ConocoPhillips Revised To $85 On Robust Production And Margin Outlook

ConocoPhillips (NYSE:COP) is the world’s largest independent exploration and production company by proved reserves and annual production. Its daily hydrocarbon production averaged at around 1,530 thousand barrels of oil equivalent (MBOED) during the first quarter of this year, and it had proved reserves of around 8.9 billion BOE at the end of last year. Headquartered in Houston, Texas, the company has operations in 27 countries, generating annual sales revenue of more than $60 billion.

After the 2013 fourth quarter and full-year earnings release, we revised our price estimate for ConocoPhillips to $77 per share, which was more than 15% above its market price at that point in time. Since then, the stock has moved up to match our price estimate. However, we now believe that a robust production and margin expansion outlook could fuel the stock price to $85/share, which is around 12.9x our 2014 full-year adjusted diluted EPS estimate for the company.

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Higher Production

ConocoPhillips plans to boost its net hydrocarbon production volume from around 1.5 million BOE per day (MMBOED) in 2012 to 1.9 MMBOED by 2017. Since the 2012 base production is expected to decline to around 0.9 MMBOED by 2017 due to normal field declines, the company effectively plans to add new production of almost 1 MMBOED in a period of 5 years. ^[1]

The biggest contributor to the independent oil explorer’s production ramp-up plan is expected to be its ongoing development of the onshore assets in the Lower 48 states of the U.S. The Lower 48 operating region is expected to contribute ~60% to its total planned incremental production from the development of existing projects and more than 36% to the total anticipated new production of 1 MMBOED. ^[1]

ConocoPhillips holds 13.8 million net acres of onshore conventional and unconventional acreage in the Lower 48 states. The company’s unconventional holdings total 2.5 million net acres and include approximately 626,000 net acres in the Bakken; 227,000 net acres in the Eagle Ford; 194,000 net acres in Permian; 130,000 net acres in Niobrara; 900,000 net acres in the San Juan Basin; and nearly 430,000 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 a particular focus on areas with higher liquids production. ^[2]

During the first quarter of this year, ConocoPhillips’ liquids production from the Lower 48 states grew by 50 MBOED over last year, driving its total net hydrocarbon production rate higher by 41 MBOED. The company’s crude oil production grew 16% y-o-y as it achieved new daily peak production rates in the Eagle Ford and the Bakken shale plays. Going forward, we expect the development of these shale plays to continue to fuel production growth at ConocoPhillips in the short to medium term. ^[3]

Thicker Margins

ConocoPhillips’ 2014 first quarter cash margins improved by $5.27 per BOE, which is equivalent to an increase of ~20% y-o-y. This could partially be attributed to higher natural gas prices in the U.S. compared to last year. Unusually cold winter in the U.S., which forced consumers to use more heat and electricity this year, drove a sharp increase in domestic natural gas prices. Spot Henry Hub prices were up more than 45% y-o-y during the first quarter due to a precipitous decline in natural gas inventories. However, even after adjusting for the difference in price realizations, the company’s cash margins improved by $3.44 per BOE, which implies ~13% year-on-year growth. The key trend behind this spectacular margin expansion has been the company’s improving volume mix. ^[3]

During the quarter, ConocoPhillips’ volume-mix improved on higher proportion of liquids as production growth mostly came from the liquids-rich unconventional plays in the Lower 48 states and oil sands in Canada. Higher liquids production boosts operating margins for oil companies as they earn more revenues per barrel of oil equivalent (BOE) on selling liquids rather than natural gas. ConocoPhillips sold liquids at an average price of over $85 per barrel last year, while the company realized average price of just around $37 per BOE of natural gas. ^[4]

In the first quarter, ConocoPhillips’ hydrocarbon production from continuing operations grew by 41 MBOED, net of field declines. More importantly, most of this growth came from the right areas, which boosted its operating margins. In North America, where natural gas prices are still depressed by international markets, the company’s natural gas production declined by 14 MBOED, while liquids production from the Lower 48 states and Canada increased by 50 and 11 MBOED, respectively. This boosted ConocoPhillips’ price-adjusted cash margins by almost $3.5 to $30.24 per BOE. We believe that this margin expansion trend is sustainable by ConocoPhillips in the short to medium term on the continued ramp up of its liquids-rich U.S. onshore assets. ^[3]

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1. Credit Suisse Energy Summit, conocophillips.com [↩] [↩]
2. Company SEC Filings, sec.gov [↩]
3. ConocoPhillips 2014 Q1 Earnings Call Presentation, conocophillips.com [↩] [↩] [↩]
4. ConocoPhillips 2013 10-K, sec.gov [↩]