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Value Investor
Wealth Building Opportunites for the Active Value Investor

September 24, 2021

Our interest in oil and natural gas exploration and production (E&P) companies has been warming up lately. Many of these stocks are beaten down, yet oil prices have remained resilient, leaving producers like ConocoPhillips meaningfully undervalued.

We are initiating coverage of ConocoPhillips (COP) with a BUY rating.

Our interest in oil and natural gas exploration and production (E&P) companies has been warming up lately. Many of these stocks are beaten down, yet oil prices have remained resilient, leaving producers like ConocoPhillips meaningfully undervalued.

Four issues seem to be weighing on E&P stocks like ConocoPhillips. First, investors are increasingly looking to avoid climate-unfriendly companies. Also, investors have low interest in exposure to volatile and unpredictable oil and gas prices, especially since the entire energy sector has a tiny 2.6% weighting in the S&P 500 index. Another concern is that company managements will lose their new-found capital spending discipline. And there is always the risk that OPEC+ opens their oil production spigots, sending oil prices down.

Yet, supporting energy prices is resilient demand, which has nearly returned to pre-pandemic levels despite still-subdued jet fuel and gasoline demand. Despite urgent calls for alternative fuels to help mitigate climate change, the challenges to reducing the reliance on carbon-based energy remains daunting, with a wholesale shift likely to be slow-moving and measured in decades.

Subdued supply growth should also support oil prices. Major global energy companies are under increasing pressure to reduce their production to help fight climate change. And, following years of aggressive drilling in the U.S., shale oil’s most productive days may be in the past. If so, domestic production, now running about 15% below 2019 levels, may be permanently lower.

Given this, we see a contrarian opportunity in ConocoPhillips. The company is the world’s largest independent E&P company, with most of its production in the United States, Canada and Australia. With the news that it is acquiring Royal Dutch Shell’s Texas assets for $9.5 billion in cash, we believe the time to buy has arrived.

We like Conoco’s low valuation at about 5x EV/EBITDAX1. It also offers a free cash flow yield of close to 12%2 – an indicator of the company’s strong cash production as well as its discounted price. Most analysts have oil prices of perhaps $55-$60/barrel in their earnings estimates, implying that profits and cash flow will be stronger than estimated, as oil has traded close to $70/barrel for most of the year so far.

Conoco’s balance sheet is robust, with an investment-grade balance sheet. While it is spending most of its cash hoard on Royal Dutch Shell’s Texas assets ($9.0 billion cash balance at the end of the second quarter), we see its strong free cash flow leading to a rebuilding of its balance sheet.

Conoco has publicly stated that it will limit its capital spending to 50% of its annual cash flow, even after its Shell purchase. We believe that the management is unlikely to renege on this commitment. For perspective on the size of this cash flow, at $50 oil, the company said the deal would allow for an incremental $10 billion of cash to be returned to investors over the next decade. This is on top of management’s guidance for $65 billion in next-decade cash distributions before the Shell deal. For perspective, Conoco’s market cap is about $76 billion. This is a remarkably attractive prospect, particularly at $70 oil. Conoco shares currently have a dividend yield of about 2.8%, offering a respectable base-level cash inflow to shareholders that appears rock-solid.

We are placing an 80 price target on ConocoPhillips shares. The shares have jumped some on the Texas acquisition news, so investors may want to buy a partial position now, then wait for any pullbacks. BUY

Please feel free to reach me by email if you have questions or comments – I’ll respond as quickly as possible.

  1. EV/EBITDAX is Enterprise value to Earnings before interest, taxes, depreciation, amortization and exploration spending. Similar to EBITDA, the EBITDAX is a proxy for cash earnings, which also excludes exploration costs that run through the income statement.
  2. Free cash flow yield is the company’s cash flow from operations less capital spending, divided by its market capitalization. It is a measure of how much free cash flow is at the company’s disposal after it maintains its business, which can then be used to pay down debt, pay recurring or special dividends and/or repurchase shares.