Seeking Alpha
We cover over 5K calls/quarter
Profile| Send Message|
( followers)  

ConocoPhillips Inc. (NYSE:COP)

Q3 2008 Earnings Call Transcript

July 23, 2008 11:00 am ET

Executives

Gary Russell - GM of IR

Jim Mulva - Chairman and CEO

John Carrig - COO

Sig Cornelius - SVP of Finance and CFO

Analysts

Robert Kessler - Simmons & Company

Paul Sankey - Deutsche Bank

Paul Cheng - Barclays Capital

Michael Lamotte - JPMorgan

Erik Mielke - Merrill Lynch

Mark Gilman - Benchmark

Neil Mcmahon - Sanford Bernstein

Operator

Welcome to the ConocoPhillips third quarter 2008 Earnings Call. (Operator Instructions).

I would now like to turn the presentation over to your host for today's conference, Mr. Gary Russell, General Manager of Investor Relations.

Gary Russell

Thanks, Jen. Welcome to everybody on the call this morning to the third-quarter conference call for ConocoPhillips.

Joining me today is Jim Mulva, our Chairman and Chief Executive Officer; John Carrig, our President and Chief Operating Officer; and Sig Cornelius, our Senior Vice President of Finance and Chief Financial Officer.

The slide presentation that Jim Mulva will take you through today is intended to help you with your understanding of our financial and operating performance in the third quarter. And you can find this presentation on our website, conocophillips.com.

If you will turn to page two with me now, you will find our typical cautionary statement. That cautionary statement basically says that we will be making forward-looking statements in our presentation today, along with responses to your questions. And those forward-looking statements include our current view of expectations. Actual results can differ materially from what those expectations are and you can find those items that might cause expectations to be different than actual results in our SEC filings.

I will now turn the call over to Jim Mulva.

Jim Mulva

Welcome to our conference call. I am going now right to page three of our presentation, and as we normally do, we will go through these slides. You can see in the third quarter our income was $5.2 billion, which is $3.39 a share. We generated $7.5 billion of cash from operations, so our debt to capital ratio remained unchanged at 19%.

Now on our upstream business, we produced 2.17 million BOE a day and that includes 422,000 BOE per day from our LUKOIL investments segment. Downstream, our refinery utilization rate was 87%, that's down from last quarter and it is primarily due to the hurricane impacts.

We purchased $2.5 billion of our stock in the third quarter and that reduced our average shares outstanding to 1.528 billion shares; 116 million shares lower than the third quarter 2007 average.

We are pretty pleased with our strong operating performance when you give consideration to the negative impacts from the Gulf Coast hurricanes in the third quarter.

So I am moving now onto page four of the presentation, total company net income. Here you can see that third-quarter net income of $5.2 billion was $251 million lower than the prior quarter, which was $5.4 billion. That's shown on the gold bar on the left-hand side of the chart.

So if you move from the left to the right, you could see our contribution from asset rationalizations in the third quarter was $129 million higher than the second quarter. Then we had prices, margins, and other market impacts reduce third-quarter income by $13 million.

We had lower volumes, primarily from LUKOIL and refining and marketing segments. That reduced income of $232 million. I'll talk more about this when we go through the individual segments. There were a number of other items that in the aggregates had a negative impact of $135 million, and that's going to be covered more in subsequent slides.

I'll now go over to the fifth slide, which is total company cash flow. And if you start on the left gold bar, you could see that in the third quarter we generated $7.5 billion of cash from operations. So that along with our cash balance at the start of the quarter $787 million, we had $8.3 billion in cash, which was available for use during the third quarter.

As we move from left to right in the slide, you can see how we used this cash, which was $4 billion for our capital program, $710 million in dividends. We purchased about $2.5 billion of our shares. We ended with cash balance in the quarter of $1.1 billion.

So I'm moving to slide six, which is our total company cash flow for the first nine months of the year. And you could see the pie chart on the left, total cash available for the first three quarters was $20.8 billion, of which $19.5 billion or 94% was generated from operations, $1.3 billion or 6% mainly came from a combination of a slight amount of debt increase and proceeds from asset sales.

If you look at the pie chart on the right, you could see how we used $20.8 billion. We spent $11.2 billion on our capital program. We purchased $7.5 billion of our stock and paid $2.2 billion in dividends.

Now, I am moving on to slide seven, start talking that Exploration & Production. And as you are aware, we experienced both lower crude oil and natural gas prices in the third quarter. Our realized crude oil price at the third quarter was $112.19 a barrel or $5.82 a barrel lower than the second quarter.

