15 June 2010

COP: Look Ahead to June 2010 Quarterly Results

This post describes our model of ConocoPhillips's (NYSE: COP) Income Statement for the second quarter of 2010, which will end on 30 June.

The purpose of the model is to establish a baseline for identifying surprises, positive or negative, in the quarterly results the company will report.  Estimates for each line of the Income Statement are derived from management's guidance, the company's historical financial results, and other publicly available data.

We begin by reviewing background information about ConocoPhillips and the business environment in which it is currently operating.

ConocoPhillips is one of the ten biggest Integrated Oil and Gas companies, which produce, refine, transport, and market energy products.  The market capitalization of ConocoPhillips is now around $80 billion. 

It has business interests around the world.

The company was formed in 2002 when Conoco, Inc., merged with Phillips Petroleum.  It added Burlington Resources, with its extensive natural gas operations, in March 2006 (when gas prices were high).  In 2004, ConocoPhillips began investing in Lukoil (OTC: LUKOY), which is now responsible for 18% of total Russian oil production

In 2009, ConocoPhillips earned $4.86 billion ($3.24 per share) on revenue of $152.8 billion.  In 2008, the roller-coaster rise and fall of crude oil prices resulted in record-high annual revenue of $246.2 billion.  However, charges slashing the carrying value of intangible assets and investments by $33 billion led to a $17 billion loss in 2009.

Investing guru Warren Buffett, of Berkshire Hathaway (NYSE: BRK.A), characterized the purchase of ConocoPhillips shares, when energy prices were soaring, as his biggest mistake in 2008.  Berkshire still owned 33 million shares on 31 March 2010.

The company's organization includes the following six operating segments:  Exploration & Production, Midstream, Refining & Marketing, Lukoil Investment, Chemicals, and Emerging Businesses.  The Chemical segment consists of a joint venture with Chevron.

The Refining and Marketing segment provided more than 70 percent of ConocoPhillips's revenue in 2009, and Exploration & Production contributed most of the rest.  However, Exploration & Production and the Lukoil Investment got credit from most of the year's Net Income.

In 2009, ConocoPhillips's worldwide production, excluding Lukoil, averaged 1.85 million barrel-of-oil equivalents per day, compared with 1.79 million boe/day in 2008.

The price of crude oil exceeded $140 per barrel at its peak in mid 2008, but speculators exiting the market in fear of economic weakness caused the price to plunge below $40 per barrel.  In 2009, the price started to recover along with optimism about the economy, predictions of a weaker dollar, and greater compliance with OPEC production quotas.  More recently, the price has been trading in the $70 to $80 range.

Natural gas prices also soared and crashed in 2008, but spot prices haven't had much of a rebound.

In October 2009, ConocoPhillips announced it would "improve returns and deliver long-term organic growth from a reduced, but more strategic, asset base."  The company signaled it would sell assets worth approximately $10 billion over the next two years, and it would trim capital expenditures in 2010 to $11 billion, from $12.5 billion in 2009. 

The Wall Street Journal reported that Conoco's "restructuring is mandatory" because of the company's concentration in oil refining and natural gas, which are two of the weakest sectors of the energy industry.

More details about the asset divestitures emerged in March 2010 when Conoco publicized its intent to sell half of its 20 percent stake in Lukoil.  Selling its shares in small open-market transactions, Conoco might realize almost $5 billion.  The Financial Times quoted Conoco CEO Jim Mulva as saying, "The new opportunities in Russia haven’t developed for us as quickly as we would have thought."

On 12 April 2010, ConocoPhillips announced it would sell its 9 percent of Syncrude, which converts oil sands in Canada into crude, to Sinopec for $4.65 billion.

In the first quarter of 2010, which ended 31 March, ConocoPhillips earned $1.40 per diluted share on a GAAP basis.  Adjusted earnings per share were $1.47 in the March quarter.  The latter figure excludes $110 million of after-tax charges related to ConocoPhillips' withdrawal from the Shah gas project in Abu Dhabi and the Yanbu refinery project in Saudi Arabia.

We're now ready to look ahead to ConocoPhillips's results for the June 2010 quarter.

This effort is based on comments made during the conference call on 29 April 2010 (transcript available from SeekingAlpha), the company's presentation to analysts on 24 March 2010, reported energy prices and margins, historical data, and seasonal patterns. 

Management stated "production is expected to be lower" in the second quarter "due to seasonal maintenance and normal decline."  "2010 production levels [are expected] to be flat with 2008 normalizing for the impact of asset dispositions."

The company also expected improved refinery utilization rates "especially internationally."

Given historical and current energy prices and margins, our current estimate for Revenue in the June 2010 quarter is $48.0 billion, which would be a 35 percent increase relative to the same quarter of 2009.

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.  CGS has been close to 76 percent of Revenue, translating into a Gross Margin of 24 percent, in each of the last few quarters.  Improved refining margins, for one thing, might enhance the Gross Margin, but this upward force will be balanced to some extent by increased maintenance activities.

We are assuming the Gross Margin will expand only to 24.5 percent.  In other words, we're estimating that the Cost of Goods Sold will be (1 - 0.245) * $48 billion or $36.2 billion.

Based on historic data, it seems reasonable to expect a Depreciation expense of $2.4 billion.  Similarly, we'll estimate SG&A expenses (including non-income taxes in our presentation) at 10 percent of Revenue, or $4.8 billion.  We will then add $350 million for Exploration expenses and $200 million for non-recurring operating charges.

These figures would result in an Operating Income of $4.0 billion, up from $1.5 billion in June 2009.

We then need to consider non-operating income and expenses.  The ongoing reduction of the Lukoil stake would presumably result in lower equity in the earnings of affiliates.  However, we don't know the pace of share sales, nor the cost basis for the shares sold.  We'll be conservative and estimate $600 million in equity earnings.

For other income less interest expenses, a net loss of $220 million would be typical.  This pushes our estimate of pre-tax income to $4.4 billion.

ConocoPhillips' effective income tax rate is quite variable from quarter to quarter, but a rate around 47 percent wouldn't be unusual when special tax matters don't interfere.  This rate would lead to provision for income taxes of $2.1 billion. 

After subtracting $20 million for Noncontrolling Interests, our estimate for Net Income becomes $2.3 billion ($1.54 per share).  In the year-earlier quarter, the company made $859 million ($0.57 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.

Notes:  Two figures were extracted from the ConocoPhillips Annual Analyst Meeting Presentation [6 MB pdf] on 24 March 2010.

Full disclosure:  Long COP at time of writing

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