ConocoPhillips' COP earnings report was largely in line with expectations, as the benefit of higher oil prices offset lower production volumes and flat refining and marketing earnings. Fourth-quarter adjusted earnings were $2.7 billion compared with $1.9 billion a year earlier. The conditions that had boosted refining earnings throughout the year largely evaporated during the quarter. While refining adjusted earnings, excluding the benefit of asset sales, were essentially flat with the fourth quarter of 2010 at $201 million, they fell from $1.2 billion in the third quarter as market conditions weakened significantly. ConocoPhillips' realized refining margin fell more than $6 per barrel from the third quarter, to $7 per barrel in fourth quarter. However, conditions have since improved somewhat, which we expect will be reflected in first-quarter earnings.
Exploration and production fourth-quarter adjusted earnings rose to $2.3 billion from $1.9 billion a year earlier. Total production for the quarter averaged 1.60 million barrels of oil equivalent per day, down from 1.73 mmboe/d during the same period a year ago, reflecting lost volumes from Libya and China, asset dispositions, and natural field decline. Full-year production averaged 1.62 mmboe/d compared with 1.75 mmboe/d in 2010. With domestic natural gas still contributing about 16% of production, we expect ConocoPhillips will be stung by the recent swoon in natural gas prices. Increased production from oil and liquids dominant regions--Canadian oil sands, Eagle Ford, Bakken--should help to somewhat offset the effect, though. The company continued to make progress in its returns improvement plan by generating $2.7 billion in cash from asset sales to fund the repurchase of $3.1 billion in stock. For the full year, ConocoPhillips sold $4.8 billion of assets and repurchased $11.1 billion worth of its own shares.
Thesis 12/28/11
Faced with a tightening resource market, ConocoPhillips made significant acquisitions over the past decade to boost reserves and increase production. The ensuing fall in commodity prices made those acquisitions appear poorly timed, however. As a result, management changed course last year by selling assets and reducing investment. Now it is taking another step by spinning off the downstream assets into a separate company.
For a supermajor oil company, increasing production has become challenging because the project size required to significantly boost output is quite large and becoming harder to find in OECD countries. As a result, majors must engage in riskier exploration projects, partner with national oil companies, or acquire independent producers to support growth. Although ConocoPhillips pursued exploration and partnerships in recent years, acquisitions dominated its strategy. While ExxonMobil XOM and Chevron CVX sat on the sidelines, ConocoPhillips acquired North American natural gas assets (Burlington Resources), Russian oil supplies (20% stake in Lukoil LUKOY), and stranded gas in Australia (Origin Energy). Even though the deals added reserves and production for the company, the subsequent drop in commodity prices calls the timing into question. In fact, these higher-priced deals culminated in a $34 billion goodwill-impairment charge.
With its acquisition strategy failing to deliver returns, ConocoPhillips decided to embark on a new strategy that included asset divestitures and share repurchases. Through year-end 2011, the company has divested about $10.5 billion worth of assets and is committed to is selling another $5 billion-$10 billion worth of underperforming assets during 2012 in an effort to shore up the balance sheet and improve returns. Divestitures will occur across its upstream and downstream asset portfolios. Cash generated from operations and divestitures to date have supported a share repurchase program that should result in buybacks of about $11 billion in 2011, with potentially another $10 billion worth in 2012.
Despite the success of this plan, management has decided to go a step further and spin off the refining and marketing assets into a separate company. The decision comes in light of the share appreciation Marathon saw when it announced a similar move earlier this year. However, the shares have faltered somewhat after the spin-off, particularly at the upstream company. Given the success ConocoPhillips' improvement plan was showing, we are a bit puzzled by the announcement. Because the company had closed much of the valuation gap with its peers, exceeding it in some cases, we think any more appreciation will be limited.
The newly created downstream company, to be called Phillips 66, will hold ConocoPhillips' refining and marketing and chemical assets. We think given the collection of some well-positioned refining assets, divestment or closure of poor performing facilities and an attractive chemical and midstream business, Phillips 66 should stack favorably to its new peer group. We think the remaining upstream business may have a more difficult time as its new peer group will include much smaller competitors who have better growth prospects. Additionally, the challenges ConocoPhillips faced as an integrated firm are likely to persist once the spin-off is complete. However, like Phillips 66, we expect ConocoPhillips will likely offer the highest dividend yield in its peer group, which could attract yield hungry investors in search of commodity exposure.
