21 September 2010

COP: Look Ahead to September 2010 Quarterly Results

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

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 company's market value is now around $80 billion, a little more than half its high. 

ConocoPhillips has business interests in 26 countries around the world, from Algeria to Vietnam.

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 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 2008.

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 Russian oil producer Lukoil (OTC: LUKOY), which it began acquiring in 2004.  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."  This plan changed in July when Conoco decided to pursue the sale of its entire Lukoil investment by the end of 2011.

ConocoPhillips has also sold equity investments in Syncrude and CFJ Properties.

For financial data reporting, ConocoPhillips has 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 generated much 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 in 2010 has generally been around $80 per barrel.  This price has settled above the $40 low in early 2009 when the global economy seemed most fragile, but well below oil's $140 peak in 2008 peak.  Crude's price tends to move up or down based on changing perceptions of how economic conditions will affect the demand for oil, how geopolitical and other forces will affect the supply, the availability of new energy sources, compliance with output quotas, and the value of the dollar.

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

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 29 million COP shares on 30 June 2010.

ConocoPhillips earned $2.77 per diluted share on a GAAP basis in the second quarter of 2010.  If special items related to the sale of equity investments are excluded, the adjusted earnings were $1.67 per share.  Reported and adjusted earnings both dwarfed the $0.57 per share reported by ConocoPhillips in 2009's second quarter.

Readers wanting to take another look at ConocoPhillips's June 2010 quarter might wish to review our Income Statement and Financial Gauge analyses.

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

The press release on 28 July 2010 announcing second quarter results did not include any specific guidance for ConocoPhillips's third quarter or the remainder of 2010.  However, during the ensuing conference call (transcript available from SeekingAlpha), the company's management commented on expectations for production, refinery utilization, and costs.

Production is expected to be "close to" 1.8 million BOE per day, as it was in 2008.  New production should offset declines in mature fields.  Refinery utilization rates are expected to fall slightly in the third quarter. 

Given these production comments, along with current energy prices and margins, our estimate for Revenue in the September 2010 quarter is $45.0 billion, which would be a 12-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.  Energy prices, refining margins, and maintenance activities can affect the Gross Margin.

We are assuming the Gross Margin will contract slightly to 23.8 percent in the September 2010 quarter.  In other words, we're estimating that the Cost of Goods Sold will be (1 - 0.238) * $45 billion = $34.3 billion.

Based on historic data, it seems reasonable to expect a Depreciation expense of $2.3 billion.  Similarly, we'll estimate SG&A expenses (including non-income taxes in our presentation) at 10 percent of Revenue, or $4.5 billion.  We will then add $300 million for Exploration expenses and $200 million for non-recurring operating charges.

These figures would result in an Operating Income of $3.4 billion, up from $2.15 billion in September 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 are estimating $750 million in equity earnings.

We're not making any provisions for gains or losses on asset sales, as we have no data to make an informed estimate.  Items related to asset sales could have a substantial impact on reported earnings.

For other income less interest expenses, a net loss of $200 million would be typical.  This brings our estimate of pre-tax income to $4.0 billion.

ConocoPhillips' effective income tax rate is quite variable from quarter to quarter, but a rate around 45 percent wouldn't be unusual when special tax matters don't interfere.  This rate would lead to provision for income taxes of $1.8 billion. 

After subtracting $20 million for Noncontrolling Interests, our estimate for Net Income becomes $2.16 billion ($1.44 per share).  In the year-earlier quarter, the company made $1.47 billion ($0.98 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.


http://futures.tradingcharts.com is the source for the historical price charts for crude oil and natural gas.

Another good source of information was 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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