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Why the ConocoPhillips Stock Buyback Means Money in Your Pocket

by | published February 11th, 2011

This morning, ConocoPhillips (NYSE:COP) announced that it was upping its quarterly dividend to 66 cents (a 20% increase) and authorizing another $10 billion in stock buybacks. This latest buyback is on top of a similar $5 billion move last year (of which the company has repurchased about $4 billion to date).

The announcement has certainly improved the short-term value of the shares (up about 2.5% today). But its significance goes well beyond any immediate impact on market price.

What we have here is a combination of the “traditional” intended reasons for a stock buyback and an indicator of where the oil market is moving – at least according to the major players in it.

We also have signals of two developments that mean significant profits are headed our way…

Before I explain, let’s explore those traditional reasons behind such a move.

The Six Traditional Benefits of A Stock Buyback

First, a stock buyback provides for a company’s earnings to be divided out among fewer remaining shares in the market. That means higher earnings per share (EPS), resulting in an almost inevitably higher price per share.

Second, to a company like ConocoPhillips – with substantial cash flow (revenues were $53.2 billion in the fourth quarter alone) – an important consideration is the return on excess cash. And stock buybacks provide a greater return (in enhancing the value of treasury stock) than a company can get simply leaving that cash in short-term money market accounts.

Third, the presence of excess cash exposes a company to takeover bids.

COP’s fourth-quarter profits came in at $2.04 billion. While that certainly covers the new 66-cent-per-share dividend, quarterly profits actually came in at more than twice that – $1.39 a share. That has led some analysts to believe that COP may announce a further dividend rise in March.

The company also ended 2010 with $10.4 billion in cash and short-term investments on hand, while reducing its debt-to-capital ratio from 31% to 25% year-on-year.

All of these elements, if left unattended, provide too much cash hanging out there to be ignored in an accelerating M&A cycle.

Fourth, a buyback allows the company to pass on extra cash to stockholders without increasing the dividend. If a pullback in revenue is anticipated (and COP had just such an event in the second quarter of 2010), the move can improve overall company financials.

Fifth, the buyback will usually increase the return on equity (ROE).
Obviously the more undervalued the stock is at the time of the buyback, the greater the increase. That is actually what the company is telling the market when it engineers a buyback – namely, that it believes its stock is undervalued. And generally, that translates into another pump in price.

Sixth – and most apparently, given the lowered number of shares outstanding, the buyback will boost aggregate demand for the stock.

The COP move calls to mind several other buybacks in the oil sector, especially the 2007 decision by Exxon Mobil Corp. (NYSE:XOM) to commit fully 80% of quarterly profits ($32 billion out of $40 billion) to repurchasing its own shares.

However, it also provides us with a clear signal of what is to come…

High Prices, Higher Profits

There will certainly be additional buybacks coming. But individual investors in the oil sector will be making profits whether their shares are subject to repurchase or not.

That’s because the COP move is telegraphing two company conclusions. First, the value of shares will be higher in the future than they are now.

Second, the sector itself will be experiencing accelerated oil pricing increases.
The XOM buyback in 2007, for example, preceded a significant run-up in crude oil prices and led to record profits for Exxon Mobil.

However, this second aspect does not automatically mean the big boys will be emphasizing oil extraction. In fact, we are witnessing a progressive increase in the percentage of that market controlled by non-traded national oil companies (NOCs); the Saudi Aramcos of the world.

COP is currently shifting the focus of its extensive restructuring plan to refining and distribution. It is moving downstream to compete with most of the other majors already emphasizing that sector.

And this is perhaps the single most important observation to take from the COP announcement.

The money made by oil majors will be coming more from intensifying their efforts in value-added production and distribution.

Gasoline and diesel, after all, provide greater profits than crude oil.

We should expect, therefore, to see the increasing movements in M&A among oil companies emphasizing the downstream sector. That just happens also to open up small and medium-sized players with well-focused and -managed approaches to fields below the threshold of NOCs or the remaining interests of majors in production.

Both of these developments will be making money for you.

Sincerely,
Kent

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  1. David Russell
    February 11th, 2011 at 16:09 | #1

    I thought as oil prices rose, profit margins in chemicals and refining dropped.

    I followed advise to look into oil service provider ETF’s. Is that still legit?

  2. Austin Dom
    February 11th, 2011 at 16:57 | #2

    Dr. Moors – You reference ExxonMobil several times in the above letter, and in some other recent notes. Can you provide more in-depth analysis of XOM as you did here for COP? Specifically, XOM’s heavy emphasis on share re-purchases vs. dividends seems very skewed. Are they trying to hedge against future oil price drops, or future earnings shortfalls? How do they stack up vs. COP? Thanks in advance for your consideration.

  3. Paul H. Gutknecht
    February 11th, 2011 at 18:33 | #3

    To me, stock buybacks say that the company does not have enough capital investment opportunities for its cash flow, or is afraid to invest because the future does not look bright for it. This seems especially odd for Conoco when oil prices will almost certainly rise, so what is Conoco really saying about what it sees as “good” investments in its future?

  4. Rich Pankhurst
    February 11th, 2011 at 19:01 | #4

    Dr. Moors, Would a conservative bet be to purchase IEZ, oil equipment or IEO, Exploration?

  5. Dmarque
    February 11th, 2011 at 19:59 | #5

    Dave:
    .
    Higher oil prices lead to increased production and exploration which lead to increased profits from higher volume.

    Marcus Irons

    @David Russell

  6. Bill Gasperso
    February 11th, 2011 at 20:03 | #6

    Dr. Moors: I recently read an promo ad about Zion Oil and Gas in the Levant Basin. How soon will they be in production and would this be a recommendation? Will the constant rocket attacks on the land of Israel hinder the development of this huge project?
    Just join today and I am certainly looking forward to getting my last 2 year losses back into my portfolio
    Thanks in advance for you direction.
    Bill Gasperson

  7. Arthur J Fisher
    February 12th, 2011 at 11:24 | #7

    EVERYTHING from crude will becom more expencive.
    profits normally follow upward

  8. Jeff Gray
    February 12th, 2011 at 15:06 | #8

    To add to what David Russell said on higher costs for refining and chemicals…if a barrel of oil costs say $30 to produce but oil is selling $100+ /b isn’t this a bigger profit potential for the COP, XOM’s as opposed to the very competitive world of retail gasoline?

  9. David Russell
    February 15th, 2011 at 08:11 | #9

    I was thinking COP had to buy substantial amount of oil on the open market to feed their downstream. I know they produce a lot of the more expensive “oil sands” oil. I may be wrong but seems like I remember CVX is one of the only majors that come close to suppling their fuel/chemical operations with oil needed, and not have to buy oil on the open market.

    I am also concerned about a -huge- drop off in demand once fuel gets close to $4.00. Guess I worry too much.

  10. Bob Canada
    March 2nd, 2011 at 17:47 | #10

    Today is March the 2nd. I subscribe to your Energy Advantage portfolio and am acquiring you portfolio. I have 2 questions.
    I am deciding how much I can afford to allocate to your portfolio so how many positions should i potentially get ready to purchase. I see 13 positions right now.

    Last question;
    Conocophillips has knocked the cover off the ball yet there has been no mention of how we should include such great moves in to our portfolio. I bought on paper but never heard how we should handle good info like this on ConocoPhillips.

    Regards
    Bob

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