Reinstate Coverage at Neutral But the Journey
is Not Yet Over
¦
Bottom Line: We reinstate coverage on COP with a Neutral Rating and
$67/sh target price (a 10% discount to NAV). Given outperformance since
April 2010, it should not be a surprise that COP shares look fairly valued on
forward multiples and offer less upside to NAV than some other large cap
producers. We believe COP can grow its cashflow per share over time with a
5% dividend yield on top but other large cap producers have
underperformed into more interesting territory.
¦
On the Key Issues: We believe management can deliver 3-5% production
growth, improve margins 3-5% pa and are committed to sell assets to create
shareholder value. We are slightly above $15bn guidance on capex due to
our project spend assumptions. Importantly, although COP’s organic
cashflow of $16.8bn ($125/bbl Brent) does not cover $15bn of capex and
$3.5bn of dividends in 2012, rising cashflow, a robust balance sheet and
falling project spend beyond 2014 give management decent flexibility to
maintain the dividend in good times and bad.
¦
Management Can Create Further Value: COP has outperformed peers into
a natural gas price downturn by selling older assets tax efficiently and
returning the cash to shareholders. However, COP still has work to do. We
note COP is on a more challenged capex treadmill than some peers, given a
lower share of long duration assets than larger peers. Further asset sales
could allow COP to invest even more assertively in its existing shale
resource (2nd largest in NAM) or to capture new opportunities to close the
competitive gap more quickly.
Reinstating Coverage
COP’s restructuring has been a success. Asset sales have outperformed in terms of price,
the smaller upstream asset base has better growth potential / returns and the COP share
price has responded in kind, outperforming the large cap group average.
The key question on investors’ minds is whether COP shares can sustain this rate of
outperformance as the restructuring phase nears its end game and as organic delivery
becomes a more important component of shareholder returns. COP management has
been pretty clear about their offering to shareholders:
¦ Grow Production 3-5% from a 2012 base: We believe this is achievable. Key growth
drivers include US shales such as the Eagle Ford, heavy oil growth in Canada and
international growth projects that are under construction in Malaysia and Australia.
Most of this growth is oily or oil-linked natural gas.
¦ Deliver Rising Cashflow Margins: A key analysis in our 2011 50% CFPS Growth :
Lets do the Math report was the argument that select producers can drive cashflow
per barrel margins higher even in a flat oil price environment. COP believes their
margins can rise 3-5% pa in a flat price environment. COP’s low margin gas
production is falling and being replaced by higher value liquids – we believe margin
improvement is achievable.
¦ Cash Returns to Shareholders: COP offers a 5% dividend yield which results in
negative free cashflow after capex and dividends have been paid in 2012 in a $125/bbl
Brent oil price environment. Over time, the combination of rising cashflow will
eventually cover capex and dividend at lower oil prices. We note that COP’s overall
gearing is also low enough to cover dividends in adverse macro conditions.
¦ Progress Longer Term Growth Options: Historically, COP has not delivered strong
exploration through the drillbit. We believe shale will alter the landscape given COP’s
large acreage holdings in the US, Canada and internationally. On our forecasts, COP
can maintain its growth trajectory through 2016, giving some time to address this area
of investor skepticism.
Addressing 4 Investor Concerns
In this note we look at four key concerns of investors:
(1) Capex: Investors understand that COP’s cashflow should rise from a combination
of production growth and margin expansion but worry that capital spending will
crowd out this cashflow increase. In particular we have built shale models to more
closely capture onshore spending and a SAGD spending outlook. COP will need
to keep base capex on a tight leash to keep within its target given rising project
spend through 2016. As large projects such as APLNG and the Ekofisk
redevelopment near completion, then COP will have rising available cashflow to
drive growth more assertively in shale.
(2) Capability: Historically, COP has been focused on growth through M&A more
than through the drillbit and the exploration reputation reflects this – good reserve
additions around their existing positions but few mega discoveries. We think the
non-conventional shales will slowly change COP’s relative competitiveness
versus the other large caps over time. COP have already demonstrated good
acreage acquisition AND operational performance in the Eagle Ford. COP have a
large liquid rich acreage position in the US – delivering cost advantaged liquids
growth from this portfolio will be a key test over time.
(3) Longer Term Outlook: COP has laid out a decent case through to 2016 of 3-5%
production growth and 3-5% margin growth. This should deliver a respectable
increase in cashflow per share. Shrinking through the sale of legacy assets to
allow reinvestment for higher returns is a sensible strategy. However, concerns
emerge after 2016. At that point the peers will have a higher share of repeatable
or long duration production in the portfolio and hence will face less of a decline
challenge. Success in shale and/or exploration elsewhere is key.
(4) Franchise Assets: COP does not score highly on this metric today due to a lack
of longer lived LNG and heavy oil projects relative to peers who have invested
heavily in these areas over the past decade. COP does have a high share of
potential franchise assets in SAGD and liquid rich shale. It just takes time and
money to ramp these to a higher share of overall production.
(5) Why Own the Shares? We believe the yield will attract and becomes more
sustainable over time. However there is more value upside and better capex
adjusted cashflow growth at peers, as COP goes through a relatively high level of
project spend. Given shale success is a hot button issue for investors, it makes
sense to us to keep some of the future cash disposal proceeds to reinvest more
assertively in shale.
(1) Focus on Capex
COP aim to spend around $15bn on average over 2012-2016. Roughly 55% of this capex
is to keep production flat with the remainder being growth project spend and exploration to
replace reserves.