Our realized natural gas price was $8.91 per Mcf, and that's $0.96 per Mcf lower than the prior quarter. And this is consistent with our previous guidance, as well as in our previous guidance, our production volumes were similar to last quarter and we are going to go through that in the next slide, which is page eight.

Third-quarter production from E&P segment was 1.75 million BOE a day, which is basically flat from the second quarter, as we progress from the left-hand side of the slide to the right. Although, our production was basically flat during the third quarter, we had the variances which are positive and some that were down.

So starting with the red bar on the left, you can see that production was 29,000 BOE a day lower in Alaska. This is primarily due to planned downtime and seasonality that we experience normally in this time of the year. Moving further to the right, our production in the Lower-48 was down 22,000 BOE a day, primarily due to the impact from the hurricanes.

In Norway, our production was 19,000 BOE a day higher, mainly from the startup of our participation in the Alvheim Field. In Russia, production was up 15,000 BOE a day and that's due to the startup of the YK Field in the Timan-Pechora area up in Siberia. In addition, the production in Canada was 13,000 BOE a day higher due to lower planned downtime.

Now it is important to note that even though production was higher in the UK, due to the startup of the Britannia satellite fields, that benefit was offset by planned and unplanned downtime and normal fuel decline. So when you add to this 1.75 million BOE a day, which is our E&P segment, and you add the equity share of LUKOIL's production, then our total company production totaled 2.17 million BOE a day in the third quarter.

Now, moving on to slide nine, talking about E&P net income. Our income in the third quarter was $3.9 billion, compared to about $4 billion in the second quarter, which is shown on the gold bar on the left. So we move from the left to the right, contribution from asset sales increased income to $126 million, and prices and other market impacts reduced income $250 million when you compare third quarter to second quarter.

Income has also improved $41 million compared to the previous quarter, as a result of just the impact of regional mix and divergence of effective tax rates on sales volumes.

Then there were other items which improved earnings $13 million. This includes positive impacts from foreign exchange and production taxes. That's offset partially by higher DD&A and operating costs, as well as, adjustments and abandonment obligations.

Now I'm going to move from the upstream to the downstream part of the company on slide 10. Our global realized marketing margins were higher in the third quarter. In the United States, the realized margin was $3.56 a barrel. Now that's up $2.33 a barrel from the second quarter and internationally $9.90 a barrel, which is up $0.85 a barrel compared to the second quarter.

In the US, the realized refining margin in the third quarter was $9.03 a barrel, that's $1.26 a barrel lower than the previous quarter. We had the benefit from higher clean product yields and improved margin for secondary products, but that was more than offset by the narrowing of the heavy crude oil differentials and inventory impacts related to the decrease in crude and refined product prices.

And then in addition, our ability to capture the higher Gulf Coast refining margins was impacted by the downtime in certain of our refineries associated with the hurricanes.

Turning to the international market, our realized refining margin was at $11.24 a barrel, that's $4.54, a barrel higher than the previous quarter and that's due to reduction in temporary inventory builds and we had better clean product yields. International margins continue to be though negatively impacted by the poor hydroskimming margins associated with primarily our Wilhelmshaven Refinery.

The domestic refining crude oil capacity utilization in the third quarter was 90%, that's 4% down from the second quarter, primarily due to the hurricane impacts. That impact was approximately 6% and was partially offset by lower turnaround activity.

The international crude oil capacity utilization was 75%, its down from 88% the prior quarter and the weak hydroskimming margins continued to impact the utilization at the company's Wilhelmshaven Refinery. We didn't run the Wilhelmshaven Refinery at all time periods through the third quarter, because of the margins that impacts utilization.

So worldwide, our Refining & Marketing crude oil capacity utilization rate was 86% compared to 93% in the prior quarter.

Now I am going to go to the next slide, page 11, which is downstream net income. Our third quarter income was $849 million, which is $185 million higher than the second quarter, which was $664 million. That is reflected in the gold bar on the left-hand side of the chart.

So if you move from the left to the right, you could see that prices, margin, other market impacts improved the income $207 million. This improvement is primarily attributed to higher global marketing margins. As previously mentioned, reduced volumes mainly as a result of the hurricanes, negatively impacted income a $128 million when you compare quarter-to-quarter.

We did experience lower operating costs, mainly due to the reduced turnaround activity and this increased income is $77 million. There are a lot of other items in the aggregate that improved the income by $29 million.

Now I'm moving on to page 12, the other segments. For financial reporting, page 12, our estimate of third quarter earnings from LUKOIL is $438 billion. This is lower than second-quarter estimate of $774 million. This is primarily due to lower volumes, prices, margin estimates. Net true up quarter-to-quarter was a positive $19 million.

