When ConocoPhillips (COP) reported first-quarter 2015 results in April of last year, there was no question that it was going to be an ugly quarter.
Significantly lower commodity prices wreaked havoc on the income statement: The company reported an adjusted loss of $222 million in the quarter compared to a profit of more than $2 billion in the prior-year period. Against the first quarter of 2014, the average realized price per barrel of oil equivalent (BOE) fell by nearly 50%.
Of course, there’s nothing management can do about this: It is a price taker. In the short term, there is little it can do besides accept the vicissitudes in commodity prices. As outlined in the release, it was doing all it could in the near term to execute in the areas it could control.
For the time being, the primary focus for management seemed to be shoring up the balance sheet and focusing on getting toward cash flow neutrality within a few years. Considering that capital expenditures and the dividend exceeded adjusted cash flow from operations by more than $2 billion in the first quarter, it was clear management had plenty of work to do moving forward.
One notable way it planned on working toward this goal was lowering capital expenditures:
“The company is also on track for $11.5 billion of capital expenditures and investments in 2015.”
Management’s original 2015 capex guidance – from December 2014 – called for a budget of $13.5 billion. It seems pretty clear that management was getting the business prepared for any additional pain that could arise in the quarters – and potentially years – to come.
Over the coming months, the environment was essentially unchanged: the price for crude oil continued in the $50 to $60 per barrel range that it had been in since the start of the year.
At the company’s annual meeting in May, management made it clear that its primary goal was a commitment to a “compelling dividend.” The first two slides presented by CEO Ryan Lance were focused solely on the dividend; he didn’t mince any words:
“The dividend remains the top priority.”
Management deserves credit for the consistent message it has delivered to investors. Owners of ConocoPhillips shares were clearly being told what they should expect from their investment.
It's management’s decision a few weeks later that still confuses me today: on July 16, 2015, management announced an increase in the dividend –Â from 73 cents per share to 74 cents per share.
While the dividend increase was small (less than 2%), it sent a very odd message: at a time when management was already guiding to sizable cash shortfalls in the business over the coming two years, as well as the inherent uncertainty of short term commodity prices (as was seen in the prior six to 12 months), how could it possibly make sense to announce an increase in the dividend?
In the press release, Lance said, "A compelling dividend is a key aspect of our value proposition. While this increase is more modest than in previous years, we believe it is appropriate given the lower commodity price environment.”
As you read that statement, remember that we're talking about a nearly 50% decline in realized prices per BOE. On the day of the announcement, ConocoPhillips stock closed at ~$58 per share.
During the second-quarter conference call, held two weeks later, Lance came out with a message for analysts and investors that, once again, did not mince any words:
“The dividend is safe. Let me repeat that. The dividend is safe.”
On the call, Lance reaffirmed the company’s cash flow guidance, which was being helped by an additional $500 million reduction in the 2015 capex guidance. For the quarter, ConocoPhillips reported adjusted earnings of less than $100 million – compared to $2 billion in the prior-year period.
Over the coming quarters, as we all know, commodity prices continued to move in the wrong direction. As management now admits, it did not anticipate the move from $50 per barrel to $30 to $35 per barrel. The dividend proved to be “safe” for just two quarters; management announced Wednesday that the quarterly dividend was being cut by 66%, to 25 cents per share.
In 2015, ConocoPhillips generated $7.5 billion in cash flow from operations, leaving a shortfall of more than $6 billion versus cumulative outflows for capital expenditures and dividend payments. At Thursday’s close, ConocoPhillips shares traded at their lowest level since March 2009.
Conclusion
Let me be clear about something: The financial impact of the dividend increase was immaterial.
There is zero question that a dividend cut would have happened either way, all other things being the same. The dividend cut is a reflection of a tough operating environment that looks like it will be sticking around longer than many expected; there simply isn’t any plausible way that a sizable cut could’ve been avoided at ConocoPhillips (at least without being irresponsible).
With that said, there’s good reason to question the rationale for increasing the dividend in July. That was a misguided signal to investors. As management would likely admit today, it did not adequately account for the range of future outcomes when it made that decision. More broadly, I think management's actions and words in relation to the dividend raises material questions about capital allocation at ConocoPhillips.
Over at least the past 12 months, management has been very clear about its focus on paying the dividend above all else. I’ve taken its comments as a willingness to forgo any other capital allocation options – such as M&A, capex or repurchases – if it had any impact on its ability to fund the dividend. I’d go so far as saying it would do this even if it meant passing on attractive long-term opportunities (hopefully I’m wrong).
This is misguided: A well-funded and growing dividend is an output that relies upon long-term focus and continued investments in the core business. If you don’t invest in attractive business opportunities on the front end, you will eventually see an impact on the back end.
For investors, there’s an important takeaway from this example: If management starts acting in a way that does not seem to mesh with sound long-term decision making, it’s a good time to start asking whether it truly is acting in the best interest of shareholders.
In the press release announcing the dividend cut, Lance said, “While we don’t know how far commodity prices will fall, or the duration of the downturn, we believe it’s prudent to plan for lower prices for a longer period of time. The decision to reduce the dividend was a difficult one. The dividend has been, and will continue to be, a top priority.”
Lance called this decision a reset for the company. Importantly, the dividend cut has also resulted in a reset of investor expectations. It may be prudent for management and the board to use this opportunity to reconsider how dedicated they are to the dividend above all else. When success or failure is judged by a single metric, it can lead to some seemingly odd decisions.
