Is ConocoPhillips Really the Top Oil Stock for a High Yield?

Image source: ConocoPhillips.

ConocoPhillips stunned investors earlier this year when it slashed its dividend by two-thirds in order to preserve cash flow amid the worst downturn to hit the oil patch in decades. What was so stunning about this decision was ConocoPhillips prior insistence that its dividend was "safe" and its "top priority." Having said all that, despite the company's deep dividend cut BofA Merrill Lynch recently called the company its "top free cash idea" meaning ConocoPhillips was its best idea for a high yield going forward. While that is a curious designation for a stock that no longer supports a high-yielding dividend, there is a good reason why it has been given this label.

Protecting what matters most

The crashing price of crude forced oil companies to take a hard look at their dividend payments to investors. Many concluded that they just couldn't afford to continue making these payments, resulting in a rash of dividend cuts over the past year. For example, Marathon Oil slashed its dividend 76% in a bid to conserve cash flow. It's a move that will save Marathon Oil $425 million per year, which was needed to help replenish its cash position after the company had to pay off $1 billion in debt due toward the end of last year. Marathon Oil concluded it needed to make these changes to maintain a strong balance sheet during the downturn, which had become its most important priority.

ConocoPhillips made a similar shift in priorities when it announced plans to reduce both its dividend and its capex earlier this year. In making those cuts the company would save $4.4 billion in net cash flow this year, which significantly improved its breakeven point so that the company could protect its balance sheet strength. Having said that, with oil prices moving higher, ConocoPhillips is now in the position where it should start generating excess cash flow given its much lowered breakeven point. It's that excess cash that has caught the attention of BofA Merrill Lynch.

Image Source: Marathon Oil Corporation.

Excess cash flow opens up more options

ConocoPhillips has already made it clear that it intends to grow its dividend once oil prices recover. However, that doesn't mean it will immediately bring its payout back to its former level. Instead, the company is targeting to have a dividend that can grow on a sustainable basis in all cycles. That suggests it's dividend payout rate will remain lower than before. However, because of that lower rate the company has the potential to generate substantial excess cash flow in the future as oil prices improve.

While some of that cash flow will be earmarked toward increasing capex to grow production, those investments will compete directly with share buybacks. That's because ConocoPhillips is adjusting how it views growth going forward, with it no longer focused on absolute production growth, instead turning its focus to growth on a per-share basis.

It's this stock buyback potential that is the fueling BofA Merrill Lynch's excitement about the company's yield potential. BofA Merrill Lynch sees the company potentially supporting very competitive growth on a per share basis going forward that could lead to robust total returns for shareholders. That's why it has the stock rated a buy, and set a $71 per share price target, which is well above the company's current $45 per share price. In other words, investors shouldn't buy ConocoPhillips solely for its dividend yield, which is no longer as strong as it once was, but instead buy it for its total yield potential given that the company plans to start returning a lot of cash to investors via buybacks.

Investor takeaway

While ConocoPhillips no longer has one of the highest dividend yields among oil stocks, it has the potential to deliver a strong total yield going forward. That's because the company plans to put a greater focus on stock buybacks in the future. It's that buyback component that makes it a compelling high-yield play even if the bulk of the yield won't be paid in cash but received via stock price appreciation as the company chips away at its share count.

The article Is ConocoPhillips Really the Top Oil Stock for a High Yield? originally appeared on Fool.com.

Matt DiLallo owns shares of ConocoPhillips. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.