The income from our midstream business was $173 million that compares to $162 million in the second quarter, which is due primarily to higher margins, marketing activity and offset somewhat by the hurricane impacts.

In Chemicals segment, our joint-venture contributed $46 million in income higher than the prior quarter of $18 million and primarily due to higher ethylene and polyethylene margins, offset somewhat by the impact of the hurricanes.

Our emerging businesses contributed $35 million in the third quarter that compares to $8 million in the second quarter. It reflects primarily the higher spark spreads and foreign exchange impacts.

Our corporate costs of $281 million were $95 million higher than the second quarter, primarily a result of foreign exchange impacts.

So now I'm going to move on to our metrics, E&P and downstream on page 13. On page 13, it shows E&P income and cash per BOE for the years 2003 through 2007. By the way when we show our peer group, what we are really looking at is competition against the five largest publicly traded companies, and that is Shell and BP, and Total and Chevron, and Exxon.

While we don't have peer data for the third quarter, obviously 2008, because we're the first one reporting, when you look at the third quarter, we would expect to be competitive on these metrics for E&P on an income and on cash per BOE.

Now, I'm going to go to slide 14. We have the same peer group, and looking at the metrics for downstream on an income and on cash per barrel, it shows for the years 2003 through 2007 we expect to be competitive on both of these metrics as we look at the third quarter results.

Now, I'm going to go to slide 15. Again the shaded areas are the same peer group, BP, Shell, Total, Exxon and Chevron. You can see that it reflects for a return on capital employed that no adjustments are made for purchase accounting. Adjustments made to the peer group reflect purchase accounting for them is attached to table three. So, our annualized ROCE for the third quarter of 2008 was 18%. That's compared to 17% for the first half.

Then we go to the last slide, 16, which is our outlook. We recently announced a plan to create long-term Australasian natural gas business with Origin focused on coalbed methane production and liquefied natural gas processing and sales and expect to close this here in the next week or so.

And then we recently announced the signing of an MOU with KazMunayGas in Kazakhstan and Mubadala from Abu Dhabi to negotiate terms for exploration and production in the N Block, the Nursultan block, offshore of Kazakhstan. This will be under a new subsoil use contract, and this is a new major exploration presence for ConocoPhillips in Kazakhstan.

On downstream, we received our government approval in early September to keep permits associated with expansion of the Wood River refinery. It's located at Roxana, Illinois, and that's jointly owned by our company and EnCana.

Then for the fourth quarter, we anticipate the company's E&P segment production will be higher in the fourth quarter than the third quarter. We expect our full year 2008 production to be slightly below 1.8 million BOE per day due to the impacts of the higher prices and the first three quarters of the year, higher prices and their impact on production sharing volumes. We experienced production loss associated with the hurricanes in the third quarter.

We expect our exploration expenses to be in the range of $400 million in the fourth quarter. Now, on downstream fourth quarter, our crude oil capacity utilization rate is expected to be in the mid-90% range. Our turnaround costs are expected to be about $75 million before tax.

Share repurchases have continued into the fourth quarter. Through the end of October, we will have purchased about $8 billion in 2008 under our previously announced program. Stock repurchase levels for the balance of the year will depend on the market conditions that we see in our capital commitments, and we're going to update the market in the early to mid part of December on the anticipated level of share repurchase that we expect for remainder of the fourth quarter.

Along with that announcement, we will announce what we have in mind for our 2009 capital program along with anticipated share repurchase plans for 2009.

So, that completes the prepared remarks, Gary. And so, I think we are ready now to take questions and comments from those participating in our conference call.

Gary Russell

Okay, Jen, go ahead and queue up the questions please.

Question-and-Answer Session

Operator

(Operator Instructions). Our first question comes from Robert Kessler with Simmons & Company.

Robert Kessler - Simmons & Company

I appreciate you're going to give us a more complete update in December in terms of your capital program and share buybacks, but it seems every day brings new volatility and a lot of shifting opportunities one would think in the balance between buybacks, organic investments, and potential M&A. I'm curious if you could just give us perhaps some more qualitative comments at this point in terms of how you are thinking about the relative mix between those three buckets.

Jim Mulva

When we look at the marketplace, the business environment and the worldwide economy and the political situation, when we look at how we are going to manage through this difficult time period and the challenges just outlined, we are looking at not just the remainder of this year, November and December, we are already looking out for all of 2009. So, we're really looking at this 14-month time period.

Obviously, we look beyond 2009. So, what we have done as a company, we are very pleased with adding new opportunities. And I'll just name a few of them: the Nursultan block that we expect to close later this year, the Shah sour gas large project that we are involved with in, in Abu Dhabi and then the Origin joint venture in Australia. So, we have added quite a few new things to an already pretty substantial opportunity list of what we are going to be investing on over the next five years or so.

