Did Conoco Cut Off a Valuable Arm?

by Aaron Levitt | July 30, 2012 10:28 am

It’s been roughly three months since major integrated energy firm ConocoPhillips (NYSE:COP[1]) became, well, a little less integrated. Abandoning the complete up- mid- and downstream model that former CEO James Mulva help create back in the early 2000s, Conoco has undergone a unique transformation[2] aimed at becoming more nimble and profitable.

The major piece to this strategy was first to divide itself in two. The downstream, or refining, sector has been a tough game to “crack” over the last few years, so Conoco spun off these operations as a separate company called Phillips 66 (NYSE:PSX[3]). That firm is now the nation’s largest independent refiner. The basic idea of the split was to free Conoco to focus on exploration and production (E&P), including North America and its vast shale-gas bounty.

With Conoco’s earnings report on Wednesday — its first a separate firm — investors can finally gauge whether these efforts are beginning to bear fruit. For the rest of energy industry, that could serve as a good litmus test for pursue a similar strategy — or not.

A Missing Piece

At first blush, it may look like Conoco should rethink its split. Now the largest U.S. oil and gas producer without refineries or a chemical business, it reported that net income fell[4] by 33% for the second quarter, now that Phillips 66 is a separate entity. Overall, Conoco reported a profit of nearly $2.27 billion, or $1.80 a share. That’s down from $3.4 billion, or $2.41 a share a year earlier. When backing out write-downs, asset gains and other items, profit from continuing operations was around $1.5 billion.

These results included one month of earnings from Conoco’s former refining business, compared to three months worth in the year-ago quarter. That extra boost from the now-discontinued /spun-off refining operations came to roughly $534 million in earnings. COP’s results were hurt by lower average realized prices for oil and natural gas, which declined 6.5% and 20%, respectively, through the quarter. Prices for other liquid hydrocarbons such as natural gas liquids (NGLs) and oil sands bitumen fell during the period as well.

However, strong performance in the firm’s various international assets drove E&P revenue higher than expected. This includes the Libyan operations returning to normal after the popular rebellion there.

Conoco also reported a decline in overall production as it curtailed drilling from its North American traditional and dry gas operations due to historic low natural gas prices.[5]

So, with the relatively poor showing from the former integrated giant, the question remains if the spin-off was truly worth it.

Despite the recent dour refining market, the downstream sector is generally a stable though low-return business. By removing these historically more consistent 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[6] integrated oil firms need to survive.

There’s some evidence that Conoco could have really used those stable cash flows. Analysts at investment bank Credit Suisse (NYSE:CS[7]) said Conoco’s report shows the company’s cash flows from operations didn’t cover its capital spending nor its healthy 4.8% dividend in the first half of the year.

This echoes similar findings from superstar Oppenheimer analyst Fadel Gheit, who said of the firm’s earnings: “As oil prices go down, people are raising red flags about Conoco that they cannot keep spending like they are. They either need to cut spending, sell assets or borrow money. None of the above is very pleasant.”

Overall, slowing economic growth in both Europe and China will continue pose a challenge because it will put downward pressure on energy prices, which is now the key to profits for the new Conoco.

What’s an Investor to Do?

With only one quarter behind it as a freestanding E&P firm, it may be too early to tell if Conoco’s grand experiment is going to be a success. But it seems that the refineries were a critical part of its former triumphs. That fact seems to be holding true when comparing the firm to another company that split its upstream- downstream partners. Shares of Marathon Petroleum (NYSE:MPC[8]) — the refining and marketing company — are up nearly 40% year to date on the back of quality earnings, while shares of Marathon Oil (NYSE:MRO[9]) — the E&P arm — are down about 8.5% on lower oil prices.

Similarly, integrated giant Chevron (NYSE:CVX[10]) saw its profit fall by 7% in the second quarter as oil prices fell. However, strong margins at Chevron’s refineries and petrochemical businesses helped cushion the blow[11] to earnings.

So, will Exxon Mobil (NYSE:XOM[12]) be spinning off its downstream segment anytime soon? Most likely not. It seems that once an energy firm hits a certain size, these generally boring and stable refining assets provide a host of benefits.

I argued in May[13] that “Conoco may not be able to enjoy the growth of successful independent oil and gas producers or the expected reliability of an integrated company.” I’d wait another quarter or two to see if this prediction comes true.

But based on the Conoco’s first earnings report, it seems that Phillips 66 was a major contributor to its success.

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

Endnotes:
  1. COP: http://studio-5.financialcontent.com/investplace/quote?Symbol=COP
  2. Conoco has undergone a unique transformation: http://investorplace.com/2012/05/can-conocos-divide-and-conquer-plan-win/
  3. PSX: http://studio-5.financialcontent.com/investplace/quote?Symbol=PSX
  4. reported that net income fell: http://www.bloomberg.com/news/2012-07-25/conocophillips-net-income-falls-after-refining-spinoff.html?cmpid=yhoo
  5. historic low natural gas prices.: http://investorplace.com/2012/07/natural-gas-finally-shows-some-spark/
  6. much-needed capital spending: http://www.washingtonpost.com/business/refinery-spinoff-production-and-price-declines-lower-conocophillips-2q-profit-33-percent/2012/07/25/gJQAOEJi8W_story.html
  7. CS: http://studio-5.financialcontent.com/investplace/quote?Symbol=CS
  8. MPC: http://studio-5.financialcontent.com/investplace/quote?Symbol=MPC
  9. MRO: http://studio-5.financialcontent.com/investplace/quote?Symbol=MRO
  10. CVX: http://studio-5.financialcontent.com/investplace/quote?Symbol=CVX
  11. helped cushion the blow: http://www.reuters.com/article/2012/07/27/us-chevron-results-idUSBRE86Q0NG20120727
  12. XOM: http://studio-5.financialcontent.com/investplace/quote?Symbol=XOM
  13. I argued in May: http://investorplace.com/2012/05/can-conocos-divide-and-conquer-plan-win/

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