We have modeled the capex of COP in its key project and shale basins. We make several
observations:
¦ Project Spending is relatively heavy over 2012-2014. The largest bucket of this
spend is APLNG (a $20bn project with COP 42.5% interest) and the Ekofisk
redevelopment to extend the production of this giant field. We note BG has recently
announced a capex hike for their project from around $15-16bn to $20bn. This had
been well flagged but raises concern for APLNG. Roughly 50% of the capex increase
was a change in BG’s AUD fx assumption, with the remainder split across industry
cost inflation, permitting in Queensland and project scope improvements.
¦ COP capex in the base has fallen with US gas prices: Stripping out the larger
projects, capex in the base has fallen quite significantly since the financial crisis. We
believe much of this is related to the decline in US natural gas prices.
As APLNG spend drops out of the program and other long life projects e.g. SAGD and
Ekofisk reach maturity, then there is up to $4bn of spending becoming available either to
produce into a US natural gas price recovery or to increase production in liquid rich shales.
Our specific project driven capex spend model is shown below. Ekofisk, APLNG and
$800m pa SAGD JV payments are significant project components that will be substantially
complete by 2016. The main shale plays we have modeled directly are the Eagle Ford and
Permian. We note that as project spending fades, there is room for capex in natural gas
(price dependent) or on liquid shales to increase.
By 2016 for example there would be $4bn of additional base capex available for spend on
shale as major project spend rolls off.
The challenge for COP is that unlike XOM and CVX where cashflow covers capex
handsomely, COP cashflow of $16.8bn in 2012 does not cover both the dividend and
capex. Management has been open about this, and as cashflow margins
improve/production grows, organic cashflow will cover capex and dividends at lower oil
prices over time. We note COP has sufficient liquidity to meet any shortfall in the event of
an economic shock.
(2) Capability – Focus on the Eagle Ford
The common investor perception is that the majors are better at delivering large offshore
projects than managing labor intensive, manufacturing style shale drilling. There is also
some perception that the Independents have been the main force behind discovering new
shale plays and delivering the best IP rates from each play through assertive
experimentation.
The Eagle Ford is COP’s key liquid shale asset in the US. Analysis of well data (shown as
Burlington the lease holder) demonstrates that COP ranks in the top quartile for revenue
mix adjusted 30 day IPs in the Eagle Ford. Data in the COP April presentation suggests
COP is also an efficient driller versus peers.
This strong relative performance in the Eagle Ford will be an important metric for investors,
given the rise of shale in the investment thesis for the group, and also given COP’s
relatively robust share of shale acreage relative to its size compared with the other Majors,
albeit still lagging the large Independents on an EV adjusted basis.
We would like some disposal proceeds to be retained to invest more assertively in shale.
Outside of North America, early industry tests in Polish shale have been inconclusive but
this does not mean there will be no success. Perhaps more exciting is a liquids rich
opportunity in the Canning Basin of Australia where COP holds an option for a 75%
interest in 11 million gross acres. This is a marine shale with the potential for a liquids
rich window (we note NGL prices in Asia are strong). Three vertical wells will be
drilled in 2012. The Canning Basin has four distinct shale units with total thickness of
between 200m and 700m at a depth of around 3-16,000ft (average 12,000ft). In a
success case risked estimates have been as high as 229 TCF for this basin overall.
(3) Longer Term Outlook – Not Yet a Franchise
Producer
A focus on franchise assets has been a key theme of our upstream research. It is difficult
to deliver steady performance and the high multiples that go with it, unless a company has
solid franchise assets given E&P is a depletion business.
COP does not score highly on this metric today due to a lack of longer lived LNG and
heavy oil projects relative to peers who have invested heavily in these areas over the past
decade. COP does have a high share of potential franchise assets in SAGD and liquid rich
shale. It just takes time and money to ramp these to a higher share of overall production.
(4) Why Own the Shares – For Steady Growth and
Dividends
COP seeks to offer investors a more balanced route to shareholder returns with both
cashflow growth and a dividend yield.
¦ 3-5% pa Production Growth From 2012 base: With a large and mature asset base,
COP will not be able to out-grow its younger Independent E&P peers. However, 3-5%
production growth looks achievable.
¦ 3-5% pa Margin Expansion: A key part of our 2011 50% “CFPS Growth : Lets do the
Math” report was that select producers can drive cashflow per barrel margins higher
even in a flat oil price environment. COP believes their margins can rise 3-5% pa in a
flat price environment. COP’s low margin gas production is falling and being replaced
by higher value liquids – we believe margin improvement is achievable.
¦ Dividend Yield: At current levels, COP’s dividend yield is close to 5%. This payout
becomes sustainable at lower oil prices over time due to improved cash generation of
the portfolio.
¦ Low Capex Adjusted Cashflow Per Share Growth: Given a comp universe that
varies in growth and dividend, we use capex adjusted cashflow per share growth to
normalize performance across companies. COP stands towards the low end of the
pack on this metric.
¦ Forward EV/CF multiples: We use 2014 to account for faster growth at peers. On this
multiple, COP shares look fairly valued.
¦ Upside to NAV: COP shares trade at a discount to NAV, but other larger cap E&P’s
have underperformed to offer even more NAV upside.
¦ Earnings: We are broadly in-line with consensus for COP in 2012, higher in 2013 due
to our oil price assumptions. |
