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Saturday, September 02, 2006

Weekend Edition: ConocoPhillips (COP) Refines its Profits

By CrossProfit, edited by Saul Sterman

Our primary analysis for ConocoPhillips (COP) is that high oil prices should continue generating above normal earnings for the next several years.

The Facts:

COP is banking on an 18% – 20% stake in Russian Lukoil to shore up its dwindling North American well production. A full 10% of production is expected to come from Lukoil.

The divesture of wells in Canada is negligible (less than 30,000 bpd) and is part of the Burlington Resources acquisition agreement. The BR acquisition was an expensive North American natural gas play. The re-entry into Libya should provide handsome profits on 40,000 bpd at a production cost of $5 per barrel! This should more than make up for the Canadian loss. COP is counting on natural gas prices remaining above $6.55 per Mcf, otherwise the BR acquisition becomes mathematically problematic. COP is the largest natural gas producer in North America.

Venezuela is no longer considered a viable reliable option for replacing existing production sites. There is plenty of heavy crude down there but no one is willing to risk spending billions to develop these new fields.

The new refinery project in Yanbu, Saudi Arabia, in conjunction with Aramco and Halliburton, should contribute to the refining division earnings as of H2 2011. This single new ’Saudi sour’ refinery project will have the capacity to supply 2% of U.S. consumption.

Historically refining operations have had far lower margins than crude production. In 2005 production accounted for only 27% of sales yet was 62% of earnings. Lately this has not been the case and has benefited COP. COP has a 36% stake in the Alaskan Prudhoe Bay fiasco. Prudhoe Bay represents approximately 15% of COP’s global oil production (136,000 bpd out of 916,000 bpd).

COP’s historical financial performance (balance sheet, income statement/earnings per share etc.) depicts a classic rollercoaster ride. Over the past decade the energy sector has been highly volatile and COP consistently exemplifies this to an extreme, more so than some of its competitors.

Comparison to peers as of 08/25/2006:

ConocoPhillips (COP) verses Chevron (CVX) verses ExxonMobil (XOM).
COP’s market cap = 109 billion, trading at a trailing PE of 6.1, dividend yield = 2.2%
CVX’s market cap = 147 billion, trading at a trailing PE of 9.2, dividend yield = 3.2%.
XOM’s market cap = 419 billion, trading at a trailing PE of 11, dividend yield = 1.8%.

The question that an investor should ask is whether COP is the best out of the three companies. On the surface COP looks very attractive. The stock is trading at a low multiple (6.1) and is paying a nice dividend. However further analysis reveals a slightly different and somewhat complicated picture.

Fundamentals: (from our proprietary research/analysis)

Reserves Replacement:
COP = 109% (enables future production growth)
CVX = 58% (not good at all, hampers future growth)
XOM = 105% (enables future production growth)

Reliance on U.S. Economy:
COP = 73%
CVX = 45%
XOM = 31%
(Should a slowdown occur in U.S. consumption COP more likely to take a hit than XOM or CVX.)

2006 & 2007 Earnings Growth:
COP, 2006 = 25% & 2007 = 13%
(Recent Q2 results are momentarily better due to BR acquisition accounting manipulations. We see oil remaining high but natural gas at 6.60 -7.70 for Q4)
CVX, 2006 = 19% & 2007 = 1%
XOM, 2006 = 18% & 2007 = 6%

Russian Roulette:

All those familiar with the Yukos travesty know that Vladimir Putin can not be trusted to abide by international standards of commerce. The entire dismantling of Yukos was due to mafia style politics; essentially someone got on Putin’s wrong side and is factually confirmed from the current events. Yukos could have done exactly what the Russian government is doing now; sell off assets and pay off the (alleged) tax bill and still be a viable business. This is the true litmus test proving that what Putin has done is nationalize private assets under the guise of capitalism only to find some new suckers that pray that the (elected) dictator won’t do the same again. If the prayers become the prey it serves them right. Not to mention that the Russian government (Putin’s circle of ten) is pocketing all of the proceeds and leaving Yukos shareholders out to dry. We call this dormant disease Putinits. The question is when will the next outbreak occur? The market currently assesses a high risk premium on Lukoil.

At CrossProfit we emphasize fundamental analysis and delve into technical analysis only upon completion of rigorous fundamental analysis. The CrossProfit evaluation line is based on fundamentals.

CrossProfit Evaluation Line: (buy below the line and sell above the line)
COP EOL 06/07 = 69.80
XOM EOL 03/07 = 75.80
CVX EOL 10/06 = 65.30

For those that are unfamiliar with the term, EOL = end of line. The evaluation line is a twelve month forward looking line that specifies a risk/reward evaluation factoring in market volatility and determines whether or not an investment opportunity exists. Towards the ‘end of the line’ the line is usually less accurate as the evaluation was based on data available a while ago. In plain English, the CVX evaluation line is the least reliable because it ends in 10/06.

Based on the above;
COP has a 6-7% upside
CVX is currently slightly overvalued
XOM has a 8-9% upside

All data excludes dividends. We expect XOM to raise its dividend or issue a special dividend in Q2 2007.

So what does all this mean?

1) Higher margins benefiting COP refineries.
2) Canadian/Libyan production cancels out each other.
3) Paid a very high price for BR acquisition resulting in lower PE multiple.
4) Increased natural gas capacity from acquisition stays profitable and contributes to earnings growth as long as the bottom doesn’t fall out on pricing.
3) Positive reserves replacement.
4) Putinitis.
5) Pipeline investment in Venezuela but no new production or refinery projects.
6) Yanbu not relevant for now.
7) Prudhoe Bay is statistically not relevant (see below).

Prudhoe Bay:
Only one COP refinery relies on Alaskan oil for its supply and that refinery can be supplied from other sources. COP will take a hit on production profits from the Alaskan fiasco. However, with refinery margins up and refining and marketing contributing over 65% of revenue, COP still comes out ahead on a YOY (year over year) basis. Had the Alaskan problem occurred a few years ago it would be a different story.


COP is a gamble on geopolitics including internal Russian politics. COP could turn out to be the best of the three by far. Assuming that a 73% reliance on the U.S. for revenue is a positive factor and the gamble on spreading supply sources amongst several high risk areas pay off, there is a theoretical 28% upside. CrossProfit concludes that 7% by next year is more likely. Should the geopolitical risks diminish, a higher PE ratio is in order.

As of today there is little downside risk. Should Putin decide to play his hand tomorrow the market has already factored in most of the damage from Putinitis. Either way COP is a stock to buy and hold for long term gains and dividends.


The investment outlook for the oil and gas industry is positive. CrossProfit analysts conclude that oil prices are expected to remain relatively high in 2006 and 2007. Order of preference is as follows; XOM, COP, CVX.

Disclosure: This comment was written by a CrossProfit analyst and does reflect the opinion of

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