RealMoney Silver - COP Comes In Ahead of the Street

COP Comes In Ahead of the Street
By Thomas P. Au
RealMoney Contributor
1/23/2008 1:10 PM EST

Updated from 11:43 a.m. EST on Jan. 22.

ConocoPhillips (COP) reported fourth-quarter earnings of $2.71 a share, modestly ahead of Street expectations of $2.57 a share, leading to adjusted full-year earnings of $9.39 a share.

Overseas operations in Russia (where production declined), Venezuela (which were expropriated) and Ecuador (which were written down) are the Achilles heel.

Developed country upstream operations increased output compared to the previous year, so the company is on track to earn over $10 a share in 2008, given higher average oil prices that should more than offset slightly lower volumes.

Downstream, global refining plant utilization rose one percentage point, to 95%, allowing the spreading out of fixed costs and largely making up for the impact of higher feedstock costs. Here, geographical concentrations had a negative impact as the company had less exposure to high-margined U.S. West Coast markets and greater exposure to weaker U.S. East Coast, Midwestern and European markets than some of its peers. Chemical operations suffered from similar issues.

As mentioned in the preview, ConocoPhillips is pushing strongly into natural gas. One major project is a joint venture in Australasia (the area between Australia and Indonesia), with Woodside, an Australian company, aimed at Far East markets. ConocoPhillips is also pursuing natural gas exploration in the Arabian peninsula in the Middle East.

Stateside, reported earnings (although not cash flows) are burdened with amortization charges connected with the 2006 acquisition of Burlington Resources' gas properties, although there won't be similar additional charges as the properties are more fully developed.

Strong cash flow means that the company has been able pay off enough debt to reduce the debt-to-total-capital ratio to below 20%, even while repurchasing stock. This posture probably will continue for at least another year because capital spending will remain flat at under $15 billion in 2008 before rising in 2009. That's because the new projects referred to above are in the planning stages and do not require large immediate expenditures.

By thus reducing its capital base, ConocoPhillips may have pulled ahead of peers on a return on capital basis. (The company is the first major to report, and therefore comparisons with others are a conjecture at this point.) This is not reflected in the stock's P/E ratio, even in comparison to other energy issues. Thus, it is a worthy selection for investors seeking a major energy company weighting.

COP Preview: Natural Gas Is the Swing Factor

ConocoPhillips (COP) probably earned about $9.25 a share on $183 billion of net revenue in 2007 ($2.57 a share on $47 billion of revenue in the December quarter vs. the Street's estimate of $2.38 per share on 75.74 billion). The 2008 consensus has earnings about a dollar a share higher, or over $10 a share on $190 billion of sales for 2008, based on the recent spike that took oil prices to over $100 a barrel, and will probably leave this year's average realizations in the $80 to $90 a barrel range.

The company's problem is that volumes, for oil at least, will decline at a low single-digit percentage rate because the company probably has not found enough new reserves in the past year or two to replace production over that span. (Other U.S. majors have this problem, but probably not to the same degree.)

A fuller story will be told when ConocoPhillips discloses estimates of reserves and the likely present value of net future cash flows in its annual report. Such figures take into account not only new reserves but also revisions of the value of last year's reserves, based on the price changes and engineering developments that have taken place in the interim.

The company's international initiatives have not gone well, with a drop-off in production in Russia and the Middle East and the expropriation of Venezuelan operations. Stateside, ConocoPhillips actually suffers from higher oil prices because it refines more oil (for gasoline) than it produces and needs to purchase the difference from others. Other downstream operations, such as chemicals, are also suffering from high feedstock costs.

The swing factor for the company appears to be natural gas, rather than oil, particularly in North America. One promising project is the development of Alaskan North Slope gas, which can be piped to the Midwestern United States via Canada, but this would be some years away. And prices for ConocoPhillips' existing gas deliveries from Texas, the Rocky Mountains and elsewhere, are historically low compared to oil. So the natural gas-heavy company has not gotten the full benefit of the recent price windfall for crude. This tilt to gas became more pronounced after the 2006 acquisition of Burlington Resources.

The stock is cheap even compared to those of its peers in the oil patch. That may be because ConocoPhillips is a newer company in its present form than similarly sized outfits, having been formed by the merger of its two component parts in 2002.

Other issues appear to be its less attractive geographical mix -- Midwest and mid-continent U.S. vs. East Coast and South Atlantic for ExxonMobil (XOM) and West Coast for Chevron (CVX) and Occidental (OXY) -- as well as a relatively heavier weighting in troubled emerging markets.

Nevertheless, this issue, like other oil equities, does represent a call option on higher oil and gas prices and at a greater discount to intrinsic value than most. As such, it represents a cheap way to play such fuel prices for those who believe that they will go higher. Berkshire Hathaway (BRKA) is a case in point as a holder.