Valuation
We are maintaining our fair value estimate of $85 per share, which is about 4.4 times our 2012 EBITDA estimate of $29 billion. Our valuation is based on a discounted cash flow model of the integrated ConocoPhillips. Because the cash flow of the company's individual segments is unlikely to change once the downstream is spun off, we see no reason to alter our valuation at this point. A sum of the parts analysis validates our DCF valuation.
Our initial analysis suggests after the upstream company is worth about $70 per share, while Phillips 66 is worth about $26 per share. Based on the anticipated capital structures of the two companies and the split ratios, the SOTP analysis implies a valuation of about $83.
We continue to believe reliance on natural gas production and refining will drag on results until ConocoPhillips completes its divestitures. However, additional Canadian production should result in a greater portion of oil volumes in the coming years. Also, in the near term ConocoPhillips should benefit from its international (about 50% of total) and Alaskan (about 25%) crude production, which is tied to more attractive Brent pricing.
In our discounted cash flow model, our benchmark oil and gas prices are based on Nymex futures contracts for 2011-13. For natural gas, we use $4.04 per thousand cubic feet in 2011, $3.34 in 2012, and $3.99 in 2013. Our long-term natural gas price assumptions for 2014 and 2015 are $6.50 and $6.70, respectively. For oil, we use Brent prices of $110 per barrel in 2011, $102 in 2012, and $99 in 2013. Our long-term oil price assumptions for 2014 and 2015 are $95 and $98, respectively. We assume a cost of equity of 11% in all scenarios.
Refining staged a recovery in 2010 that has continued into 2011, sustaining downstream profits. Meanwhile, natural gas prices face the headwinds of high inventories, adequate supply, and reduced demand. A collapse in refining margins would provide downside to our valuation, while higher natural gas prices would offer upside. We anticipate share repurchases to continue in 2011 and explicitly model about $11 billion worth for the full year.
Risk
Persistently low oil and gas prices would hurt cash flow and force ConocoPhillips to reduce its capital plans or raise debt to fund growth. The company's large projects run the risk of delays, cost inflation, and falling commodity prices, which could ruin their economics. Global operations and partnerships with national oil companies expose the company to the threat of expropriation of assets and modification of contract terms by governments.
Management & Stewardship
James Mulva has been chairman and CEO of ConocoPhillips since the 2002 merger of Phillips Petroleum and Conoco, adding the chairman role in 2004. Before 2002, he held the same positions at Phillips Petroleum, among other executive management roles in his 25-year tenure with the firm. Under his leadership, the firm undertook a growth by acquisition strategy that failed to deliver returns. Recent efforts to implement a shrink-to-grow strategy while refocusing on shareholder returns have so far been successful. Execution of the new strategy will probably be Mulva's last major initiative before stepping down sometime in 2012 after completion of the spin-off.
Ryan Lance, current SVP of E&P, International, will assume the chairman and CEO role of ConocoPhillps, the upstream company. Greg Garland, SVP of E&P, Americas, will become chairman and CEO of Phillips 66. He will be joined by several other senior executives from ChevronPhillips Chemical.
Mulva is paid rather well, with $24 million in 2008, $14 million in 2009, and $18 million in 2010, though most was incentive-based and in line with the company's peers. Incentives are based on a variety of company metrics including shareholder returns, returns on capital, and income per barrel produced all relative to its peer group. We like the fact that compensation is primarily performance-based and that the goals are tied to shareholder returns.
Overview
Financial Health:
In the past year, ConocoPhillips applied proceeds from asset sales toward debt retirement, lowering its debt/capital ratio to about 26% at the end of the third quarter. Further debt reduction is unlikely as the company aims to improve shareholder returns with share repurchases and dividend increases. Operating cash flow should be sufficient to cover the capital plan at current commodity price levels.
Profile:
ConocoPhillips is an international integrated energy company. In 2010, it produced 913,000 barrels per day of oil and natural gas liquids and 4.6 billion cubic feet a day of natural gas, primarily from the United States, Canada, Norway, and the United Kingdom. Proven reserves at year-end 2010 stood at 6.7 billion barrels of oil equivalent (plus 2.1 billion for equity affiliates), 44% of which are natural gas. With refining capacity of 2 million barrels of oil a day, it's the second-largest refinery operator in the U.S.
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