Can Conoco’s Divide-and-Conquer Plan Win?

by Aaron Levitt | May 18, 2012 7:00 am

It’s been roughly 10 years since the mega-merger of Conoco and Phillips Petroleum, which created the nation’s third-largest oil corporation behind Exxon Mobil (NYSE:XOM[1]) and Chevron (NYSE:CVX[2]). However, times are a-changin’ at ConocoPhillips (NYSE:COP[3]). Abandoning the super-integrated model that former CEO James Mulva helped create back in the early 2000s, the energy firm is undergoing a unique transformation aimed at becoming more nimble and profitable.

The first stage of this remodeling was to divide itself in two. The downstream, or refining, sector has been a tough game to play[4] over the last few years because oil prices tied to Brent crude have remained elevated. That has kept compressing margins and creating poor “crack spreads” — the difference between the cost of crude oil inputs and refined product outputs — that have been a drag on earnings for variety of integrated majors. To that end, Conoco recently followed Marathon Oil’s (NYSE:MRO[5]) lead and spun off its refining, marketing and chemicals business as Phillips 66[6] (NYSE:PSX[7]).

Now free to focus on exploration and production activities, the new smaller ConocoPhillips is continuing with its plans to adapt and be nimble. That means shifting these E&P efforts toward North America and its shale gas bounty.

However, the real question remains: Will these moves turn into profits for the firm and ultimately, its shareholders?

A New Breed of Energy Firm?

Former CEO Mulva is the last of a dying breed. Conoco’s prior leader helped pioneer the integrated model of building energy companies. The ultimate idea was to create a firm that delivered oil from the ground to consumer’s gas tanks via its own international network of exploration, refining and distribution assets. However, over time this model seems to be an increasing drag on profitability and has worn thin.

The problem: poor returns by these integrated oil companies’ refining and petrochemical businesses. In good times, refining and marketing are a costly, low-return business that requires just the right “goldilocks scenario” to turn in a quality profit. But when things get ugly — as they are doing now — the downstream sector can act has a huge drag on a firm’s profit and outlook.

The last two quarters worth of earnings announcements have been a testament to that. That’s why many large energy companies have been urged by institutional investors and analysts to undergo surgery and remove the lame limbs. Already, we’ve seen former refiner Sunoco[8] (NYSE:SUN[9]) put itself up for sale, while other integrated firms like Chevron begin to close their refining operations in developed markets.

Integration Is Less Critical Now

At the same time, much of the world — in the way of national and state-owned oil companies — has caught up to America’s firms. Integration used to be more important as energy-rich nations and their state-energy firms needed to secure a complete network of upstream, midstream and downstream assets in order to see any real gains. However, today’s state oil firms like Brazil’s Petrobras (NYSE:PBR[10]) are giants in their own right[11] and can pick and choose who has the best capabilities in each sector. That is, if they even need any help at all.

So, Conoco’s split into two separate firms certainly seems warranted given how bad the refining segment has gotten. It’ll be interesting to see what other major energy firms follow suit and begin selling/splitting off these operations.

By doing this, Conoco is in a unique position. It has turned itself into an independent E&P-focused business similar to an Apache (NYSE:APA[12]) or Devon (NYSE:DVN[13]), but it still retains the size and global scope of a major international oil group. That’s actually a pretty cool proposition for Conoco. Still, it all depends on what the company does with its new-found nimbleness — and that could be a problem.

The second piece of Conoco’s transformation has been a push into North America’s vast resources. For the foreseeable future, new CEO Ryan Lance plans on spending roughly 60% of the company’s annual $15 billion capital spending budget on various E&P efforts across the continent. This includes pouring dollars into the Eagle Ford shale in Texas, new acreage in Alaska’s North Slope[14] and the oil-rich Bakken shale of North Dakota. This projected spending has come on the back of various international asset sales as the company continues to slim down.

Selling Off Assets

Already, Conoco has sold roughly $30 billion in assets over the last three years, including its 20-year interest in Russian oil company Lukoil (PINK:LUKOY[15]), the critical Seaway pipeline and various natural gas-producing assets. However, it isn’t stopping there. Conoco has plans to sell an additional $10 billion of assets[16] during 2012. On the chopping block are all the firm’s Nigerian assets[17], including both on- and offshore oil and gas fields as well as its stake in the Brass liquefied natural gas facility. The sales should raise around $2.5 billion.

While having focus and getting rid of noncore assets are always good, I have to wonder if Conoco’s strategy might come back to bite the company down the road. One of the key drivers for the bulk of the energy complex has been the shift toward more international and unconventional reserves. Conoco’s new competitors in the independent segment, like Apache and Occidental Petroleum (NYSE:OXY[18]), are already key producers in regions like Argentina, Africa and Latin America.

The key to being a successful independent oil and gas is the ability to increase reserves. Eventually, Conoco will have to expand its business. As global oil and gas demand continues to surge higher, these sorts of international assets will ultimately become more valuable. Conoco might find itself in trouble long term without them.

To be fair, some of Conoco’s focus in North America — like Canada’s oil sands — does fit into the unconventional frame and could generate growth. But for most peers, international has been the focus.

Additionally, by removing the historically more stable refining and petrochemical businesses, Conoco has increased its exposure to the volatility of oil and gas prices. Independents live or die by the price per barrel. Likewise, cash flows from refining assets can provide a nice buffer or boost to the much-needed capital spending integrated oils require to survive.

So, Conoco’s grand experiment remains up in the air. It’s still one of the world’s major producers of crude oil, and in the short term, shares offer one of the highest dividends of any of its North American peers at nearly 5%. However, the question is the long term. Conoco may not be able to enjoy the growth of successful independent oil and gas producers or the expected reliability of an integrated company.

Investors can only wait and see if Conoco’s grand plan pans out. In the meantime, that yield is still looking pretty good in the current market environment.

As of this writing, Aaron Levitt doesn’t own any securities mentioned here.

Endnotes:
  1. XOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=XOM
  2. CVX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVX
  3. COP: http://studio-5.financialcontent.com/investplace/quote?Symbol=COP
  4. tough game to play: http://investorplace.com/2012/05/what-the-oil-majors-earnings-reveal/
  5. MRO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MRO
  6. Phillips 66: http://news.yahoo.com/conocophillips-board-approves-split-215127334.html
  7. PSX: http://studio-5.financialcontent.com/investplace/quote?Symbol=PSX
  8. former refiner Sunoco: http://investorplace.com/2012/05/sunocos-buyout-could-boost-pump-prices/
  9. SUN: http://studio-5.financialcontent.com/investplace/quote?Symbol=SUN
  10. PBR: http://studio-5.financialcontent.com/investplace/quote?Symbol=PBR
  11. giants in their own right: http://investorplace.com/2012/05/latin-america-still-offers-energy-plays/
  12. APA: http://studio-5.financialcontent.com/investplace/quote?Symbol=APA
  13. DVN: http://studio-5.financialcontent.com/investplace/quote?Symbol=DVN
  14. Alaska’s North Slope: http://investorplace.com/2012/05/energy-independence-alaska-heats-up/
  15. LUKOY: http://studio-5.financialcontent.com/investplace/quote?Symbol=LUKOY
  16. $10 billion of assets: http://www.bloomberg.com/news/2012-03-05/conocophillips-expects-10-billion-of-asset-sales-in-2012.html
  17. the firm’s Nigerian assets: http://www.reuters.com/article/2012/05/08/us-conocophillips-nigeria-idUSBRE8470TB20120508
  18. OXY: http://studio-5.financialcontent.com/investplace/quote?Symbol=OXY

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