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ConocoPhillips: Find Safety in Energy

Posted on: September 8, 2008 - Email Article - Printable Version

Rishin Banker

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Economists, politicians, investors, and all taxpayers alike have been stirred by the movement of commodity prices this year. This is an economic environment where respected energy experts from equally respected institutions completely disagree about the short-term future of crude oil prices. This is a political environment where the American presidency is up for grabs and each candidate brings drastically different ramifications for the energy sector. This is an investing environment where the Energy Select Sector Spider [XLE: 51.33, 0.00 (0.00%)], an ETF designed to model the S&P 500 Energy Sector, achieved a positive year-to-date performance of nearly 15% in mid-May but is currently under the water year-to-date by the same number.

To put your money in an energy company at this time would be to make a serious bet. You could be betting that OPEC does indeed cut production and a barrel of crude oil will be twice as expensive a year from now; or that the Pickens Plan will succeed and our transportation system will be powered by natural gas five years from now; or that the ban on offshore drilling is lifted and various drilling companies will be able to tap into American coastal oil reserves ten years from now. These bets make the energy sector fascinating for some, but intimidating for others. If you are looking to get your feet wet in the energy sector without taking on high levels of risk, take a look at ConocoPhillips [COP: 55.47, 0.00 (0.00%)], a major integrated oil and gas play that provides solid growth potential despite its large market cap. The following themes highlight ConocoPhillips as a secure energy play in this type of market:

Diversified and Adaptive Business Segments

As a global integrated energy company, ConocoPhillips operates in several different business segments and geographic locations. Though primarily based in the United States, they do have growing positions in the Asia Pacific, the Middle East, and Russia, which I will cover in greater detail below. The two primary areas of ConocoPhillips’ business are the upstream Exploration & Production and the downstream Refining & Marketing. In 2007, the E&P segment made up 38% of net income, while R&M composed 50%. Interestingly enough, this balance has undertaken a significant reversal year-to-date for 2008, as, based on second quarter financial results, E&P composed 72% of net income while R&M reduced its contribution to 12%. This shift in business focus is a direct result of the shift in commodity prices, as the upstream side benefits from higher crude prices while the downstream side takes a hit, and vice versa.

The exposure to the refining industry in particular provides a partial hedge against the falling crude prices that have tormented the energy sector in the last several months. Refiners’ profit margins are determined by a metric called the “crackspread,” which basically represents the difference between crude and gasoline prices. The recent drop in crude prices may hurt the E&P segment to some extent, but this will likely be made up for in the R&M segment, making the upcoming third quarter earnings results a critical test to the balance of their business. However, before the skeptic in you comes loose, please keep in mind: ConocoPhillips has beaten analysts’ earnings estimates 12 out of the last 14 quarters, a period of incredibly volatile and noticeably different environments in the energy industry. The fact that this success streak has been achieved speaks wonders about the management’s ability to perform and produce solid results in a variety of environments.

LUKOIL Investment and International Exposure

So what differentiates ConocoPhillips from the other major integrated oil and gas companies like ExxonMobil [XOM: 81.63, 0.00 (0.00%)] and Chevron [CVX: 76.66, 0.00 (0.00%)]? There are many valid answers, including their position as the largest investor in Canadian oil sands, largest producer of oil and gas in Alaska, or heaviest asset concentration of natural gas versus crude — these are all great examples of how ConocoPhillips trumps the other “Big Oil” companies in terms of growth potential, but I would also like to add another word to the list: Russia. ConocoPhillips holds a 20% equity stake in LUKOIL, Russia’s largest producer of oil and the world’s second largest public company, next to Exxon Mobil, in terms of proven oil and gas reserves. Additionally, Russia is the largest non-OPEC oil producer, meaning that they are independent of any supply constraints that OPEC might decide upon, allowing them to benefit from the resultant higher prices. In short, Russia is a huge part of the global energy story and the only way for U.S. investors to gain significant exposure into their industry is through ConocoPhillips’ stake in LUKOIL, as the other major Russian oil and gas companies are completely nationalized.

In addition to providing excellent international exposure, the LUKOIL investment has paid off tremendously for ConocoPhillips. The 20% stake represents only 6% of ConocoPhillips’ assets, but this translates to a whopping 15% of net income. Because their effective tax rate on the LUKOIL investment is only 2.6%, this is and will continue to be a very profitable arm of their business. Although Russia’s geopolitical concerns may seem to increase the risk level to undesired levels, in actuality, LUKOIL’s near-nationalized state allows it to reap in many benefits from Putin’s arguably corrupt regime, including economic policies that lead to the vacuuming of smaller oil and gas companies under the wing of LUKOIL, and the maintenance of an unbelievably low tax rate at 28% to the Russian government (compare that to the U.S. rate at 45%). This over-exaggerated risk, coupled with Russia’s recent movements in Georgia, actually makes these assets undervalued in this market environment. Furthermore, the 20% equity stake includes a position on LUKOIL’s Board of Directors which requires unanimous approval for all major decisions.

Valuation and Strong Commitment to Investors

The greatest testament to the future of ConocoPhillips is the confidence its management has in the growth of its share price. Not only has the dividend been growing at a compounded annual growth rate of 15% over the last five years, but they have also instituted a monstrous share repurchase plan of $10 billion over the year 2008. In fact, $0.22 of the $3.50 second quarter earnings per share were directly attributable to the $2.5 billion share buybacks. With a thriving 2008 cash flow at $28.6 billion, ConocoPhillips is able to give nearly half of that back to shareholders in the forms of dividends and share repurchases without threatening its capital program. In short, this extensive share repurchase program implies that the management believes there is no better investment right now than ConocoPhillips itself. Take a look at some additional valuation metrics that underline the strong health of the business:

Dividend Yield: $1.88 (2.50%)
Trailing P/E Ratio: 5.60
PEG Ratio: 0.7
Market Cap: $114.64 Billion
WACC: 9.88%
ROE: 19.88%

Source: Bloomberg

Recommendation

As with any equity purchase, it is important to first determine your desired risk and diversification levels before jumping in the market. While ConocoPhillips still bears many of the risks that the rest of the industry copes with, their diversified segments, international exposure, and strong financial positioning make it a safer play in a volatile market. At the same time, unlike ExxonMobil and Chevron, the smaller-capped ConocoPhillips has strong CAGRs and unique exposure to the right emerging markets by emphasizing natural gas and investing in Russia’s LUKOIL. This is a recommended play to reduce some risk in an energy-oriented portfolio, or to expose yourself to the energy sector without bearing too much additional risk. In this type of market it is virtually impossible to accurately predict short-term commodity prices unless you have a Ph.D in Soothsaying — with ConocoPhillips, however, you can be well-positioned to ride the energy wave without making huge bets.

-Rishin Banker

Disclosure: The mutual fund the author is associated with is long COP.

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