So, as we look at this, first and foremost is that we want to maintain a really strong financial balance sheet position with flexibility and credit capability. Second, we want to fund those capital commitments and opportunities that we have as a company. So looking at what we have added and what we're already doing, and I am not enumerating all the different things that you are very familiar with, we expect that we will most likely have a capital program in 2009 that looks a lot like what we're going to experience in 2008, which is in the neighborhood of, say, $15 billion.

After always maintaining a strong balance sheet and funding our capital program -- by the way, when we fund our capital program we don't want to ever lose optionality. So, there are some things just because of market conditions, say, drilling programs and all because of the lower price environment that we see in North America, say, Canada and Lower 48, there are things that we can defer, but we don't lose the optionality.

We are making all of this fit. So, having maintained a strong balance sheet, funding our capital program through this downcycle, we like the discipline of annual increases and dividends. And then whatever the market gives us over and above all of those things, then we will be considering buying our shares back in, because we like the price that we see for buying our shares in.

So, that gives you hopefully the color of how we approach looking at things. It's not just November, December. It's what we look at between now and the end of 2009.

Then the other thing is that we like to have a fair degree of flexibility capability. There will be the opportunities to pick up some attractive acreage where we already have strong positions, say, in Canada and the Lower 48. We are not talking about large amounts, but there may be the opportunities for $100 million or $200 million or $300 million. And we want to do that to really support our basic business not just today, but over the next number of years.

So, hopefully I've given you the color of how we approach the priority and the sequencing if we look through this challenging environment that we are managing through.

Robert Kessler - Simmons & Company

Jim thanks for the color, and I appreciate the preliminary $15 billion number kind of flat year-on-year. Any thoughts as to what kind of inflation or deflation, as the case may be, embedded into that figure so far?

Jim Mulva

Well, we haven't really built in expectations of lower costs. So, we are still using pretty strong inflation expectations for 2009 and subsequent periods. But we are starting to see the moderation inflation and some cost reduction in some of the things that we procure. And we're starting to see that there is maybe some softness in the rig rates. So that's not been built into our forecast. So, to some extent, you might view that as some upside. So that's how we have approached it.

Robert Kessler - Simmons & Company

Thank you very much.

Operator

Our next question comes from Paul Sankey with Deutsche Bank.

Paul Sankey - Deutsche Bank

Jim, we've seen very weak demand over the past few weeks, and I wondered if you could just make any observations that you've got in that respect.

Our concern is that demand is now so weak that we may get to the point where we are at the cash cost of production for certain producers. Just from your perspective, given your position in Alaska, given your position in the North Sea, perhaps also your view of LUKOIL in Russia, could you just talk a little bit about what you think the cash cost is for you to produce in those regions?

And also, you just referenced there, but if you could talk a little bit more about the extent to which those costs will fall as the oil price falls. Thanks.

Jim Mulva

Well, thank you. I thought you're headed first towards the downstream, and then as the nature of your question, it's more on the upstream side. But I'm going to use the opportunity to first talk about the downstream. We watch very, very closely what is the cash cost associated with each barrel of production by each of our refineries. So, obviously it will constrain production in the refineries if we're not covering our cash costs.

But we monitor this very closely certainly on a day-to-day basis. And at this point in time, other than when we talk about Wilhelmshaven where we've cut back because of hydro-skimming margins, even though in difficult times, we see positive cash margins in the downstream.

In terms of the demand, obviously the demand is down around the world, and you know all the statistics associated with that.

In terms of upstream part of the company, maybe John Carrig or Sig Cornelius could talk more about it. But we are watching our cash costs very, very closely. But even with the levels of oil and gas prices that we see, we continue to see positive generation from all of our production. So John or Sig do you have something more to comment on?

John Carrig

I don't have any specific numbers for you, Paul. Jim went over the per barrel metrics and you can see the profitability associated with those as well as the cash costs. And you can infer from that what the level of DD&A is. Obviously, the three big factors or perhaps four, one is the absolute price of the realized product, two the tax level, three the DD&A, and four the operating costs which were impacted by utility costs as well.

As prices come down, they do come down somewhat, but there are some costs that would be more fixed in nature? As Jim has indicated, there is some softness in rigs and tubular goods and we would hope to see that manifest itself particularly as if there was a significant and extended downturn, but we will plan to provide more granularity on that probably in March, but certainly as we progress.

