Do You Believe Shell? Try Conoco

Its business model isn't counting on rising prices.
At Closing, April 24th
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ConocoPhillips probably doesn't see it this way, but a good starting point for its analyst jamboree on Thursday came earlier this month, courtesy of Royal Dutch Shell Plc's earnings call. This was Shell's CFO:

Oil, we've long been of the opinion that demand will peak before supply. And that peak may be somewhere between 5 and 15 years hence ...

Peak oil demand perhaps as soon as 2021? No wonder Shell's pushing a natural-gas story. But Conoco has a compelling narrative of its own for oil's possible pre-end days.

This isn't about shifting to more gas. The exact opposite, in fact: Conoco plans to sell up to $8 billion worth of North American gas assets, taking gas down to less than a tenth of projected production. The real story involves that $8 billion and what Conoco intends to do with its cash in general. Here's the headline, delivered upfront on Thursday morning by CEO Ryan Lance:

You can't count on rising commodity prices to bail out your business model.

That ought to be printed above the door of every oil company's headquarters. It isn't quite as apocalyptic as saying oil demand will peak in the 2020s. But Conoco's scenarios recognize that possibility and, above all, prioritize paying off debt and pushing cash to shareholders before any investment for growth.

In an industry that tends to promise ever-increasing production and/or dividends, Conoco's is a bit more honest, given the volatility of the cycle.

The New World

Conoco has learned from bitter experience that the energy cycle trumps all

Source: Bloomberg

Conoco's plan is centered on a capital expenditure budget to maintain flat production of about $4.5 to $5 billion a year, dividends of $1.2 billion, authority to buy back $3 billion of shares and a target of cutting debt by $7 billion by 2019.

Consensus forecasts compiled by Bloomberg imply operating cash flow of $21.6 billion across 2017 and 2018. Take out $10 billion of capex and assume Conoco uses all that buyback capacity over the next two years. On that basis, it could comfortably raise its dividend by 10 percent each year and still generate excess cash of $5.8 billion by the end of 2018.

And that's in part because buying back shares offsets some of the cost of raising the dividend (while also boosting production on a per-share basis). Throw in $5 billion of disposal proceeds -- the bottom end of the target -- and Conoco would exit 2018 with about $10.8 billion of excess cash; enough to cut its debt and invest for further growth. Meanwhile, it would have delivered on its target of paying out between 20 and 30 percent of operating cash flow to investors.

Glide Math

Conoco's guidance suggests it could comfortably buy back shares, raise dividends and generate excess cash over the next 2 years

Source: Bloomberg, the company, Bloomberg Gadfly analysis

Note: Data as per current consensus estimates for operating cash flow, assuming annual capex of $5 billion, buybacks of $1.5 billion and increases in dividend per share of 10 percent.

Like most company targets, it reads a little halcyonic. The key here, though, is that capex figure and the portfolio backing it.

When Conoco split off its downstream arm Phillips 66 in 2012, it had eight megaprojects on the go. As I've discussed previously, megaprojects' long timescales and individual nature (which limits economies of scale) make them especially risky in an environment of volatile energy prices. That's why the industry embarked on so many of them when oil was coasting along at $100 a barrel and then, Conoco included, saw their free cash flow and returns drop off a cliff when the cycle turned south.

Conoco's new strategy reflects some penitence for earlier excesses. The megaprojects, liquefied natural gas and oil sands, are now largely done and will provide a steady base of supply for capex of just $500 million a year. The key to Conoco making the strategy work will be its ability to manage decline in its conventional assets in places like the North Sea and, especially, its unconventional fields in places like the Eagle Ford and Permian shale basins.

Conoco claims it can make all this work with oil prices below $50 a barrel (Brent currently trades at about $46.) All the major oil companies are slashing their breakeven targets, albeit not to this degree. One thing lending credence to Conoco's is its careful explanation of fully loaded costs for each barrel, including things like corporate overhead -- something the rest of the industry doesn't always present clearly. Indeed, given that most of the sector's presentations offer a mix of complex maps, photos of rigs and fuzzy bar charts with no numbers, Thursday's deck from Conoco was a rare example of relative transparency.

Having seen its earlier strategy collapse with February's ignominious dividend cut, a more-open approach was warranted. Focusing on lower-cost barrels offers the best hedge against excess supply or even peak demand, as well as the chance of windfalls when prices turn up. Conoco's message isn't a bullish one for the energy industry as a whole. That's why it's the right one.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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    Liam Denning in New York at

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    Mark Gongloff at

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