US R&M--ConocoPhillips preferred over R&Ms for refining exposure - Goldman Sachs - April 03, 2006
While we remain bullish on the outlook for US refining markets in 2006, we believe that the integrated oils?and in particular ConocoPhillips?offer a more compelling risk/reward opportunity for investing in the refining cycle than do the independent R&Ms. We see an 18% arbitrage opportunity between Conoco and Valero assuming equal EV/DACF multiples for R&M assets. On an absolute basis, we estimate 32% upside potential to an $84 'traditional' peak value for Conoco. After a period of Not Rated, we are reinstating our investment opinion on Conoco with an Outperform rating and in turn lowering our rating on Valero Energy to In-Line, both in the context of our Attractive coverage view. While we are comfortable owning Conoco shares outright, we believe a structured trade could also make sense for investors less bullish on Conoco's non-refining exposures. Valero remains our favorite pure-play R&M.
Please see our detailed 17-page report, "US R&M: COP preferred over R&Ms for refining exposure." If you are on our e-mail distribution list, a .pdf will be sent today.
Independent R&Ms re-rated up; will the integrateds' R&M valuations follow? We believe that there is a large valuation gap between the independent R&Ms and the implied R&M valuation for the integrated oils. Although to a certain extent it is logical that pure-play refiners could garner some valuation premium during an up-cycle given that they represent "cleaner" downstream exposure, we believe that the gap has widened to such an extent that the risk/reward overwhelmingly favors the integrated oils.
Conoco's refining assets deserve "bellwether" R&M valuation multiple, in our view We believe that ConocoPhillips' refining assets reflect those of a "bellwether" US refiner given its geographically diverse base, medium- to high-conversion capacity, track record of execution, and limited retail marketing exposure. Yet we estimate Conoco overall to be trading at 4.8X 2007E EV/DACF (enterprise value to debt-adjusted cash flow) and an implied R&M 2007E EV/DACF of 3.1X. This compares to the independent R&M average of 6.3X and Valero's 5.7X.
To the extent investors do not wish to be exposed to any of Conoco's non-R&M business segments, we believe that a structured trade could make sense. Potential hedges against long Conoco shares would be a combination of Valero shares, a basket of domestic oils/large-cap E&Ps, and Lukoil (U/A, covered by Michele della Vigna). For every $1 of long Conoco position, we estimate an investor would want to be hedged with $0.45 of a basket of E&P companies, $0.15 of Valero, and $0.05 of Lukoil.
Although the implications of pure-play R&M valuations would be positive for other super-cap oils and domestic integrateds, we believe that a combination of an international asset base, marketing/retail exposure, and lack of geographical diversity within the United States obfuscates the comparability. Having said that, we believe that shares of Amerada Hess (IL/A), Marathon Oil (U/A), and Murphy Oil (OP/A) could also be beneficiaries of investors attributing pure-play refinery valuations to the integrateds' R&M asset base. COP valuation: 18% arbitrage to VLO multiples, 32% upside to traditional peak Assuming Valero's cash flow multiple for Conoco's R&M assets, we see 18% upside potential to $77 per share. On an absolute basis, we see 32% upside to an $84 "traditional" peak value for Conoco. Our "traditional" peak valuations are based on a $45 per barrel long-term WTI oil and price commensurate other commodity price assumptions.
Valero remains our favorite R&M pure-play company For investors who do not care for Conoco's non-refining businesses or a structured trade that could hedge unwanted exposure, Valero remains our favorite R&M pure-play company given its "bellwether" status, high conversion capacity, track-record of acquisition integration, and strong management team. Our downgrade of Valero to In-Line from Outperform is not driven by a less favorable view of Valero, but rather the superior relative opportunity we see in Conoco shares at this time. We see 2% upside to a $61 "traditional" peak value and 39% upside to an $84 super-spike-adjusted peak value.
Key catalysts Catalysts for Conoco shares include improved investor sentiment toward the sector, delivery of major E&P projects and production targets, including the acquired Burlington properties, and the use of free cash flow to pay down debt. We do not believe that management would consider spinning off its refining business as we think that management can add significant value to shareholders over the medium to long term as an integrated company.
Catalysts for the overall refining sector are lower refined product imports, potential supply disruptions given the various product specification changes in the United States, and continued strength in product demand.
Key risk to owning Conoco over pure-play R&Ms would be E&P disappointments In our view, the key risks to owning Conoco (or other integrateds) in lieu of pure-play R&Ms would be any negative developments in its non-refining businesses. Disappointment with Conoco's E&P projects, misses to its E&P production profile, or concerns with the acquisition of Burlington could all drive underperformance in its shares vis-a-vis pure-play R&Ms. On the other hand, we think these risks are known to investors and actually appear to be driving the current discounted valuation.
In addition, a further material ratcheting up of expectations for long-term refining margins could favor the pure-plays. However, if investors were to increase long-term refining margin expectations, we would be surprised if the same did not occur for crude oil and US natural gas prices to the benefit of ConocoPhillips.
Finally, our 1Q 2006 EPS forecast of $2.30 for Conoco is below the $2.45 First Call consensus expectation. As we have written previously, actual 1Q commodity prices are on track to come in below original expectations. A sensitivity analysis based on preliminary 1Q prices would point to 1Q EPS of $2.10-$2.20 for Conoco, but we will wait for final pricing, as usual, before reviewing our estimates. Based on our bullish 2H 2006 and 2007 commodity outlook, our full-year 2006 and 2007 forecasts are currently (and likely to remain) higher than consensus.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
