Choose This E&P Leader for Income and Growth


The operations of integrated oil majors can be split into three categories, all of which have very different business dynamics. First is the more public face of oil companies, the refining and marketing business. This includes the service stations where you fill up your car, and the big refineries alongside some highways in the U.S., also known as the "downstream" side of oil and gas. Next is the "midstream" side of the business, which essentially involves the transportation of oil by pipeline, rail, truck, etc. The third side is exploration and production (E&P), which includes finding and drilling for crude oil, then transporting it all over the world. One company that is an excellent play on E&P, also known as the "upstream" side of the business, is ConocoPhillips .

The E&P business
Pretty much all of the integrated majors are involved in both E&P and the refining and marketing businesses. For example, ExxonMobil derives 64% of its earnings from E&P and 36% from its refining, marketing, and chemicals operations. Despite ExxonMobil's claim that its refining costs are much lower than its peers, the E&P side of the business carries much higher profit margins and lower margin volatility than the refining and marketing side.

To further highlight the discrepancy in profitability between the two sides of the oil business, consider that 85% of Chevron's earnings are a result of E&P, even though it makes up just 27% of the company's total revenues. In other words, of the $58 billion in E&P revenue last year, $21.9 billion was profit (net profit margin of 37.8%). Refining and marketing sales totaled $183.9 billion, but resulted in just $3.86 billion of profit, for a net profit margin of just 2.1%.

While the refining and marketing business can be lucrative, especially with sales volumes in the $100's of billions, the margins are simply too low for comfort. Consider that if the margins drop by even a small amount, the refining and marketing division could indeed lose money, while the large margins in E&P make its profitability less sensitive to margin fluctuations.

Why choose Conoco?
Up until a year or so ago, Conoco was an integrated oil and gas company. The company's downstream operations were split off into a new company called Phillips 66, leaving ConocoPhillips as one of the largest independent E&P companies in the world.

Conoco has E&P operations in the U.S., Norway, U.K., Canada, and several other countries around the world. The company averages around 1.6 million barrels of oil per day, with just under half of that occurring in the U.S.

Conoco has several advantages over its rivals as a result of being a standalone E&P company. The spinoff allows Conoco to focus entirely on optimizing its E&P business assets, which generally carry more profitability than the upstream business. The company also has economies of scale working in its favor, as it is the largest standalone E&P company in the world, and therefore can operate more efficiently in terms of such expenses as transportation and personnel.

For a comparison to another standalone E&P company, consider Marathon Oil , which also split off its downstream operations in the recent past. For the current fiscal year, Marathon is expected to earn $2.70 per share, or a total net profit of $2.16 billion on $16.04 billion in revenue, for a net profit margin of 12%. Now consider that Conoco is projected to earn a net profit of $7.22 billion on $54.51 billion of revenue, or a profit margin of 13.3%. Not a tremendous difference, but a significant one that highlights the effects of economies of scale on two similar operations of different sizes.

The numbers: still a good value after the gains?
The main concern that a lot of investors see with ConocoPhillips is that the company has done remarkably well recently, at least as far as share price is concerned. In fact, since July shares have risen by about 20% and are just under their 52-week high.

Source: TD Ameritrade

Even after these gains, Conoco still looks pretty attractively priced, trading for just 12.9 times TTM earnings. The company has set goals for itself of both 3%-5% production growth and 3%-5% margin expansion over the coming years, which should combine to give annual earnings growth in the high single-digit range.

Conoco is also one of the best dividend payers in the sector, currently yielding 3.85% with an excellent record of raising the payout every year. The current yield represents a payout ratio of around 46%, so the company should have plenty of room to raise the payout going forward, especially if it is able to meet its goals with regards to production growth and profit margins.

Bottom line
With a very profitable business that only looks to be getting stronger, ConocoPhillips definitely deserves consideration by any investor looking for a great combination of income and growth.

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Matthew Frankel has no position in any stocks mentioned. The Motley Fool recommends Chevron. 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.

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