29 March 2009

COP: Look Ahead to March 2009 Quarterly Results

The GCFR Overall Gauge of ConocoPhillips (NYSE: COP) fell from 52 of the 100 possible points to 44 in the fourth quarter of 2008.  Our original and updated analysis reports explained how this score was attained in some detail.  (Recent tweaks to our gauges bumped up the current score and the previous result at ConocoPhillips by two points each.  The Overall gauge now reads 46 points.)

We've now modeled ConocoPhillips's Income Statement for the March 2009 quarter.  The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data that the company will announce on, or about, 23 April 2009.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we present some background information.

Conoco, Inc., and Phillips Petroleum combined in August 2002 to form ConocoPhillipsBurlington Resources, with its extensive natural gas operations, was added to the mix in March 2006.  The combination produced a behemoth that is number five, when sorted by annual Revenues, on the Fortune 500 list of the largest U.S. corporations.  When stacked up against other global oil and gas major companies, ConocoPhillips has the seventh-most Market Capitalization.

The weak economy worldwide in late 2008 reduced demand for oil and gas, which caused prices for energy products to fall dramatically.  At ConocoPhillips, Revenue in the fourth quarter of 2008 was 15.5 percent less than in the fourth quarter of 2007.  Lower prices also meant that Conoco's assets weren't worth as much as they once were.  The company decided to reduce the carrying value of its intangible assets and investments by $35 billion, which was about 19 percent of the company's Total AssetsAsset impairment charges led to a Net Loss of $31.8 billion (minus $21.37 per share) in the fourth quarter. 

ConocoPhillips shares fell 29 percent, from $73.25 to $51.80, during the last three months of 2008.  The decline has continued in 2009, and the share price is now close to $40.
ConocoPhillips owns 20 percent of LUKOIL (OTC: LUKOY), which is responsible for more than 18 percent of Russia's oil production.  LUKOIL's shrinking market value was responsible for $7.4 billion of the fourth quarter's impairment charges.  Note that the LUKOIL charge is significantly greater than the one Conoco recorded in 2007, when troubles with the Venezuelan government resulted in a $4.5 billion charge for expropriated assets.

Berkshire Hathaway, Inc. (NYSE: BRK.A), run by super-investor Warren Buffett, and its affiliates owned about 79 million shares of ConocoPhillips on 31 December 2008, up from 17.5 million shares on 31 March 2008.  Buffett recently characterized the purchase of these shares, when energy prices were soaring, as his biggest mistake in 2008.

In October 2008, Conoco and Australia's Origin Energy, Ltd., (ASX:ORG) formed a 50/50 joint venture named Australia Pacific LNG.  The new company "will focus on coalbed methane production from the Bowen and Surat basins in Queensland, Australia, and LNG processing and export sales."

At its annual meeting with financial analysts on 11 March 2009, Chairman and CEO Jim Mulva described the company's plans and objectives for 2009.  ConocoPhillips will make capital investments totaling $12.5 billion in 2009.  Capital spending was a heftier $19.1 billion in 2008; however, $4.7 billion was dedicated specifically to the Origin Energy deal.

The fourth quarter earnings announcement included the following limited guidance for the first quarter of 2009.

“We have created a self-sustaining, competitive international integrated energy company, and our long-term strategy remains unchanged.  Through organic growth and prior business transactions, we have the resources and opportunities for long-term growth.  Our existing portfolio of high-quality assets enables us to replace reserves, maintain current production levels, and responsibly deliver energy to consumers in a low price environment.  In light of the current business environment, we are reducing our cost structure and constraining capital to live within our means.
“We anticipate the company’s first-quarter [Exploration and Production] segment production will be near fourth-quarter 2008 production, and we expect exploration expenses to be around $400 million for the quarter.  Downstream, we anticipate the worldwide refining crude oil capacity utilization rate in the first quarter to be in the low-80-percent range due to planned turnaround activity in the United States and continued economic run reductions at the Wilhelmshaven refinery.  Turnaround costs are expected to be approximately $225 million before-tax for the quarter."
[Emphasis added.]

Conoco's Revenue depends on factors such as, but not limited to, how much oil and gas the company produces, the prices at which it this output is sold, how much crude oil is processed by its refineries, and the price difference between crude and refined oil products.  The Refining and Marketing segment provided 68 percent of the company's total Revenue in 2008, and the Exploration and Production segment was responsible for 29 percent.

As we've seen, geopolitical and natural forces can have a significant effect on productivity and prices. 

The average daily price of a barrel of Light Sweet Crude oil was 25 to 30 percent lower in the first three months of 2009 than in the last three months of 2008.  If production was constant, as implied by the company's guidance, Revenue at the Exploration and Production segment could be down 25 to 30 percent from the fourth quarter of 2009.

Revenue at the Refining and Marketing Segment will also be negatively affected by the lower energy prices, but other factors must also be considered.  Refining margins rebounded strongly in the U.S. in early 2009, but were down elsewhere.  BP's Global Indicator Margin, which represents an average of a sort, was up 24 percent at last check from the fourth quarter of 2008.  ConocoPhillips won't, however, realize the full benefits of the higher margin because its capacity utilization rate is expected to be down from about 93 percent to the "low-80-percent range."

Considering lower prices, a higher margin, and lower capacity utilization, we estimate that Revenue at the Refining and Marketing segment will be down 20 percent from the fourth quarter of 2008.

If Refining and Marketing revenue was down 20 percent, Exploration and Production revenue was down 27.5 percent, and revenue from all other segments was flat, then total Revenue would be down 24.6 percent in the first quarter of 2009 relative to the fourth quarter of 2008.  Since Revenue in the December 2008 quarter was $44.5 billion, our Revenue estimate for the first quarter of 2009 is (1 - 0.246) * $44.5 billion = $33.6 billion.

ConocoPhillips' Gross Margin in 2008 was 25.1 percent.  While the trend was somewhat downward, we expect the margin will be hold the 25 percent level in the first quarter.  In other words, we're estimating that the Cost of Goods Sold [i.e., purchased crude oil, natural gas and products + Production and operating expenses] will be (1 - 0.25) * $33.6 billion or $25.2 billion.

We'll also assume, based on historic data, a Depreciation expense of 6.5 percent of Revenue, or $2.2 billion.  Similarly, we'll estimate SG&A expenses (mostly non-income taxes) at 12 percent of Revenue, or $4.0 billion.  We will then add $400 million for Exploration expense per company guidance and $100 million for non-recurring operating charges.

These figures would result in an Operating Income of $1.7 billion, down 72.5 percent from the March 2008 quarter when energy prices were sky high.

We then need to consider non-operating income and expenses, such as equity in the earnings of affiliates and interest.  Considering past results, we will set our expectation for net non-operating income at $720 million.  This pushes our estimate of pre-tax income to $2.4 billion.

ConocoPhillips' effective income tax rate is quite variable from quarter to quarter.  A rate of 44.0 percent would lead to provision for income taxes of $1.1 billion.  This should be close if there aren't too many special tax matters in the quarter.

After subtracting $20 million for Minority Interests, our estimate for Net Income becomes $1.3 billion ($0.88 per share).

Please note that the table format below, which we use for all analyses, can and often does differ in material respects from company-used formats.  A common difference is the classification of income and expenses as Operating and Non-Operating.  The standardization is simply for convenience and to facilitate cross-company comparisons.


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