ConocoPhillips (IL/A): Analyst meeting preview--returns on new refining CAPEX the big question - Goldman Sachs - November 14, 2005
We continue to believe ConocoPhillips can perform well on an absolute basis given our bullish commodity macro outlook and Attractive coverage view. However, we maintain an In-Line rating on COP shares, as we continue to see even greater relative upside in higher-beta large-cap domestic oil/E&P companies like Murphy Oil and XTO Energy (both OP/A rated) and better downside risk control in Exxon Mobil (OP/A). Key issues at the company's November 16 analyst meeting include greater detail on its stepped-up refining investment program, its ability to get back on-track for 3%-5% (ex- Lukoil) annual E&P volume growth, and what it plans to do with continued strong free cash flow. We believe superior returns on new refining investments are only likely if Gulf Coast margins stay above $8 per barrel, well in excess of historic levels. 4% per annum E&P volume growth appears doable.
R&M: 9% ROCE EXPECTED ON INCREMENTAL REFINING SPENDING OVER THE LONG-RUN
At ConocoPhillips's November 16 analyst meeting, we believe investors will be most interested to hear details on the company's refining expansion plans. We expect management will provide details on the planned $3-$4 billion of incremental refining spending it first alluded to during last year's analyst meeting and has again highlighted in recent weeks/months. We think Conoco will likely focus on upgrading units and brownfield expansion projects, although given the potential large absolute size, some of the brownfield projects could be close to grassroots-equivalent.
Our preliminary estimates show that the projects could generate a 9% long-term ROCE assuming $5 per barrel long-term Gulf Coast 3:2:1 refining margins and $10 per barrel light-heavy crude oil spreads (as represented by WTI-Maya). We assume $4 billion in total spend, with projects ranging from upgrading units to both charge and production capacity, de-bottlenecking projects, and new crude units. Under an $8-$9 per barrel long-term Gulf Coast margin assumption and $14-$15 per barrel light-heavy spreads (levels similar to what the WTI oil strip prices imply), we estimate a 13% ROCE. Under $6.75 per barrel Gulf Coast margin and $12 per barrel light-heavy spread assumptions--roughly equivalent to $45 per barrel WTI oil--we estimate an 11% ROCE (see Exhibit 1).
In our view, investors will likely view the possible $4 billion of spend as aggressive and question whether it improves (or dilutes) Conoco's long-term returns on capital. To be fair, our analysis may underestimate the level of synergies that can be captured in integrating new units to existing refinery infrastructure (our analysis is essentially based on "stand-alone" units). At the same time, however, we believe cost inflation risk exists especially given industry's general lack of recent experience in large-scale grassroots refinery projects.
E&P PROJECTS ON-TRACK TO DELIVER 4% PER ANNUM GROWTH EX-LUKOIL THROUGH 2008
We expect Conoco to grow its E&P production excluding its share of Lukoil production at a 4% per annum clip through 2008, which is a bit lower than past guidance of roughly 5%-6% per year. Projects in Asia-Pacific (Indonesia, Timor Sea, China, and Vietnam) and Venezuela account for roughly 50% of Conoco's estimated growth by 2008, while projects in the Middle East and Russia appear to play an increasing role towards the end of the decade (see Exhibit 2). In our view, the shift in Conoco's production towards non-OECD countries and key E&P "win zones" such as the Middle East, Russia, and global gas, will likely help to reduce expected returns on capital employed (ROCE) volatility.
In terms of Conoco's 2005 E&P production, although flat production over 2004 levels is disappointing given expectations of 5% growth at last year's analyst meeting, we do not believe the miss to be a result of an asset problem. Rather, an above-normal hurricane season, the impact of production sharing contracts on reported volumes, and unplanned downtime--factors that are mostly transient in our view--reduced reported volumes.
We estimate Conoco's E&P capital expenditure will rise to nearly $8 billion in 2006, which is a 10% increase over 2005 levels. Our estimate excludes funds for the likely additional acquisition of Lukoil shares in 2006. Company-wide we expect capital expenditure in 2006 to rise to $11 billion, which is a 13% increase over 2005 levels and excludes roughly $1 billion we think it will spend buying Lukoil shares in 2006.
WITH DEBT LEVELS NEAR DESIRED "MINIMUM" LEVELS, SHARE BUYBACKS COULD ACCELERATE
On its 3Q earnings conference call, management appeared to show greater willingness to buyback shares beyond merely offsetting dilution related to stock-based compensation. In our view, given a strong balance sheet and likely robust free cash generation over the coming years, we believe management will accelerate a share buyback program. By year-end 2005 we estimate Conoco's net debt-to-tangible capital will be 21% and for 2006 we estimate $6.8 billion in free cash flow, which assumes a $68 per barrel WTI oil price.
VALUATION: 34% UPSIDE TO TRADITIONAL PEAK VALUATIONS
We estimate 34% upside to an $84 traditional peak value and 7% upside to a $67 traditional mid-cycle value which assumes a $35 per barrel long-term WTI spot oil price. This compares to the super-cap integrated oil peers showing on average 45%/16% upside to traditional peak/mid-cycle valuations, respectively. Conoco shares currently trade at 4.6X EV/DACF (enterprise value to debt-adjusted cash flow) versus the peer group average of 5.4X.
UPDATED ESTIMATES
We are raising our normalized 2008-2010 EPS estimates for ConocoPhillips to reflect estimated impact of higher refining spending. Our respective normalized 2008-2010 EPS estimates now stand at $5.45 ($5.35 previously), $5.75 ($5.61 previously), and $6.00 ($5.87 previously).
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
