ConocoPhillips' Biggest Win in 2016
Image source: Getty Images.
Like most of its peers, oil giant ConocoPhillips (NYSE: COP) found itself flat-footed when oil prices started to come crashing down in the middle of 2014. The company was in the midst of a major expansion phase, which required it to spend more money than it brought in even at triple digit oil prices. Needless to say, the company could not keep up that spending level given the new market reality. This predicament forced it to make several difficult decisions, which ultimately lowered the company's breakeven level from more than $75 per barrel to less than $50. That new lower breakeven point represents the company's biggest win of the past year.
Facing reality
Early on in the downturn, ConocoPhillips' primary focus was to cut costs as it adjusted to ever lower oil prices. The company's two chief targets were its capex budget and operational expenses. Heading into 2015, for example, the company estimated that it would spend $13.5 billion on capex, which was 20% lower than the prior year. However, as the year wore on the company slowly chipped away at that number. By the end of 2015, the company had cut it down to $10.2 billion and only expected to spend $7.7 billion in 2016 due to the completion of several large projects. Meanwhile, the company cut operating costs from $10.5 billion in 2014 to an initially projected $7.7 billion in 2016.
However, as the company continued to face the reality that oil prices were not heading higher anytime soon, it made the tough decision to cut even deeper. These reductions included the decision to exit deepwater exploration and to significantly reduce the dividend, which would go from $0.74 per share each quarter to just $0.25 per share. These moves, along with additional capex and operating cost cuts, would increase ConocoPhillips' cash flow by $4.4 billion on an annual basis, enabling the company to perform better at lower oil prices.
As a result of its continued efforts to push down costs, ConocoPhillips now believes that it only needs to spend $5 billion on capex per year to maintain its current production level. Meanwhile, it sees operational expenses averaging about $5.2 billion per year. These spending levels, when combined with the new dividend rate, pushes the company's break-even point to below $50 per barrel. For ConocoPhillps, that level should be low enough to sustain its operations in any future oil market.
Image source: ConocoPhillips.
Focusing on flexibility
Aside from cutting expenses, the other crucial driver of ConocoPhillips' transformation into a low-cost oil company is its strategic shift away from major growth projects such as LNG, oil sands, and deepwater developments. Instead, the company will focus on driving future growth from short-cycle shale plays.
Under its old model, ConocoPhillips would invest billions of dollars over several years to bring several major projects online. For example, ConocoPhillips and French oil giant Total (NYSE: TOT) first started development on their Surmont 2 oil sands facility in 2010. The 50/50 joint venture spent billions of dollars developing the project, which did not deliver first oil untilSeptember of 2015. Meanwhile, the ConocoPhillips/Total venture will not reach its maximum production capacity of 118,000 barrels per day until 2017.
Contrast this withhorizontal shale development, which can deliver first oil in a matter of months. While shale wells typically only produce 1,000 barrels per day in the first year, the company can drill hundreds of them each year at the cost of around $5 million per well. Not only do the faster cycle times for shale developments meanConocoPhillips can add oil more quickly, but it canadjust the spending rate up or down to match the oil market. This flexibility means the company can grow faster when prices are higher and quickly capture the upside.
For example, at $50 oil, ConocoPhillips expects that it can increase production by up to 2% per year while also growing the dividend, buying back stock, and paying down debt. Meanwhile, if prices rise to $60 a barrel, it can allocate more capital across those priorities while also growing production by up to 4%. Finally, at $70 oil it can allocate even more money to each area and potentially boost output by as much as 8%. This increased flexibility ensures that ConocoPhillips can deliver sustainable shareholder returns in any oil price environment. It is flexibility that would have never been possible if the company hadn't lowered its breakeven level and didn't have a vast resource position across most of the major resource plays in North America.
Investor takeaway
ConocoPhillips is in a much stronger position at the end of 2016 than it was at the beginning of the downturn. The company had to make several difficult decisions to drive this transformation, which ultimately pushed its break-even point to less than $50 per barrel. However, that level represents a significant win for the company because it is now in a stronger position to manage through any oil price environment.
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Matt DiLallo owns shares of ConocoPhillips. The Motley Fool recommends Total. 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.