefis Modelling Work?
How do we get the historical numbers for this chart?
Trefis has a team of in-house Analysts who gather historical data from company filings and other verifiable sources. When historicals are available, we explain how we got them at the bottom of the Trefis analysis section below.
Who came up with the Trefis forecast for future years?
The Trefis team of in-house Analysts considers a variety of factors when projecting any forecast. The rationale for our projections is explained in the Trefis analysis section below.
How does my dragging the trendline on the chart impact the stock price?
- We use forecasts for business drivers to calculate forecasted Revenues and Profits for each division of the company.
- We then use forecasted Profits in a Discounted Cash Flow (DCF) model to obtain the Price Estimate for the company.
See more on: DCF Methodology
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