Why Did ConocoPhillips’ Stock Surge By Almost 10% Last Week?

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ConocoPhillips

The upward rally in the oil and gas stocks, driven by the production cuts by the OPEC, has finally come to an end. The latest data about the US oil inventories and production has been disappointing, causing the oil prices to come crashing down to under $50 per barrel. For the same reason, ConocoPhillips (NYSE:COP), the world’s largest independent exploration and production company by reserves, faced a 15% plunge in its stock price in the last couple of weeks, despite posting better-than-expected 4Q’16 results earlier this year.

However, just before the closing of the first quarter of 2017, ConocoPhillips announced the sale of its non-operating interest in its oil sands venture and natural gas holdings in Canada to Cenovus for a sum of $13.3 billion. While the deal is expected to close by the second quarter of this year, the market has reacted positively to the news, causing ConocoPhillips’ stock to surge by almost 9% within a single trading day. Below, we briefly discuss the terms of the deal and implications of the deal on the company.

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Source: Google Finance

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Terms Of The Deal

At the beginning of this year, ConocoPhillips had announced its plan of reducing its global footprint by almost 50% and concentrating only on strategic and high margin markets. For this, the oil and gas producer expected to divest assets worth $5-$8 billion between 2017 and 2018, mainly to reduce its exposure in the North American natural gas market.

In line with this strategy, last week, the company entered into a definitive agreement with Cenovus (NYSE: CVE) to divest 50% of its non-operated interest in the Foster Creek Christina Lake (FCCL) oil sands partnership, as well as a majority of its western Canada Deep Basin gas assets, for a total sum of of $13.3 billion((ConocoPhillips Announces Sale Of Canada Assets, 29th March 2017, www.conocophillips.com)). However, ConocoPhillips Canada will continue to hold 50% operating interest in the Surmont oil sands joint venture and 100% ownership of its Blueberry-Montney unconventional acreage position.

The company will receive $10.6 billion in cash, and 208 million Cenovus shares worth $2.7 billion as part of the deal. In addition to this, the company will receive five years of uncapped contingent payments, if the Western Canada Select (WCS) crude price exceeds $52 Canadian dollars per barrel.

Does The Deal Make Sense For ConocoPhillips?

From an operational standpoint, the deal will allow ConocoPhillips to focus exclusively on its Surmont oil sands and liquids-rich Blueberry-Montney unconventional asset. Accordingly, the company expects the transaction to be accretive to its cash margins, as the asset sale is likely to lower the average cost of supply of the company’s portfolio. However, the oil and gas player estimates a negligible impact on its cash flows from operating activities at $50 per barrel Brent price, as the cash flow from the disposition of the Canadian assets will be roughly offset by lower interest expense. That said, ConocoPhillips will continue to hold an upside potential in a strong oil price environment due to the uncapped five-year contingent payment associated with the deal.
From a financial perspective, the deal is perfectly aligned with the company’s strategy to divest its non-core and non-strategic assets, and utilize the proceeds to optimize its highly levered balance sheet. With this deal, the E&P company aims to bring down its long term debt obligations to $20 billion by the end of this year, as opposed to its previous expectation of meeting this target by 2019. Also, this drastic fall in the company’s debt obligations will enable it to achieve an “A” credit rating for its debt faster-than-anticipated.
Moreover, a sizeable drop in the long term debt will cause the interest expenses to shrink significantly, boosting the company’s profitability in the short term.

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Apart from optimizing its capital structure, ConocoPhillips has been focused at returning higher value to its shareholders (Read more: How Does ConocoPhillips Plan To Improve Its Shareholders’ Return In The Next Few Years?). According to the company’s latest investor presentation, the company targets to payout 20%-30% of its cash flows from operations to its investors over the next few years. With the sale of its Canadian assets, the company plans to increase the pace and level of its share repurchase program. To this effect, the US-based company’s board of directors has already doubled its existing share repurchase authorization from $3 billion to $6 billion. Further, ConocoPhillips intends to spend $3 billion on share buybacks in 2017, instead of $1 billion as decided earlier. The remaining $3 billion of share repurchase authorization will be spent in 2018 and 2019. The reduced debt, coupled with higher share buyback, will enhance the company’s earnings, and, in turn, allow the company to return higher value to its shareholders.

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Based on the above discussion, we believe that ConocoPhillips’ decision to divest its non-strategic Canadian assets is a good move. The transaction will not only allow the company to retain the upside potential in the assets through the contingent payment clause, but will also enable the oil and gas company to optimize its balance sheet and enhance its shareholders return.

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