ConocoPhillips Upped to Neutral

We have upgraded our long-term recommendation on a major global exploration and production (E&P) company − ConocoPhillips (COP - Analyst Report) − to Neutral from Underperform.

The better-than-expected third quarter financial results, its robust crude oil production growth as well as its pipeline of project start-ups are the main drivers behind our upbeat note.

ConocoPhillips reported impressive third quarter results that exceeded our expectation and were also up by almost 2.9% from the year-earlier profit. This came on the back of higher-than-expected production of crude oil from its high-margin areas like the Eagle Ford and Bakken. The third quarter marked the completion of the first full quarter of operation for ConocoPhillips as a pure play oil and gas producer after the spin-off of its refining and marketing business. The midstream business now operates as Phillips 66 (PSX - Snapshot Report).

The company’s exploration initiatives in the liquids-rich plays are gaining momentum through the Eagle Ford, Bakken and North Barnett shale plays. It is stepping up its drilling activities in the North American onshore liquids-rich plays and expects combined production from its Eagle Ford, Bakken, and Permian acreage to exceed 200 thousand barrels of oil equivalent per day (MBoe/d) in 2013.

Again, ConocoPhillips has a pipeline of project start-ups that are likely to fuel its production growth story. These include the Malaysian deepwater projects, the liquefied natural gas (LNG) project in Australia, the UK, Norway, and the Canadian oil sands, besides the U.S. Lower 48 liquids-rich plays.

As part of ConocoPhillips’ three-year strategic plan, the Houston, Texas-based company plans to divest assets that do not fit well with its business model. It has generated $2.1 billion in proceeds from asset sales for the first nine months of 2012 and maintained a divestment target of $8–10 billion by the end of 2013. The proceeds are earmarked for portfolio optimization, debt reduction and increasing shareholder distribution.

However, the company’s near-term weak production volume keeps us wary. Its production declined almost 1% in the most recent quarter. The decline was mainly due to the impact of divestitures and maintenance. In addition, the natural decline in fields also resulted in the weak production. This year’s production guidance range was consequently narrowed to 1.570-1.580 million barrels of oil equivalent (MMBOE/d) from 1.565-1.585 MMBOE/d.

The third quarter also highlighted the company’s cash flow deficit issue. Again, management remains committed to maintaining the dividend payout as its highest priority. As operating cash flow is currently below the necessary level to cover its costs and dividend payouts, the cash flow deficit will likely linger for 2013.

Hence, in view of above discussion, we expect the stock to perform in line with the broader market.