18 June 2009

COP: Look Ahead to June 2009 Quarterly Results

The GCFR Overall Gauge of ConocoPhillips (NYSE: COP) slipped from 46 to 44 of the 100 possible points in the first quarter of 2009.  Our initial and updated analysis reports explained in some detail how this score was attained.

Lower energy prices have had a crippling effect on Conoco's results.  Earnings per share fell from $2.62 in March 2008 to $0.56 in this year's first quarter.  Revenue dropped 44 percent.

With some concern, we noted that Conoco's Long-term Debt to Equity ratio had more than doubled in the 12 months ending 31 March 2009.  LTD increased 39 percent ($21.1 billion to $29.3 billion), and Shareholders' Equity nosedived 37 percent ($89.6 billion to $56.2 billion) as a byproduct of the massive asset impairment charges Conoco recorded in 2008.

We have now modeled ConocoPhillips's Income Statement for the soon-to-be-concluded June 2009 quarter.  The intent of this exercise was to produce a baseline for identifying any deviations, positive or negative, in the actual data the company will announce in late July.  GCFR estimates are derived from trends in the historical financial results and guidance provided by company management.

First, we set the stage with some background information about the company and the business environment in which it operates.

ConocoPhillips (NYSE: COP) is the seventh-largest, when ranked by market capitalization, Major Integrated Oil & Gas firm in the world.  [Exxon Mobil (NYSE: XOM) is number one by a wide margin.]   ConocoPhillips is fourth on the 2009 edition of the Fortune 500 list of the largest U.S. corporations, up from fifth in 2008.

Conoco, Inc., and Phillips Petroleum merged in August 2002.  Burlington Resources, with its extensive natural gas operations, was added in March 2006.

Energy prices (and, therefore, the revenues of energy producers) surged through the first half of 2008.  The price of crude oil exceeded $140 per barrel at its peak.  The global economy then stalled, and speculators exited the market.  A barrel of crude plunged below $40 by the end of 2008.  However, the price has spiked again this spring to about $70 per barrel.  The recent rise has been linked to fears of a weaker dollar and inflation.  (Others are skeptical the increase is justified.)

Natural gas prices also crashed last year, but they haven't had a rebound equivalent to crude's.

The low price of crude oil at the end of 2008 implied that Conoco's assets were worth less than they had been.  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 Assets at the time.  Asset impairment charges led to a loss of $31.8 billion (minus $21.37 per share) in the fourth quarter of 2008.

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 in 2008 was responsible for $7.4 billion of the impairment charges.  Note that the LUKOIL charge was significantly greater than the widely publicized charge ConocoPhillips recorded in 2007, when troubles with the Venezuelan government resulted in a $4.5 billion charge for expropriated assets.

Berkshire Hathaway (NYSE: BRK.A), run by investing guru Warren Buffett, owned more than 71 million shares of ConocoPhillips on 31 March 2009.  Berkshire pared its holdings by about 8 million shares in the first quarter of 2009.  Buffett characterized the purchase of Conoco 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."

We're now ready to look ahead.

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


Mr. Mulva concluded: [...]

“Looking ahead to next quarter, we expect the company’s second-quarter E&P segment production will be lower than the first quarter, primarily due to planned maintenance and seasonality. However, full-year production is expected to be slightly higher than 2008. Exploration expenses are anticipated to be approximately $325 million for the quarter.

“In our downstream refining business, we expect the worldwide refining crude oil capacity utilization rate to be in the upper-80-percent range during the second quarter and turnaround costs to be approximately $125 million before-tax for the quarter.”

[Emphasis added.]

To put the second part of the guidance in perspective, we note that Conoco's worldwide refining crude oil capacity utilization rate was 81 percent in the first quarter of 2009, 93 percent in the fourth quarter of 2008, and 89 percent in the first quarter of 2008.

Conoco's Revenue is dependent, for the most part, on how much oil and natural gas it produces and refines, the cost of production, and the prices at which various energy products are bought and sold.  The company's Refining and Marketing segment provided 68 percent of total Revenue in 2008, and the Exploration and Production segment was responsible for 29 percent.

Geopolitical and natural forces can have a significant effect on productivity and prices. 

For information on energy commodity prices and refining margins, the trading conditions data published by BP is especially helpful.  From this source, we learn:
  • The average price per barrel of Brent crude oil has rebounded from $44.46 in the first quarter of this year to about $56.50 in the current quarter. 
  • The benchmark price of Russian oil jumped even higher, from $19.52 to $30.87.
  • U.S. natural gas prices have continued their long decline, from $4.91/mmbtu to $3.51.
  • BP's Refining Global Indicator Margin has also declined, from 6.2 to 5.3.

Rising oil prices and more efficient refineries, relative to the first quarter, will tend to increase Conoco's Revenue in the second quarter.  However, lower production and lower gas prices will have the opposite effect.  We're not sure how much to weight each of these factors, but our cursory investigation suggests that the crude oil price as the most dominant factor in determining the Revenue.

Therefore, we believe the positive effect of the higher oil prices on Revenue will prove more significant than the downward pressure caused by the lower gas prices.  We also suspect that the benefits of the significantly higher refinery utilization rate will outweigh the expected (small) drop in oil production.

Under these circumstances, we estimate that second quarter Revenue will be 15 percent greater than the first quarter's $30.7 billion.  Therefore, our target is $35.4 billion.

ConocoPhillips' Gross Margin in the first quarter was 27.4 percent, which is 1 to 2 percent higher than it had been recently.  We will set our target for the Gross Margin at 26 percent because we are concerned about the effect of the refining margin.  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 - 0.26) * $35.4 billion or $26.2 billion.

Based on historic data, it seems reasonable to expect a Depreciation expense of $2.3 billion.  Similarly, we'll estimate SG&A expenses (mostly non-income taxes) at 12 percent of Revenue, or $4.2 billion.  We will then add $325 million for Exploration expense per company guidance and $200 million for non-recurring operating charges.

These figures would result in an Operating Income of $2.1 billion, down 74 percent from the June 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 $300 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 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 ($0.89 per share).   In the year-earlier quarter, earnings were $5.4 billion ($3.50 per share).

Please click here to see a full-sized, normalized depiction of the projected results next to ConocoPhillips's quarterly Income Statements for the last couple of years.  Please note that our organization of revenues, expenses, gains, and losses, which we use for all analyses, can and often does differ in material respects from company-used formats.  The standardization facilitates cross-company comparisons.

  1. The source for the historical charts of crude oil and natural gas futures is Tradingcharts.com
  2. The Lukoil ADR price chart is from Yahoo! Finance
  3. The US EIA and BP's trading conditions were sources of energy price data.

Full disclosure:  Long COP at time of writing

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