Be Cautious on ConocoPhillips

 | Jun 25, 2014 | 11:00 AM EDT
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ConocoPhillips (COP) has had a great, two-year run, but now it's time to get cautious on the stock. Since spinning off its refining arm in June 2012, the shares of ConocoPhillips have gone from the mid-$50 range to just about $85 as of the beginning of last week. When one factors in the dividends, which represented a yield of over 5% in 2012, this major oil company's ascent has been remarkable.

Both improving margins and increased production drove Conoco's outsized returns. Conoco was (and is) able to attain this potent combination by divesting lower-margin assets in far-flung geographies and then investing the proceeds in to North American shale and Canadian oil sands, both of which offer higher margins and, at the moment, better growth prospects. These prudent investment decisions, coupled with the fact that Conoco was seriously undervalued compared to its U.S. big oil peers at the time, led to remarkable gains over the last two years.

That dynamic, however, is changing. While Conoco's five-year plan for growth and margin expansion are still under way, the company is now more than halfway through that plan, and the horizon beyond looks decidedly less certain. And, as we will see, after a gain of about 60% over the last two years, Conoco is no longer cheap when compared to its peers.

ConocoPhillips (COP) vs. ExxonMobil (XOM) and Chevron (CVX)
Source: Yahoo! Finance

This chart compares the relative performance of ConocoPhillips with its two U.S. peers: ExxonMobil (XOM) and Chevron (CVX). As you can see, Conoco's gain is almost double that of Chevron's. But it doesn't stop there. From a valuation standpoint, Conoco is now much closer to its peers than it used to be. Conoco trades at about 2x book value, which is right in the middle of Exxon (2.5x) and Chevron (1.67x).

Comparing enterprise value (EV) to earnings before interest, taxes, depreciation and amortization (EBITDA) yields a similar result. Conoco sits at 5.27x, Chevron is nearby at 6.48x and Exxon sits at 7.53x. Conoco may not be the most expensive of the bunch (Exxon is), but  it is no longer trading at an obvious discount to its peers, either. With a yield of 3.4%, Conoco's yield is now very close to Chevron's yield of 3.25%.

Since 2012, Conoco's production growth has generally outpaced that of its peers thanks to heavy investment in the shale and in oil sands. It is safe to say that Conoco's decision to be an early mover in the shale has differentiated the company from Exxon or Chevron. Conoco's decision to swap low-margin acreage for the shale and the oil sands was a "big win."

But the longer-term future of North American shale oil is much less certain. Many experts believe that the U.S. will soon see a glut in light sweet crude oil within just a few years. Unfortunately, there is a congressional ban on crude oil exports. While gasoline can be exported, there is not enough refining capacity to handle the expected supply of just a few years ahead. This suggests that there could be substantial volatility ahead for domestic oil prices, and this could put an end to Conoco's steady growth prospects. This is likely the reason why management gave guidance until only the end of 2016. They will probably make due on production growth promises through 2016, but there are good reasons to believe this growth momentum will not continue past that time.

In short, the easy money has been made in Conoco. That's not to say that Conoco is no longer a good investment. In fact, it could easily continue its pattern of double-digit returns for the next two years. However, Conoco is no longer the screaming buy that it used to be.

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