ConocoPhillips' Best Moves in 2016

By Matthew DiLallo Markets Fool.com

Image source: ConocoPhillips.

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ConocoPhillips(NYSE: COP) investors have endured a couple of brutal years, with the company's stock dropping more than 60% from its peak in the middle of 2014 before hitting bottom earlier this year. But the stock is up sharply from the bottom, and is now up by double digits for the year thanks to several smart moves. Here's a look back at three that should continue to pay off in 2017 and beyond.

Biting the bullet and resetting the dividend

In early February, ConocoPhillips announced a complete 180 on its dividendpolicy, deciding to reduce the payout by two-thirds after spending the prior year pounding the table that the dividend was safe and remained its top priority. The decision to slash the payout, however, was a prudent move given the continued slump in oil prices, which was starting to put pressure on the balance sheet. That move, combined with additional expense reductions, would improve the company's net cash flow by $4.4 billion.

These efforts also dramatically reduced the company's cash flow breakeven point, which had been $75 per barrel but is now just $50 per barrel. That lower breakeven level increases financial flexibility going forward. Not only can it better withstand lower oil prices, but it has more options when prices rise.

Taking the first step away from the deepwater

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Another tough decision the company made as a result of the downturn was to begin a phased exit of deepwater exploration because it felt the risks of were not worth the rewards. That is after the company drilled a string of expensive dry holes in recent years. One of its latest came this past June, when the first exploration well of the Shelburne Basin joint venture between supermajor Royal Dutch Shell (NYSE: RDS-A)(NYSE: RDS-B), Canadian oil giant Suncor Energy (NYSE: SU), and ConocoPhillips came up dry. Suncor Energy said that its 20% stake in the ill-fated well cost the company 105 million Canadian dollars. Given ConocoPhillips' larger 30% stake, it saw an even greater investment go down the drain.

Image source: Suncor Energy Corp.

That dry hole aside, ConocoPhillips did take the first step out the door earlier this year after agreeing to sell its Senegal assets, including two recent discoveries, to Australia's Woodside Petroleum. The company completed that sale in October for $440 million, which was above the asset's $285 million carrying value, so the company did create some value from these discoveries. Meanwhile, that deal not only provided money to reduce debt but set the stage for the next phase of the exit.

Charting a new way forward

These moves enabled the company to establish a new strategy for the future. Driving its distinct approach is a unique set of capital allocation priorities, which are as follows:

  1. Invest what's required to maintain production and pay the dividend.
  2. Grow the dividend on an annual basis.
  3. Reduce debt to $20 billion and target an A credit rating.
  4. Pay 20% to 30% of cash flow from operations out to investors via dividends and stock buybacks.
  5. Grow production in a disciplined manner.

In addition to setting these priorities, the company put into motion actions to accelerate value creation. These included authorizing a $3 billion share repurchase program, which it would pay for by selling $5 billion to $8 billion of assets, primarily consisting of North American natural gas properties.

These moves position the company to grow shareholder value in the years to come. For example, if oil stays around $50 per barrel, the company will generate enough cash flow to increase the dividend, reduce debt, repurchase shares, and grow production by up to 2% annually. Combined, these initiatives should drive total annual returns between 5% and 10% per year at that oil price. Meanwhile, if crude improves to $60 a barrel, the company can return more cash to investors and grow output by up to 4% annually, which should yield 10% to 15% total annual returns. Finally, at $70 oil, the company can accomplish all its capital allocation priorities while fueling up to 8% production growth, which should deliver 15% to 20% total annual returns. This flexibility is something the company has never had before.

Investor takeaway

ConocoPhillips needed to make several tough decisions to reposition itself so it can thrive at lower oil prices. That is exactly what has happened, evidenced by the fact that the oil producer reduced its breakeven point from $75 oil down to less than $50 per barrel. Because of that, the company is in a position where it does not need higher oil prices to create value for shareholders, but if those prices come, it has the flexibility to accelerate value creation.

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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.