With a hedge, could Conoco have it all?

conoco logo

Liam Denning’s Heard on the Street column in this morning’s Wall Street Journal is reliably hard-nosed about budget trade-offs:

Investors want it all—but they should be careful about companies that promise it.

ConocoPhillips is a case in point. … E&P stocks tend to compete on growth, whereas the integrated majors are prized for how much cash they return to shareholders. Conoco offers both. It targets annual production growth of between 3% and 5% a year out to 2016. And it offers a dividend yield of 4.6%, around double the average for its peers.

What’s not to like about that?

…Conoco’s near-term strategy implicitly relies on high oil prices, not merely to provide operating cash flows but also to attract high prices for disposals. The danger is not that Conoco suddenly can’t pay its dividend; indeed, it has prioritized it. Rather, it is that weaker prices or unexpected costs would upset the cash-flow math and force investors to dial back their enhanced expectations–and Conoco’s valuation with them.

Conoco’s exposure to oil prices is a matter of choice, not circumstances. The company does practically no hedging. The company’s stated “policy is to remain exposed to the market price of commodities.” In fact, the company takes this curious commitment so far that “we use swap contracts to convert fixed-price sales contracts which are often requested by natural gas and refined product customers, to floating market prices.”[1]

Conoco has good company as a non-hedger. We’ve written before about the notable fact that ExxonMobil refuses to hedge. But even among smaller E&P firms, roughly 50% of the firms report no hedges at all in any given year.[2]

Perhaps Conoco can afford to remain exposed. Its balance sheet is in very good shape so that it has unused debt capacity which could cover some shortfall. Nevertheless, if exposure to commodity prices were truly a threat to Conoco’s twin goals of investing for growth and paying a reliable dividend, the company could do something about that. But to do so would require giving up its third goal of being fully exposed to oil prices.

Two out of three ain’t bad.


[1] ConocoPhillips Form 10-K for FY2011, p. 74.

[2] Haushalter, G. David, 2000, Financing Policy, Basis Risk and Corporate Hedging: Evidence from Oil and Gas Producers, Journal of Finance 55, 107-152.

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