ConocoPhillips’ Earnings To Receive A Boost From Higher Production, Thicker Margins

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ConocoPhillips (NYSE:COP) is scheduled to announce its 2014 third quarter earnings on October 30. We expect lower crude oil prices to weigh on the company’s year-on-year earnings growth. Benchmark crude oil prices have declined sharply over the past few weeks on rising supplies and falling demand growth estimates. The average Brent crude oil spot price declined by almost 8% year-on-year during the third quarter. However, spot Henry Hub natural gas prices were up more than 11% y-o-y during the last three months, which should partially offset the impact of lower crude oil prices. In addition to higher natural gas prices in the U.S., we expect ConocoPhillips to also benefit from better sales volume mix compared to last year. This is primarily because we expect the ongoing development of liquids-rich assets in the Lower 48 states to boost its hydrocarbon production the most. During the earnings conference call, we will be looking for an update on ConocoPhillips’ new project development, which is aimed at growing its average daily hydrocarbon production in the long run.

ConocoPhillips is the world’s largest independent exploration and production company by proved reserves and annual production. Its daily hydrocarbon production averaged at around 1,556 thousand barrels of oil equivalent (MBOED) during the second quarter of this year, and it had proved reserves of around 8.9 billion barrels of oil equivalent (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. We currently have an $85/share price estimate for ConocoPhillips, which is around 12.8x our 2014 full-year adjusted diluted EPS estimate for the company. [1]

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Increased Lower 48 Development To Boost Hydrocarbon Production

ConocoPhillips expects to boost its net hydrocarbon production rate from around 1.5 million BOE per day (MMBOED) in 2013 to 1.9 MMBOED by 2017. Since the company’s 2013 base production is expected to decline to around 1.1 MMBOED by 2017 due to normal field declines, it effectively plans to add new production of almost 0.8 MMBOED in a period of 4 years. A large majority of this new production (~50%) is expected to come from the ongoing development of its onshore assets in the Lower 48 states. We expect the ongoing development of the company’s acreage in the Eagle Ford and the Bakken shale plays to account for most of the hydrocarbon production growth during the third quarter. [2]

The Eagle Ford shale is now the largest tight oil play in the U.S. by EIA estimates. Its proved crude oil reserves of 3.4 billion barrels are greater than those of the Bakken Formation of North Dakota. ConocoPhillips plans to invest $3 billion annually in the development of its acreage in the Eagle Ford play and expects to more than double the rate of production from around 119 MBOED in 2013 to over 250 MBOED by 2017. In the previous quarter, the company’s average production rate from the Eagle Ford jumped over 30% y-o-y to 157 MBOED. [3]

The Bakken Shale Play is located in Eastern Montana and Western North Dakota, as well as parts of Saskatchewan and Manitoba in the Williston Basin. According to latest EIA estimates, the Bakken tight oil play holds 3.2 billion barrels of technically and economically recoverable crude oil. ConocoPhillips plans to invest roughly $1 billion annually in the development of its acreage in the Bakken play and expects to ramp up production rate from around 33 MBOED in 2013 to over 68 MBOED by 2017. During the second quarter, the company’s average production rate from the Bakken stood at 51 MBOED, which was almost 70% higher than the previous year’s quarter. [4]

Efficiency Improvements and Better Mix To Drive Margin Expansion

The growth in ConocoPhillips’ Lower 48 production is also expected to boost its third quarter operating margins because of continuous improvements in drilling and completion cost efficiencies and better volume-mix. Over the past 4 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. Most 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 technique in 75% of all the wells drilled in the Eagle Ford play this year. [1]

In addition to cost efficiency improvements, ConocoPhillips’ operating margins are also expected to expand because of the improvement in its sales volume-mix. During the first half of this year, ConocoPhillips’ hydrocarbon production from continuing operations (excluding Libya) grew by 60 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 standards, the company’s natural gas production declined by 14 MBOED or approximately 3.5% y-o-y, while liquids (crude oil and natural gas liquids) production from the Lower 48 states increased by 40 MBOED or 17% y-o-y. This boosted ConocoPhillips’ price-adjusted cash margins by almost $2.1 to $29.63 per BOE. We expect ConocoPhillips’ cash margins to continue to expand in the short to medium term on the continued ramp up of its liquids-rich onshore assets in the U.S. [2]

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Notes:
  1. ConocoPhillips 2013 10-K SEC Filing, sec.gov [] []
  2. Investor Update, conocophillips.com [] []
  3. ConocoPhillips Second-Quarter Detailed Supplemental Information, conocophillips.com []
  4. 2014 Q2 Earnings Call Presentation, conocophillips.com []