ConocoPhillips Drills A Gusher In Q3, Increases Dividends And Buybacks

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ConocoPhillips (NYSE:COP) reported Q3 earnings this morning and – as expected given relatively high oil & gas prices – it was a very strong report. As a result, the company increased the base quarterly dividend 11% (from $0.46/share to $0.51) and boosted its existing share buyback plan by $20 billion to $45 billion. Today, I’ll take a closer look at the earnings, update investors on COP’s additional moves in the global LNG market, and discuss how the company is returning capital to its shareholders.

Earnings

Conoco’s Q3 EPS report certainly demonstrated the benefit of the yoy increase in oil & gas prices: the company’s average realized price was $83.07/boe – 46% higher than the $56.92/boe realized in Q3 of 2021. Into that higher price environment COP delivered production of 1.754 million boe/d of production, including record lower-48 production of 1.013 million boe/d, including:

  • 668,000 boe/d from the Permian
  • 224,000 boe/d from the Eagle Ford
  • 96,000 boe/d from the Bakken

That being the case, COP’s Q3 FY22 financial results were significantly higher as compared to last year’s quarter. Q3 highlights included:

  • Revenue was $21.6 billion (+86% yoy)
  • EPS was $3.55/share (+99% yoy).
  • Free-cash-flow was $4.7 billion, or an estimated $3.70/share
  • COP ended the quarter with $10.7 billion in cash ($8.42/share)
  • First oil was achieved at Gumusut Phase 3 in Malaysia

The slide below was taken from the Q3 earnings presentation and summarizes COP’s YTD cash-flow, including the whopping $14.5 billion in FCF the company has generated during the first 9 months of the year:

ConocoPhillips

More detailed information on the quarter can be found in COP’s Q3 supplemental report.

Free Cash Flow

In my last article on ConocoPhillips, I reported on COP’s FCF generation as a percentage of total revenue and compared its performance with that of some of its shale focused peers (see The COP Advantage Shines Through In Q2). As shown in the chart in that article, in Q2 COP only turned 27% of total revenue into FCF as compared to 47% for Diamondback (FANG), 39% for Occidental (OXY), and 46% for Pioneer Natural Resources (PXD).

Obviously, this is not a flattering metric for COP as compared to its peers – and that is even more the case considering Conoco generally achieves superior overall realized prices as compared to those peers, and has an arguably stronger & global portfolio as compared to its domestically focused shale drillers. For example, COP has Brent based production in Alaska and global LNG operations as key differentiating assets. Now, there are obviously many factors affecting FCF generation (the timing of cap-ex & maintenance expenses related to downtime, LNG shipment timing, asset acquisitions & divestitures, etc.), and as COP continues to integrate its two recent and big acquisitions in the Permian (Concho Resources and Shell’s assets), its FCF/Revenue ratio increased in 7 percentage points in Q2 from a rather dismal 20% in Q1. I was expecting further efficiency gains for this quarter.

However, the Q3 results released today showed the FCF/Revenue ratio was $4.7/$21.5 = 22%, down from 27% in the prior quarter. In comparison, PXD also announced Q3 earnings this week and its FCF/revenue ratio was $1.7 billion/$4.224 billion, or 40%. I expected much better from COP on this metric so this was a disappointment. The company obviously has further work to do to become a more efficient operator because this is a very important ratio for shareholders. After all, at current pricing, a 5% increase in FCF/revenue could easily add an additional $4-5 billion of FCF annually or in the neighborhood of an incremental estimated ~$3.50/share. That’s huge. Yet this is big opportunity for investors. I say that because COP currently trades at a TTM P/E of ~10.5x and a forward P/E of 9x despite the tremendous upside potential if the company simply gets more efficient at turning a larger percent of revenue into FCF as its peers are doing.

LNG

Back in June, I reported that COP was pivoting its growth strategy going forward away from shale oil and toward LNG (see COP Shifts Focus To LNG, Stock On Sale) and listed several recent strategic investments the company had made in LNG. (Note the stock is up 43% since that article was published on Seeking Alpha, so the stock was, indeed, “on sale” at that time).

Increasing its global footprint in LNG makes abundant sense given COP’s background in LNG (COP has been an innovative pioneer in LNG technology for over 50-years – since the company started its Kenai LNG facility in 1969), the planet’s need for cleaner burning fuels, and the fact that Putin has cut-off natural gas supplies to the EU and I doubt they’ll ever rely on Russia for natural gas supply again. Given the lack of adequate ex-Russian production and pipeline access to the EU, LNG appears to be the only short-, mid-, and long-term solution to increase natural gas supply to the EU.

This week, COP – already a stakeholder in the Qatari North Field East development JV (3.125%) – was reported to have taken a 6.25% stake in the Qatar North Field South (“NFS”) LNG project. Shell (SHEL) and TotalEnergies (TTE) had previously taken key stakes in the NFS project. In addition, we learned in the Q3 report today that COP has inked a companion terminal services agreement in Germany for a 15-year period at the prospective German LNG Terminal. The volume and terms associated with that agreement were not disclosed.

