ConocoPhillips (IL/A): Analyst meeting takeaways - Goldman Sachs - November 17, 2005
We came away from ConocoPhillip's analyst meeting continuing to believe the stock can perform well on an absolute basis given our bullish commodity macro outlook and Attractive coverage view, but feeling that an In-Line rating versus the sector is most appropriate. We believe Conoco's focus on brownfield, upgrading, and yield-enhancing projects in refining--as opposed to greenfield-like expansions--raises confidence that long-term returns will remain at or near the top of the peer group. Our view of the E&P outlook was a bit more mixed, as production guidance was effectively lowered despite increasing E&P capex and high relative re-investment rates. Of course missed production guidance and cost inflation is an industry-wide phenomenon and Conoco's E&P portfolio otherwise appears to be increasingly well positioned in many of the industry's key areas of opportunity.
REFINING INVESTMENT PROGRAM MAKES SENSE
Details of Conoco's US refining investment program were largely as expected, although the relative weight on upgrading units versus new crude capacity (including creep) was greater than what we had previously assumed. Conoco expects its $4-$5 billion program to increase its "advantaged crude" processing capability by 650,000 barrels per day while increasing crude distillation capacity by 230,000 barrels per day and clean product yields by 300,000 barrels per day. Given marginal spending on new crude capacity as well as higher-than-expected clean product yields, we now estimate long-term returns on its new refining projects will be in the 10%-12% range versus our previous estimate of 9%. We note that the company's projections of refining returns on its new investments is higher than ours, with our figures potentially proving to be conservative. Further clarification on the economics of its projects would help to further fine tune our estimates and potentially close the gap with the company's higher return forecsats. Our base-case 10%-12% return on new investment assumes a $5 per barrel long-term Gulf Coast 3:2:1 refining margins and $10 per barrel light-heavy crude oil spreads (for more details, please see our November 14, 2005 note, "Analyst meeting preview--returns on new refining CAPEX the big question"). 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 mid-to-high-teens 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 a low-to-mid-teens ROCE.
IS ADDITIONAL EXPANSION BY CONOCO IN CANADA'S OIL SANDS THE NEXT LOGICAL STEP?
We believe Conoco's US refining system is strategically well positioned to take advantage of robust upstream growth in Canada's oil sands/heavy oil. Relative to the expected 650,000 barrels per day increase in advantaged crude processing capacity, Conoco's expected net heavy oil production from both Venezuela and Canada is only a fraction of that amount. We would not be surprised to see Conoco look for additional oil sands/heavy oil projects in Canada beyond its existing interest in Syncrude and Surmont. The company has a strong track record of executing "integrated" projects, as it has in Venezuela, with Canada's oil sands/heavy oil a logical opportunity for the company.
E&P PORTFOLIO IMPROVING, THOUGH LOWERED PRODUCTION GUIDANCE AND HIGH RELATIVE RE-INVESTMENT RATES PRESENTS SOME CONCERN
We believe Conoco's overall E&P portfolio is in as good of a shape as it has been in either since the merger or when considering the legacy companies' historical positions. A slight disappointment, however, from the analyst meeting was Conoco's further nudging down of E&P production guidance despite higher expected capital spending and relatively high re-investment rates. Compared with the 5% CAGR once expected for 2004-2006, Conoco's new guidance points to a 4% CAGR for the same time period after adjusting for the impact of production sharing contracts and 3% without any adjustments. Conoco's long-term growth expectations also appear to have been lowered somewhat, with management now guiding to a 2% long-term growth rate excluding Lukoil though an unchanged 3% when Lukoil is included. Note, management did indicate that its new guidance could prove conservative, although beating production guidance (even once lowered) has not been accomplished by many of the super-cap oils. The concern with slightly lowered E&P production guidance is that re-investment rates remain above average, especially versus the super-cap integrated oil peer group. In our view, investors are likely to remain uncertain as to how Conoco's E&P profitability would hold up in a less robust commodity environment, even though we think commodity prices will stay high for at least the next few years. In some respects, we think Conoco may not attain a full super major valuation until investors see how its earnings and profitability hold up in a commodity downcycle. We believe BP did not earn its super major stripes until the sharp 1998 downcycle when its earnings and returns clearly outperformed the second-tier domestic oil group it was once part of earlier in the 1990s. Of course, we and presumably Conoco would just as soon not see a repeat of 1998 just to possibly earn a higher relative valuation multiple. We would welcome similar volume growth to its peers at similar reinvestment rates as another way to earn a higher valuation.
WE EXPECT SHARE REPURCHASE TO CONTINUE TO ACCELERATE, ASSUMING NO ACQUISITIONS
If our base case estimate of $68 per barrel WTI oil for 2006 proves to be in the ballpark, we estimate Conoco could generate enough free cash to buy back almost $6 billion in shares next year, significantly above the roughly $1 billion remaining in the current share buyback program. This assumes a $13 billion capital program for 2006, which includes $2 billion in Lukoil share purchases. In our view, given a now strong balance sheet, we believe Conoco likely will use a large portion of its free cash to repurchase shares.
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. |
