Description

Outside of Canada, which is home to the oil sands and the Montney Shale, it is difficult to find value in the E&P universe. Most of the universe comprises companies that possess limited drilling inventories. With limited reinvestment options, they will be coerced to return capital while their production base and reserves stagnate through the remainder of the decade.

E&P equities are typically valued myopically. As a result, long-term projects tend not get discounted into the valuation of the equities and typically detract from the valuations. This is because the capital expenditures on the longer-term projects detract from the current ROIC calculations and investors will penalize the valuation by taking down the multiple on near term year’s earnings.  During the previous cycle, we witnessed this set up contribute to outperformance for companies that were spending on long-term projects. The Long Lake and Horizon oil sands projects were not discounted in the stock prices of Nexen and Canadian Natural, respectively, until approximately two years before the projects were brought onstream. Similarly, the spending on tertiary recovery projects were a drag on Denbury’s valuation until a year prior to when they were online.

Since announcing the $22.5 billion all stock acquisition of MRO on 5/29/24, the stock of ConocoPhilips has languished. It is worth noting that COP had the ability to pay cash in the transaction; however, MRO demanded an all-stock transaction. COP management has publicly indicated that MRO approached them following its own strategic reviews. When digging into the financial profile of ConocoPhilips, it is clear why MRO found the COP stock attractive. COP appears poised to outperform the US independent landscape considerably over the balance of the decade assuming WTI remains in the $75-80/barrel range.

Importantly, COP is well-protected in an adverse scenario. It has the lowest leverage compared with other independent E&P companies, with a net debt leverage ratio of 0.4x. In addition, the company can cover its dividend and capital expenditures needed to maintain flat production with an oil price as low as $47 WTI.

What really differentiates COP from its peers is its deep North American drilling inventory. Approximately 60% of its production comes from the United States. The key areas are Alaska (11%), Delaware Basin (27%), Midland Basin (9%), Eagle Ford (11%), and the Bakken (5%). The company boasts a very impressive 40+ year inventory in its Tier 1 acreage in the Delaware Basin at the current drilling pace. In addition, it holds a 20-year inventory of Tier 1 acreage in the Midland Basin. The company is the second largest producer in the Delaware Basin and its tier 1 inventory relative to its current production is second to none. For example, Exxon and EOG each have less than 10 years of tier 1 inventory remaining in the Delaware Basin. In the Midland, COP’s running room is only matched by Chevron and Apache. It has roughly double the amount of tier 1 inventory as Occidental.

The attractive inventory position provides COP with a long and visible runway to grow its Lower 48 production at a 6% CAGR through 2030. This growth will be complemented by the company’s Willow project in Alaska. Spending begins this year on Willow, which will require $7-7.5 billion of capital expenditures over the next four years. This project will contribute incremental production of 180k boe/d on a current base of 1.1m boe/d. At $80 WTI, the company will achieve a 20% after-tax return on capital.

We think the financial profile of COP can appeal to value and growth investors. As mentioned above, the downside is well protected and the growth can be financed in a low-$50 price environment. During 2023, when WTI averaged $77.67, operating cash flow totaled $20 billion. The company spent 56% of its cash flow, or $11.2, billion on capital expenditures in order to grow production by 5%. Despite the required investment on Willow, the capital expenditures are not projected to increase above $11.5 billion over the next couple of years. Willow comes onstream in 2029 and if we assume that capital expenditures drop to a maintenance level of $8 billion per year, free cash flow will total $20.5 billion in 2029, assuming $75 WTI. In other words, free cash flow will approximately double over the next four years.

While free cash flow will increase significantly, the company will generate cumulative free cash flow of $76 billion, or 60% of the market capitalization. COP will return approximately $3.9 billion via dividends in 2024. The company would like to grow its dividend by 5% annually. This will most likely come by reducing the denominator via share repurchases. After returning $23.3 billion in dividends, COP will be able to repurchase $53 billion over the next 5.5 years. Furthermore, assuming the company maintains leverage at 0.5x, it can add an incremental $7 billion to its balance sheet, which takes the amount of share repurchases to $60 billion, or half of the market capitalization. By the end of 2029, the share count could be reduced to roughly 750 million. As a result, free cash flow per share could approximate $27 per share. Assuming the stock trades at a 10% free cash flow yield, this translates to a high 20% IRR over the next 4.5 years.

It should be noted that the above analysis does not include the financial impact of the MRO acquisition, which is projected to be accretive to free cash flow per share. The rationale for the acquisition is to give the combined company scale in the Bakken and Eagle Ford shales. The combined company will become the largest producer in the Eagle Ford as it will be 30% larger than EOG and 2.5x the third largest producer. Part of the rationale behind the deal was that COP management is bullish on the opportunity for refracs in the Bakken Shale. COP believes that the economics of the refracs compete with the Tier 1 opportunities.

From a technical perspective, following the acquisitions of HES and PXD, there is a dearth of large cap independents. COP should become a beneficiary of this vacuum and its valuation could benefit from scarcity value and attractive liquidity.

Catalyst

- closing of MRO deal

- share repurchases