Jim Mulva

Obviously, when we talk about a $15 billion program, if we go forward into 2009, we will not be as aggressive in our drilling programs, in the Lower 48 and Canada, but we are not losing the optionality to ultimately drill those wells. Also, we are looking at if we think that we are going to see costs come in, lower costs, the timing of that, both from the market standpoint, but also the cost of drilling those wells, you could say, well, maybe some deferral makes some sense just from the cost side. So, just want you to know how we approached looking at this. I don't know Sig; if you had something you wanted to comment on?

Sig Cornelius

No, I really can't add any more than what's already been said by John.

Paul Sankey - Deutsche Bank

What you are saying is that, let's say we are at 70 or somewhat softer today, but around that level your entire portfolio is now cash positive and I guess what you are telling me is that the operating costs are falling. Could you give me a sense of what percentage of the cost are the rigs? I mean, I'm thinking that labor probably will be pretty sticky in terms of costs. I guess obviously the DD&A for instance will be sticky, but could you just give me a sense for the sensitivities of the various components?

Jim Mulva

Not really. Maybe we could do that off-line, but we don't have, I don't have that immediately in front of me.

Gary Russell

Paul, what I would suggest is to take a look at the appendix in the presentation that we made in March at the analyst meeting, and there's some pretty good information on cost and cash contribution by region, and that's a pretty good place to start.

Paul Sankey – Deutsche Bank

Yes, I appreciate that Gary. And you guys' disclosure is excellent. It is the sensitivity that we are really struggling with, but I take the point and we won't labor it. Jim, one thing you didn't mention if I could just briefly ask you, management change, you've made some shifts. Could you just make any observations about that? And I will leave it there, thanks.

Jim Mulva

Well, we made changes. Obviously, I have got a number of years to go as Chairman and CEO of the company and for personal reasons, several in our Management team have decided to not work full time, and so we just felt that at this point in time it made sense to make changes, not piecemeal, as we go through the next several years. So we put in place, we like the idea of having a Chief Operating Officer in John Carrig.

If you look at all the changes that we've made, people are pretty familiar with having worked together in all of these areas. We think we have put a lot more focus, not that we haven't in the past, but there is more focus on basic operations of the company and cost discipline and everything. So we're pretty pleased with this and by having a Chief Operating Officer, we even put more focus on this during a period of time like this, and also the importance of relationships in all the projects that we are working on.

So we put in place this team and I don't think you're going to see much change. You never know what's going to happen with respect to health issues or whatever. Everyone is healthy, and so, I don't think you're going to see much change over the next several years. We put it in place at this point in time and it's not piecemeal.

Paul Sankey – Deutsche Bank

Thanks.

Operator

Our next question is from Paul Cheng with Barclays Capital.

Paul Cheng - Barclays Capital

Gentlemen, I just have a quick question. Jim, thank you for giving us the priority of your cash use. Just want to follow-up, given the current market condition, should we assume you will be willing to borrow money for share buyback or I will ask the question that you want to live within your means.

Jim Mulva

Well, thank you. Your last comment is really true. We want to live within our means, which means we look at our cash flow and we want to make sure that we are covering our capital program. We like both the dividend, and we like the discipline of annual increases in dividends. So we start with that basic approach, live within our means.

Now, we say with our balance sheet, our debt ratio is 20% to 25%. And we like to keep it right in that area, but now to the extent that we see less volatility, a little more certainty in terms of the marketplace. Both in terms of the environment of what we think oil prices and gas prices and crack spreads might look like as we go through the next 12 or 24 months. And we see that the credit markets become more attractive.

Certainly at this point in time, there's not much depth or size and cost doesn't make much sense to us to be in the public debt markets. To the extent that we see a more certainty or more probability, what we think the environment looks like and the political situation, and the credit markets, well then we can consider whether we would be interested in bringing our debt up somewhat for share repurchase, but until we see more certainty or probability, I think our concentration is to live within our means, which is going to be strong balance sheet, maintain liquidity, and cash position and credit capacity, fund our capital program, right dividend increases.

As to the extent that we see a better marketplace and better credit markets, then we would consider taking leverage up and buying our shares.

Paul Cheng - Barclays Capital

Jim, given the current stock market and the bond market turmoil, stock market has dropped say, more than 20% in a matter of say, weeks. Should we assume that any hit to your pension and correspondingly that you need to increase substantially your pension contribution, cash contribution or is there any hit on the P&L related to that?

Jim Mulva

We do have already in mind that we will put in more money into our pension fund and it has already been factored into our operating plans that we are putting in place for 2009, but it is not materially that different than what we have been doing over the last several years. We would update the financial community when we make our normal annual presentation, which I think is in March.

Gary Russell

Yes.

Jim Mulva

It's March of this year.

