Strike Oil by Following in Buffett's Footsteps

Legendary investor Warren Buffett is very bullish on  ConocoPhillips (COP). According to a recent regulatory filing, Buffett's  Berkshire Hathaway (BRK.B) has amassed more than 83 million shares in the oil major as of the end of September. This was well up from the 17.5 million shares Berkshire held at the end of March, so clearly Buffett's conviction in the stock has strengthened considerably. In fact, Berkshire Hathaway is now Conoco's largest shareholder.

Buffett isn't the only savvy investor buying up Conoco's shares. Another eight of our Ultimate Stock-Pickers hold a stake in the firm as well, making its stock one of the most widely held by these leading investment managers. Conoco is also one of the largest holdings in Chris Davis and Ken Feinberg's  Davis New York Venture  (NYVTX). In their fund's Fall 2008 Review, Davis and Feinberg make a compelling case that investments in energy and natural resources could play a role in building the fund's compound return over the next decade or so:

"As developing nations add to worldwide incremental demand for commodities like oil and natural resources, we believe the long-term average price ranges for such resources could climb, notwithstanding the recent pullback in certain commodity prices. Consistent with our energy and natural resource-related investments to date, we will remain on the lookout for disciplined capital allocators who can generate attractive profits for shareholders given a stable price environment and windfall profits under more bullish scenarios."

So, Conoco is clearly on our radar screen. As such, I thought it would be a good time to check in with Morningstar analyst Allen Good to dig deeper into this company.

Allen, will you please give us a brief overview of the ConocoPhillips' business?

ConocoPhillips is the smallest of three U.S. supermajor integrated firms. What differentiates Conoco from its domestic peers is its production profile and reliance on refining operations. Natural gas represents about half of the Conoco's total 2007 production, whereas oil accounts for more than 60% of Exxon and Chevron's production.

Conoco also generates most of its revenues in the U.S. market, thanks to its position as the country's second-largest refiner. But the company's exploration and production operations still account for most of the net income, with a significant chunk coming from overseas. In 2007, Conoco's exploration and production segment generated nearly 60% of total income, with international accounting for about half of the total.

What is the basis for the company's narrow economic moat rating?

Conoco deserves a narrow economic moat because it has consistently delivered a return on invested capital in excess of its cost of capital and we believe it will continue to do so. Returns over the past five years have averaged more than 15%. We think that Conoco, like other oil producers, benefits from OPEC's ability to influence global supply and stabilize pricing. With supplies of oil from non-OPEC companies dwindling, OPEC should become even more powerful, which would likely benefit Conoco and other producers over the long run.

Additionally, the company's ownership of an extensive natural gas pipeline, gathering systems, and facilities to unlock stranded natural gas resources (not to mention the difficulty involved in obtaining approval for and constructing these assets) further strengthens its economic moat, in our view.

How do you view Conoco's management team?

We hold Conoco's management team, led by James Mulva since 2002, in high regard. It seems to be on the forefront of recognizing the new role major integrated oil companies will play in future resource development. Although you could question the price paid for some assets, Conoco certainly has proved to be more aggressive than some of its competitors in its drive to acquire production and reserves. The acquisition of Burlington Resources in 2006, the purchase of a 20% equity stake in Russian oil and gas firm Lukoil, and most recently the outbidding of BG Group for Australia's Origin Energy are all testaments to the company's drive to secure future production. Deals like Lukoil and natural gas projects in Qatar demonstrate management's ability to work well with foreign governments and national oil companies. Discussions with management revealed a willingness and flexibility when dealing with foreign governments that we believe will lead to further deals.

How would you characterize the firm's financial health?

Like its peers, Conoco is in strong financial shape, having used the high oil prices and inflated refining margins of the past few years to pay off debt and build a nice cash balance. At the end of the third quarter, the company was sitting on about $1.1 billion of cash and debt to capital was below 20%. Its cash flow from operations has easily funded capital expenditures.

Despite the weak price environment, management intends to keep capital spending at 2008 levels for the next year. We do not anticipate cash flow problems in the future; however, if low oil prices persist, cuts in capital spending could likely free up enough cash to maintain the dividend.

Why do you believe the stock is undervalued?

The stock trades at a deep discount to our fair value estimate, which is based on a discounted cash flow analysis incorporating three different scenarios. Each scenario uses different oil and natural gas price assumptions for the fourth and fifth years in our model, while the first three years use the NYMEX futures curve. The three scenarios--high, base, and low--assume oil prices in perpetuity of $150, $80, and $50 per barrel and natural gas prices of $15, $9, and $5 per mcf, respectively. We adjust other inputs such as production costs, refining margins, and capital spending to match each price environment. After weighting each scenario's valuation-- 20% high case of $176 per share, 40% base case of $102 per share, and 40% low case of $66 per share--we arrive at a $103 per share fair value estimate. We believe the market's current valuation of Conoco assumes oil prices closer to $25 into perpetuity, which we deem as a very unlikely scenario.

What do you consider to be the key risks for investors?

As a supermajor integrated firm, Conoco faces many risks. As the company expands internationally and enters more agreements with governments and national oil companies, it must deal with geopolitical risks. Conoco will have to navigate these political minefields carefully to ensure smooth operations. The company has already found itself the in the unfortunate position of taking a loss of $4.5 billion as a result of an asset expropriation in Venezuela.

Of course, Conoco will always have exposure to global commodity movements. Whether it's oil prices, steel prices, or gasoline prices, Conoco will feel the effects. Fortunately for Conoco, its broad range of operations offers some diversification and safety as one segment may benefit from an environment that is harmful to another.

Conoco's aggressive approach to acquisitions puts the firm in danger should commodity prices continue their recent fall. While it's likely global energy demand for oil and gas will continue to rise in the long term, the risk remains that technology, conservation, and economic weakness could keep prices in check, which could mean that Conoco's investments may not pan out as expected.

The Ultimate Stock-Picker's Take
I tend to agree with Allen's views on Conoco and the risk/reward trade-off with the stock looks very attractive to me. The shares are presently trading at about half of our fair value estimate and the stock also looks cheap on a variety of other metrics--price/book value is just 0.9 times (and book value appears to be conservatively stated) and forward price/earnings is a modest 7 times. Conoco boasts an attractive 3.5% dividend yield as well. I also believe that our highly concentrated portfolio could benefit from some exposure to the oil and gas industry. So, ConocoPhillips could be a worthy addition to our Ultimate Stock-Picker's portfolio, but I want to dig deeper into a couple more stocks on our watch list before making a final decision. To be the first to see our analysis of other stocks on our watch list as well as my eventual decision on Conoco, please be sure to sign up for our free e-mail alerts.