ConocoPhillips’ Q3 Earnings Fall On Lower Oil Prices Despite Higher Production, Better Mix

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Despite higher hydrocarbon production and better volume-mix, ConocoPhillips’ (NYSE:COP) third quarter earnings declined on lower crude oil prices. Global benchmark crude oil prices have fallen sharply over the past few weeks on rising supplies and slower demand growth, especially from China, where the rate of growth in demand for petroleum products has fallen to almost half of what it was a year ago. The company’s earnings per share (EPS) adjusted for one-time items fell by over 12% year-on-year to $1.29. Its hydrocarbon production increased by 4% y-o-y, as the impact of higher downtime was more than offset by the increased development of its key assets in the Lower 48 states of the U.S. More importantly, production growth came primarily from liquids, which are priced higher than natural gas, that led to thicker operating margins due to a positive volume-mix effect. [1]

ConocoPhillips is the world’s largest independent exploration and production company by proved reserves and annual production. Its daily hydrocarbon production from continued operations averaged at 1,473 thousand barrels of oil equivalent (MBOED) during the third 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. Based on the recent earnings announcement, we have revised our price estimate for ConocoPhillips to $78/share, which is around 12.6x our 2014 full-year adjusted diluted EPS estimate for the company.

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Lower 48 Development Drives Higher Production, Better Mix

ConocoPhillips’ third quarter hydrocarbon production adjusted for downtime related variance increased by 62 MBOED or 4.3% y-o-y. Almost 71% of this production growth (44 MBOED) came from its operations in the Lower 48 states of the U.S., where the company is ramping up the development of its onshore assets. Production from the Lower 48 states at 543 MBOED was up by around 8.8% y-o-y, which not only boosted the company’s sales revenue but also improved its volume-mix that led to thicker margins. [1]

Most of the growth in ConocoPhillips’ Lower 48 production came from the development of its acreage in the Eagle Ford and Bakken shale plays. 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. During the third quarter, the company’s average oil and gas production from the Eagle Ford jumped almost 25% y-o-y to 157 MBOED. [2]

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 third quarter, the company’s average production rate from the Bakken stood at 55 MBOED, which was almost 62% higher than the previous year’s quarter. [2]

More importantly, liquids now represent 54.4% 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 the third quarter, the company’s crude oil production from the Lower 48 states grew by 25% y-o-y, while total hydrocarbon production from the region increased by just around 9%. This is significant because natural gas volumes are not as lucrative in the U.S. owing to lower commodity prices. Last year, ConocoPhillips sold liquids at an average price of over $85 per barrel, while the company realized average price of just around $37 per BOE of natural gas. [3]

Therefore, a shift in production volume towards liquids is driving better volume-mix, which is boosting the company’s cash operating margins. ConocoPhillips’ third quarter cash margins declined by $0.25 per BOE, primarily due to lower crude oil prices, compared to last year. However, after adjusting for the difference in price realizations, the company’s cash margins improved by $2.33 per BOE, which implies a growth of almost 7.8% over the previous year’s quarter. Beyond short-term volatility in commodity prices, we expect ConocoPhillips’ cash margin expansion to continue in the long run on improving volume-mix. [2]

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Notes:
  1. ConocoPhillips Reports Third-Quarter 2014 Results; Delivering Production and Margin Growth, conocophillips.com [] []
  2. 2014 Q3 Earnings Call Presentation, conocophillips.com [] [] []
  3. ConocoPhillips 2013 10-K SEC Filing, sec.gov []