Paul Cheng - Barclays Capital

Okay. That's great. And in the international E&P operation, the effective tax rate is about 4% lower than the second quarter. Is that just purely the production mix or is there any special adjustment we should be aware?

Gary Russell

That's the mix.

Paul Cheng - Barclays Capital

It's just the mix. Okay. And in the international refining margin, I think, Jim mentioned that you guys benefit from some inventory changes. Can you quantify for us how big the benefit is?

John Carrig

The inventory changes are also a function of the realized crack. You can segregate those out, but the realized crack basically doubled or went up by $5 from $6 to $11 from the second to the third quarter. Some of that was inventory, some of that was the yields, and it all factors into the margin. So, clearly there are certain inventory effects, but they were largely impacts that we suffered some in the second quarter and the inventory impacts were basically reversed in the third.

Paul Cheng - Barclays Capital

Yes, because, John, if we are looking at even your own indicators, seems like the international margin was down sequentially, so it's a bit surprising that how strong it turned out to be. So should we assume that the entire increase is really related to the inventory benefit or that is only a small portion?

John Carrig

No, we would characterize it as relatively modest. The marketing margins were better.

Paul Cheng - Barclays Capital

No, but I'm talking about your realization in the refining margin in the international. It's up $5 nearly and based on even your own benchmark indicator it is down sequentially, so we are trying to reconcile what is causing such a great margin realization.

John Carrig

Once again, I think from our perspective in relative terms we felt that the margin in the second quarter wasn't as good as it could be. That was to some extent impacted or offset when the third quarter showed up. So the realized margin in the third quarter. Gary can try to help you off-line if there is more detail, Paul, but that is overall how we see it.

Paul Cheng - Barclays Capital

That's great, final question. All region, can you give us some kind of production outlook for the next two or three years?

Jim Mulva

Well, production is going to be rather modest over the next several years, but we are going to update that when we announce doing the transaction. But you will get more of that in March.

Paul Cheng - Barclays Capital

Okay. Thank you.

Operator

Our next question comes from Michael Lamotte with JPMorgan.

Michael Lamotte - JPMorgan

Thanks. Good morning, gentlemen. Would you mind sharing with us your thoughts on financing for Origin? I guess given the short-term nature of the commitment you will borrow against your existing credit lines, but in light of what's going on in the broader credit markets, I just was curious as to what the long-term financing might look like.

Sig Cornelius

Well, we have already essentially arranged all the financing for Origin. We have the cash on hand. We have several billion dollars in commercial paper that we use, and we have a strong A1/P1 rating and access to the marketplace is good. And so, we don't like the long-term markets at this point in time.

But as we go into 2009, we probably will pick some of that long-term. And we just think that the markets will settle down and we will have better opportunities. We just don't want to burden the company with issuing any kind of fixed rate money long-term at interest rates that we think are much higher than we ought to be paying. So it's already arranged. And so that's basically what our plan is.

Michael Lamotte - JPMorgan

Okay. I'm hearing from other companies that issuance premiums today are sort of running 50 to 75 basis points just given how locked up the credit markets are. Is that about the kind of break that we would be looking to see before you would term some of this out?

Sig Cornelius

Well, I don't want to talk about other companies, but a few companies, sizable large companies both in and outside of our industry have done some longer-term public issuance and have been in the neighborhood of 400 basis points over treasuries. We'd like to see dramatically better spreads than that. So, we just don't like to be paying kind of those spreads, don't think we should.

Michael Lamotte - JPMorgan

I agree. Jim, on the political front, our Washington analyst team thinks that's the Obama camp would like to come after big oil to the tune of about $10 billion to fund alternatives and renewables. Do you have any thoughts on where we stand with windfall profits or other potential changes in taxes that would impact you next year?

Jim Mulva

No, I don't have any further thoughts with respect to the specifics that you've outlined. But there is a little doubt that our industry is going to be really challenged with respect to the public's view towards the income that we are earning and reporting.

Of course, in our industry, we are really the primary solution to providing energy in the future. So, we think that any increase in taxation takes away from our ability to fund our capital programs. And then furthermore, it's a direct impact on employment. I mean we are the ones that know how to do this. We are making the investments. We need to make the investments, and it really relates not only to providing energy, but also jobs.

The other thing is as we already pay taxes that are at a rate double of what the rest of industry in the United States do. Now, that's what the rules are, and that's fine. But on the other hand, any increased taxes are going to result in less investment, less supply and less jobs.

On the other hand, we have seen the market work. $147 oil price was too high, but the market has adjusted and worked. And oil prices and natural gas prices and crack spreads have adjusted. That's how the market works. And so, we have a real challenge in front of us.

