19 December 2009

COP: Look Ahead to December 2009 Quarterly Results

ConocoPhillips (NYSE: COP) earned $1.00 per share during the third quarter of 2009, down sharply from $3.40 in the same period of 2008.

In October, we examined Conoco's Income Statement for the September quarter and compared the entries on each line to our "look-ahead" estimates.  We later performed a financial gauge analysis of Conoco, which determined that the GCFR Overall gauge fell from 27 to 18 of the 100 possible points.

We have now modeled Conoco's Income Statement for the quarter that will end on 31 December 2009.  The intent of this exercise was to produce a baseline for identifying deviations, positive or negative, in the actual data that the company will announce in late January or early February 2010.  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 ConocoPhillips and the business environment in which it is currently operating.

ConocoPhillips was formed in 2002 when Conoco, Inc., merged with Phillips PetroleumBurlington Resources, with its extensive natural gas operations, was added in March 2006 (when gas prices were high).

The combined company has the fifth-highest Revenue among major Integrated Oil and Gas firms.  Other large companies in this industry include Exxon Mobil (NYSE: XOM), Royal Dutch Shell (NYSE: RDS.A), Chevron Corp. (NYSE: CVX), PetroChina (NYSE: PTR), Petroleo Brasileiro (NYSE: PBR), and BP (NYSE: BP).

As is the case for most major oil and gas companies, ConocoPhillips has interests around the globe.  For example, ConocoPhillips owns 20 percent of LUKOIL (OTC: LUKOY), which is responsible for more than 18 percent of Russia's oil production.

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

Conoco also has operations in the North Sea.  Production this year was adversely affected by problems at the Ekofisk field in Norway.

When evaluating each potential energy exploration or production opportunity, the company's management must balance the project's various risks and the potential rewards.  Operating overseas might, depending on the country, involve political risks.  An expropriation forced Conoco to record "a complete impairment of its entire interest in its oil projects in Venezuela of approximately $4.5 billion, before- and after-tax." 

Assets in which Conoco has an ownership interest have also been expropriated in Ecuador.

Berkshire Hathaway (NYSE: BRK.A), run by investing guru Warren Buffett, owned 57.4 million shares of ConocoPhillips, worth almost $2.6 billion, on 30 September 2009.  Berkshire owned about 79 million shares on 31 December 2008.  Buffett characterized the purchase of Conoco shares, when energy prices were soaring, as his biggest mistake in 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.

Energy prices 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 later in 2008.  Crude oil plunged below $40 per barrel by the end of last year, but the price has rebounded above $70 in 2009.  The higher price has been attributed to optimism about the economy and fears of a weaker dollar, and greater compliance with output quotas.

Natural gas prices also soared and crashed last year, but spot prices haven't had much of a rebound.

The low price of crude oil at the end of 2008 led Conoco to conclude that the company's assets were worth less than before.  The company reduced 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.

In October 2009, ConocoPhillips announced it would "improve returns and deliver long-term organic growth from a reduced, but more strategic, asset base."  In the next two years, the company intends to sell assets worth approximately $10 billion.  In addition, capital expenditures in 2010 will be about 10 percent less than in 2008.

We're now ready to look ahead to the results of the fourth quarter.

A presentation [pdf] by Conoco management at the third-quarter conference call included the following notes about the outlook for the remainder of 2009.

  • Expected full-year E&P production of 1.85 MMBOED
  • Fourth-quarter refining utilization in the upper-70-percent range
  • Anticipated fourth-quarter benefits from reduction of discretionary inventory
  • Near-Term Projects
    • Start up of N. Belut
    • Commissioning of San Francisco hydrocracker
    • Final investment decisions on heavy oil expansions
  • Exploration Updates

From the conference call transcript, we learn that the anticipated production level for the year is "more than 3% higher than full year 2008."  Refinery utilization will be much less than the third quarter's 90 percent rate because the refinery in Wilhelmshaven, Germany, will be shut for scheduled maintenance.

Conoco expects "to realize a benefit of around $1.5 billion in cash and $150 million in earnings" when it reduces inventory held to take advantage of contango market prices.

Given this outlook and current and historical energy prices and margins, we expect Conoco's Revenue in the fourth quarter to equal $45 billion, which would be a 1.1 percent increase relative to the fourth quarter of 2008.

Of the various costs and expenses reported by Conoco, we group "Purchased crude oil, natural gas and products" and "Production and operating expenses" and call the combination Cost of Goods Sold.  In the September quarter, CGS was 76 percent of Revenue, which translates into a Gross Margin of 24 percent.  Because refining margins remain weak and utilization will drop, we are assuming the Gross Margin will slip to 23.5 percent.  In other words, we're estimating that the Cost of Goods Sold will be (1 - 0.235) * $45.0 billion or $34.4 billion.

Based on historic data, it seems reasonable to expect a Depreciation expense of $2.4 billion.  Similarly, we'll estimate SG&A expenses (mostly non-income taxes) at 11.5 percent of Revenue, or $5.2 billion.  We will then add $350 million for Exploration expenses and $100 million for non-recurring operating charges.

These figures would result in an Operating Income of $2.55 billion.

We then need to consider non-operating income and expenses.  For equity in the earnings of affiliates, our expectation is $1 billion.  For other income less interest expenses, a net loss of of $200 million seems reasonable.  This pushes our estimate of pretax income to $3.35 billion.

ConocoPhillips' effective income tax rate is quite variable from quarter to quarter, but a rate around 45 percent is typical when special tax matters don't interfere.  This rate would lead to provision for income taxes of $1.5 billion. 

After subtracting $20 million for Minority Interests, our estimate for Net Income becomes $1.8 billion ($1.22 per share).   In the year-earlier quarter, the company lost a whopping $21.38 per share on asset impairment charges.

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.

Note:  Tradingcharts.com is the source for the historical charts of crude oil and natural gas futures.

Full disclosure:  Long COP at time of writing

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