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Adapting to oil's new reality

The industry has been battered by price volatility over the past two years. For ConocoPhillips, adaptation is the key to not just surviving, but thriving

ConocoPhillips's boss Ryan Lance isn't waiting around for the oil market to ride to the rescue with higher prices. Instead, Lance is remaking the company he runs into one that can prosper in a world awash in crude and where oil prices may face downward pressure for years to come.

"It's a well-supplied world when you look at what's happening in the Middle East, Russia, around the world and what's happening with the unconventionals. So that's what we worry abouthow do you run your company at a lower price deck over time," Lance told AOGC Daily.

Oil prices could see a rebound in the coming months as supply and demand come into balance and refiners ramp up, drawing down inventories, Lance says. But counting on those higher prices sticking around would be a mistake. Higher prices are only going to draw supply back to the market, and the increasing focus on short-cycle investments like American tight oil mean that supply response will come faster than before. "There may very well be some spikes in prices but those spikes are going to generate a lot of supply and cause a lot of volatility and cause the price to go back down again quickly".

This is bad news for oil bulls still counting on low prices to drag output down and trigger a sustained price recovery. In addition to the US, Middle East and Russia, which are capable of growing output at $50-per-barrel oil, Lance points to his own company's global portfolio and doesn't see that playing out. "Our Asia position is growing. We're flat in Europe in the North Sea. We're flat in Alaska. We're growing in Canada," Lance says. "I don't see the four-to-five-percent production decline coming in that non-Opec, non-Russian and non-US space, so I worry about that."

New prices, new reality

The upshot for Lance and ConocoPhillips? "You had better figure out how to run a company at $40 and $50/b oil." Lance has set about doing that by putting the company on a sturdier financial foundation and reshaping its portfolio into one that works better in oil's new reality.

To that end, ConocoPhillips has focused on paying down debt and funneling cash back to shareholders, rather than plowing it back into its operations to lift output. The strategy has been accelerated by a couple of major asset sales in recent months. First, the sale of much of the company's Canadian business for $13.3bn to Cenovus, followed shortly by the sale of its San Juan Basin natural gas business in the US for $3bn to Hilcorp. The deals easily exceeded a $5bn to $8bn divestment target the company laid out in November last year.

Discussions around the Canadian deal started early this year with narrower talks over selling the company's Deep Basin gas assets to Cenovus. But those negotiations quickly expanded when Cenovus expressed an interest in buying ConocoPhillips out of its 50% stake in the Cenovus-operated Foster Creek Christina Lake oil sands project. It ended up being the largest upstream deal since Shell's takeover of BG two years ago. "It was a great opportunity for us to do what we needed to do from a balance sheet repair and return to shareholder perspective," Lance said of the deal.

Of the $10.6bn in cash ConocoPhillips got as part of the Cenovus deal, about $7bn went directly to paying down debt, meeting the company's target of reducing its debt to $20bn two years ahead of schedule. It now hopes to reduce the debt to $15bn by 2019 as it looks to reclaim its top-notch investment rating, which took a hit during the downturn. Another $3bn or so went back to shareholders through an expanded share buyback programme. Investors loved the Cenovus deal, and pushed ConocoPhillips's share price up around 8% on the day it was announced.

The broader strategy, though, isn't without its critics. ConocoPhillips occupies something of a no man's land for some analysts. It's too big to compete on output growth with smaller shale companies touting double-digit yearly expansion. Nor does it try to compete with the integrated majors since its split from Phillips 66, the refining and marketing business. Instead, the company has a portfolio-geared to US shale and a few international hotspotsthat looks like an independent but the more prudent cash management of a major.

Some would rather see ConocoPhillips ditch the fiscal prudence and chase growth. "While certainly a shareholder-friendly step, it does not address one of our longstanding concerns about ConocoPhillips, which is the lacklustre organic growth relative to other comparable large-cap E&Ps such as EOG and Occidental," analysts at Raymond James, an investment bank, wrote after the Cenovus deal.

A sustainable approach

Lance, though, is more concerned with building a portfolio that can maintain output, sustainably generate free cash flow and keep paying the dividend even when prices falter. "We do believe you've got to invest enough money into your business to maintain flat production, or modestly grow your company, but you want to do that at as low capital intensity and as low a break even as you can," says Lance.

That has seen ConocoPhillips radically re-shape its portfolio. Just a few years ago the company was in 28 countries. It is now in half that many. The US deep water business has been jettisoned. It sold its stake in Kazakhstan's Kashagan oil project, where runaway cost inflation made it the world's most expensive oil project and earned it the alternative moniker "cash all gone". ConocoPhillips is no longer drilling off the oil-rich West African coast. It has also quit Russia and a slew of high-risk frontier deep water areas in Greenland, the US and Canada.

As a result, the company has a leaner portfolio, but one that is far more resilient to lower prices. It says its breakeven price has fallen from $75 a barrel a few years ago to less than $50/b today. It has 14bn barrels of oil equivalent in resources with an average cost of supply of around $35/b. ConocoPhillips says it can now keep output flat with capital spending of just $4.5bn a year, compared with the $17.1bn it spent in 2014.

It will lean on the investments it made in recent years on large-scale projects like the APLNG project in Australia and the Surmont oil sands project in Canada, which it didn't sell, to maintain output, but it is increasingly looking to invest closer to home in US shale. "The major projects that we've invested in over the last few years are now online, and now we're more focused on the shorter cycle, higher return, lower cost of supply tight oil investment," says Lance.

The company is picking up activity in the US, especially in the Eagle Ford shale. "We got back to really just three rigs in the US and Canada and we're now ramped up to eleven or twelve rigs, so we've actually put money back to work even in that $50 environment because of the work we've done lowering the cost of supply," says Lance.

Tight oil revival

The company's Eagle Ford position is the core of its US shale business, though output took a hit in 2016 as the company scaled back operations in the face of lower prices. Net peak output there was 176,000 barrels of oil equivalent in 2016, down 7% from 2015's peak. But well completion costs are down 40% since 2014 and the company says it has 3,500 locations it can drill at a cost of supply of less than $40/b. The company plans to run five rigs in the Eagle Ford this year, compared to three last year.

ConocoPhillips is also looking to ramp up in the Delaware section of the Permian. It holds a large legacy position in the fast-growing basin, though much of that acreage is outside the core Midland and Delaware sections of the Permian that have seen the fastest growth. Unconventional output is just 15,000 barrels of oil equivalent per day in the Permian, but the company says that it now has 1.8bn boe of resources in the Delaware it can produce at a cost of supply of less than $50/b.

ConocoPhillips is also continuing to invest throughout Asia, a region that has largely avoided the portfolio purge. It is developing a major offshore gas project in China's Bohai Bay alongside China National Offshore Oil Corporation. It is also pressing ahead with a deep-water exploration programme off Malaysia. Its APLNG and Darwin Australia will make it an important player in Asia's LNG market for years to come. "We're close to the market. That's where a lot of the growth is going on. We understand that, we see that and it gives us great insight into what's happening on the demand side, so that's a big and important part of the company," says Lance.

After the battering the industry took over much of the past couple years, Lance wants to make sure his company is as prepared as possible for the next storm. "We're going to be in a much better and a much different position for the next cycle, which is coming, I don't know when and I don't know how deep it will be, but it will come."

This article appeared in the AOGC daily newsletter, produced by Petroleum Economist for attendees of the 19th Asia Oil and Gas Conference held in Kuala Lumpar.

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