And our challenge is we understand the public domain with respect to the volatility and cost of energy, but we also are working in a political process that doesn't have a great deal of knowledge and understanding of what our industry really does. And so, we have to really stand up and talk and make known our point that increased taxation and regulation is just not the thing to do.

The other thing is we have reported our earnings for the third quarter. You know what the oil and gas price and crack spreads are. The sustainability of earnings if we just report our third quarter is not going to be $5.2 billion. It's going to be dramatically less, given the metrics that we look at and the market conditions. So, those are the things that we have to make known in the public domain.

Michael Lamotte - JPMorgan

Well, I would hope that as you pointed out with the corrections in those margins and commodity prices as well as the sensitivity to jobs in the current economy that sort of cooler heads would prevail. But I'm glad to hear you are sort of prepared for the worst it sounds like.

Jim Mulva

I don't know how well prepared, but we are certainly going to make known --.

Michael Lamotte - JPMorgan

Working to make sure it doesn't happen, I guess.

Jim Mulva

And we certainly solicit your help as well.

Michael Lamotte - JPMorgan

Fair enough. Last question for me on LUKOIL. Given the intensity of the credit crisis and sort of market confidence issues in Russia in general and the importance that LUKOIL has had in terms of contributing to volumes and reserves for Conoco the last year, in the event that they run into credit issues or cash issues, do you have the ability to sort of maintain their programs with some sort of credit extension to them or a true-up in terms of increasing interest and share projects and that kind of a thing?

Jim Mulva

Well, we stay in close communication with LUKOIL and with Vagit Alekperov, and we certainly recognize what's happening in the Russian marketplace and the issues in terms of access to the markets and the capital markets. But they have their challenges, and they work through them, and they know what their operating capital programs are and the financial plan. But there is no discussion or no plans with respect to ConocoPhillips changing our ownership position from 20% LUKOIL, and we have no plans to be extending credit or cash advances to LUKOIL.

Michael Lamotte - JPMorgan

Okay, great. Thanks.

Operator

Our next question is from Erik Mielke - Merrill Lynch.

Erik Mielke - Merrill Lynch

Good morning. I'd like to stay with the theme of LUKOIL and Russia and just asking you about the changes in the taxes that we are seeing over there. Firstly, there is a temporary reduction in the export duty in the fourth quarter. What the impact would be on your profitability from the YK fields?

And also, if you can comment on the extension of the tax reductions to Timan-Pechora, which I think would take effect from next year; whether the YK fields would qualify for that tax reduction?

Finally a broader question on Russia. Given the turmoil and the changes that we are seeing there, whether you are seeing increased opportunities for you to pursue additional projects and partnerships with LUKOIL or with others?

Jim Mulva

Okay, the first question, the YK field, does qualify for these changes in taxation. And the result will be as we ramp up production in 2009, we will see increased profitability return from that production. So that's going to be helpful to us in Russia.

And the second point, it's quite true. We see opportunities. Of course, we have to work through these and make sure that working with LUKOIL and with Gazprom and others that what are those opportunities to invest primarily in the upstream part of the business in Russia, possibly outside of Russia, but let's just talk about inside Russia.

I think there will be more opportunities, because Russian leadership has indicated that they feel that it is important to have international companies not just in the oil and gas business, but international companies in all industry participating and making investments in Russia and Russia is wanting to grow and develop their relationships in the world community.

So, we do see that there will be some opportunities, but we need to work them very closely and make sure that they meet the objectives of what we (inaudible) and that they also meet the objectives, whether it's LUKOIL or Gazprom. So, it's during periods of time like this that we do see the opportunities, but you have to really work them well and make sure that you get them sorted out right for the long-term for the company.

Erik Mielke - Merrill Lynch

And then there are sort of things that you are considering with Gazprom, would that be focused on the LNG markets or the domestic market?

Jim Mulva

Well, I don't think it's probably appropriate for me to get into that. I just a week or two ago met with Alexei Miller, CEO of Gazprom, and we are discussing several of those opportunities. But I don't think it's appropriate to go through what specifically they may be.

Erik Mielke - Merrill Lynch

Okay, thanks. Can I ask on the current trading environment for both crude and for products? Given the financial markets and the turbulence that we have seen there, how is that impacting who you trade with and how you do business and what do you think of the prices that we see on the screens?

Jim Mulva

Well, we watch this very carefully. What we have seen is that the financial markets seem to have less presence in backing away from being in the trading business, the commercial business. We as a company have a pretty sizable commercial organization, but we don't speculate and take flat price risk or anything, we just trade around our assets and our volumes. We need 3 million barrels a day to run our refineries and we have 1.8 million BOE a day of production that we need to sell at competitive prices.