Going forward – and in the global quest for cleaner energy – COP is ideally positioned for greater demand-pull for more cleaner burning LNG. In the words of QatarEnergy chief executive Saad Sherida Al-Kaabi:

As we have previously emphasized, LNG produced from the North Field Expansion projects will have the lowest carbon emission levels in the world.

Today, COP is a leader in LNG Technology and licenses its Optimized Cascade Process throughout the world. Indeed, companies operating nearly all of the major LNG export terminals currently in operation today have licensed COP’s process technology:

ConocoPhillips

Indeed, in the 2021 Annual Report, the company said:

We are the second-largest LNG liquefaction technology provider globally. Our Optimized Cascade®LNG liquefaction technology has been licensed for use in 27 LNG trains around the world, with feasibility studies ongoing for additional trains.

Shareholder Returns

As I have mentioned in previous articles on shale companies that have adopted a (base+variable) dividend policy, leading financial websites (including Seeking Alpha and Yahoo Finance, for example) have had a hard time figuring out how to accurately report their yield. For instance, prior to today’s dividend increase most financial website reported COP’s yield as 1.45% based on its base dividend alone. However, as can be seen by this distribution summary taken from COP’s recent Sensitivity & Guidelines Presentation, the majority of dividend income is being paid through the variable dividend:

ConocoPhillips

NOTE: Updated annotations in red by the author.

As you can see from the graphic, total dividends declared and paid during FY22 will total $4.49/share. That equates to a 3.55% yield based on COP’s $126.51 closing price yesterday, or more than double the reported yield most major financial websites are reporting. This divergence of actual yield as compared to base dividend yield applies for the other leading shale producers as well.

Another point is that COP continues to significantly over-emphasize share buybacks as compared to dividends directly to shareholders. As can be seen in the graphic above, over the first three quarters of FY22 COP has spent $6.58 billion on buybacks and only $3.56 billion on dividends.

The $6.58 billion spent on buybacks this year has resulted in an average fully diluted share count reduction of an estimated 4.4% (1.328151 billion shares at year-end 2021 versus 1.269321 billion shares at the end of Q3).

In addition, note the $3.56 billion in dividends to shareholders still pales in comparison not only to the amount of cash COP has spent on share buybacks but also to the massive $10.7 billion cash hoard the company has built up (an estimated $8.42/share). Considering COP already has an A-rated balance sheet, its somewhat puzzling that the company has not made more use of the variable dividend to deliver much more cash directly to shareholders as peers EOG and PXD are doing. For example, note that PXD has declared over $25/share in dividends to shareholders so far in 2022. That being the case, COP’s quarter-over-quarter decrease in the variable dividend (to $0.70 versus $1.40) was a disappointment.

Risks

Being a commodity price taker, COP is exposed to global oil & gas prices and a commodity price downturn would obviously negatively impact the company’s financial returns (and variable dividend). A downturn could potentially come from high inflation and the resulting rising interest rates which could cause a significant global economic contraction and demand destruction. Longer term, the transition to EVs could also cause significant demand destruction for gasoline (i.e. oil).

Meantime, COP’s over-emphasis on share buybacks is a red-flag. I say that because energy companies are famous for increasing share buybacks during commodity price up-cycles (when the share price is high), and suspending buybacks during commodity price down-cycles when the share price is low and arguably represents much better value. Exxon (XOM) is exhibit #1 in this regard.

In addition, COP’s large cash-hoard suggest that CEO Lance could be shopping to make another large acquisition. That, in addition to the over-emphasis on buybacks, means he is forcing shareholders to double-down on oil & gas instead of rewarding them with increased dividend income, which the company obviously could do. Meantime, note that Lance, which is also Chairman of the Board (violating a significant governance rule …), recently cashed-in on his stock-based compensation by selling COP stock and buying leading copper producer Freeport-McMoRan (FCX) – see FCX: Why ConocoPhillips’ CEO Sold Oil & Bought Copper. Perhaps that move is an indication that Lance sees the EV transition as a big threat to oil despite the fact that he is forcing COP shareholders to effectively double-down on oil.

Summary & Conclusion

COP has continued the momentum of previous quarters and delivered very strong quarterly results in Q3. However, the company’s free-cash-flow as a percentage of total revenue continues to be significantly below that of its shale focused peers. However, its FCF profile is still very strong, and despite building up a huge cash-reserve ($10+ billion), the company has (finally) started to deliver some decent variable dividends to shareholders. However, COP shareholders – of which I am one – should expect more of a fair-shake on dividend income considering the company’s over-emphasis on stock buybacks, the already strong balance sheet, and the company’s very large cash position. That said, given the current commodity price environment due primarily to Putin’s war-of-choice on Ukraine that broke the global energy (and food) supply chains, investors need direct exposure to the global oil & gas market, and COP is a great choice in that regard. I reiterate my BUY position on COP because I believe oil & gas prices will remain strong through the winter and into next spring and that COP has tremendous upside if management can simply improve the company’s overall efficiency at turning a higher percentage of revenue into FCF.

I’ll end with a 5-year price chart of COP versus peers EOG and PXD and note that COP has finally shown the leadership that its superior production profile – with exposure to higher Brent pricing – suggests it should:

Data by YCharts

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