So we actually see an opportunity to some extent in the commercial side of the business, and we see the financial participants having less of a presence. So commercial organization continues to make contribution both upstream and downstream and whatever we earn in trading around our assets and our volumes, we actually allocate that back into higher realized prices both upstream and downstream.

Erik Mielke - Merrill Lynch

Final one from me, on the exploration expense guidance for the fourth quarter, $400 million, somewhat higher than where you have been running recently, any specific projects you want to highlight?

Jim Mulva

No, I don't think so.

Erik Mielke - Merrill Lynch

Okay, thank you.

Operator

Our next question comes from Mark Gilman with Benchmark.

Mark Gilman - Benchmark

I have two things. First, I was wondering if you could just give a brief update on where things stand vis-à-vis an upgrading project at Wilhelmshaven. Secondly, going back to an objective discussed in March of this year, Jim, you commented on an effort underway to essentially rebuild the exploration component of the company's upstream program. Since that point in time, yes, you have acquired some leases in the (inaudible); the memorandum of understanding in terms of the N-Block, but frankly it seems as if the focus has really been a bit more on discovered resource opportunities, namely Abu Dhabi and Origin. Is the objective vis-à-vis the exploration program still very much intact or are you thinking of shifting?

Jim Mulva

Okay. First on Wilhelmshaven, even with the challenging market conditions that we see when we look at our conversion project at Wilhelmshaven and it really has a good rate of return. So we look at how can we do it even better? That is in our capital program going forward.

No change in exploration. Maybe, we haven't come out and identified exactly this program, where we are going and how we are adding to it, but we will do better and you will see more of that when you see the March presentation, but there's no change with respect to our direction.

We've actually put quite a bit of money during 2008 towards capturing these opportunities and picking up acreage. So I don't thing think we've done as good a job obviously that we could have with respect to yourself, Mark, or others. So we need to do that better.

Mark Gilman - Benchmark

Okay. If I could just follow-up, that $400 million expense in the fourth quarter, I would assume that that's not drilling activity, but perhaps G&G and/or additional lease amortization.

Jim Mulva

Well, let us come back to you on the details of that, because I don't have that right in front of me, but Gary, you can call Mark.

Gary Russell

Yes, I'll call you, Mark. I would say its all three components. It's not heavily oriented towards one or the other.

Mark Gilman - Benchmark

Okay, guys. Thank you.

Operator

Our next question comes from Neil McMahon with Sanford Bernstein.

Neil Mcmahon - Sanford Bernstein

A few questions. Maybe to start off with first one on Origin, given what's happened to the market conditions while you were negotiating this deal, paying by our calculations 30% premium above the BG bid on a unit basis for the gas position seems a bit rich, and sort of feels like what happened during the Burlington acquisition in terms of timing. Is there any chance to renegotiate this bid, given what's happened to the entire energy complex even though Australia has held up reasonably and before you pay the $5 billion upfront payment?

Jim Mulva

Well first, there is no real opportunity to renegotiate in the transaction that we have agreed to do and with respect to the premium over and above what you outlined for British Gas. Of course there's different assumptions that could be made, what we see ultimately is four [trillions] of LNG and that was factored into our forecast.

And even though we had some pretty strong inflation assumptions as we went forward over this next number of years and to the extent that we see some help on terms of inflation constraint, that is going to help with respect to our returns, but no, we expect to close the transaction here in the next week or two.

Neil Mcmahon - Sanford Bernstein

Jim, this may be a bit flippant a point, but is there not an issue just with the overall strategy going forward? As you continue to put in a higher bid than the next company, that one could argue that you are nearly bidding away any price raise from LNG you may see in the future and you will never really get that uplift in returns and therefore be competitive if you keep doing these sort of deals. I just thought it was odd for you to go into something you've never done before really and pay a price well in excess of where the stock was trading at the start of this year.

Jim Mulva

Well, first of all, we utilized our expectations of prices that were not prices that were in the marketplace at the time we actually agreed and announced the transaction. So, we have far more modest assumptions. Second, this is our business. We are one of the biggest coal bed methane producers through our experience in San Juan and other places in the world, we really know this business well and we know how to do LNG and we are in the markets in LNG in Asia. So we really know this well.

That's really how we've approached doing the transaction. We like the country from their political perspective and we like the markets. We certainly understand what's going on at this point in time in the marketplace, but what we are really looking to is delivering LNG starting in 2014/2015 and subsequent years, and we expect the markets for liquefied natural gas to be much stronger than we see today.

So that's really what we are investing at this point in time as for delivering these projects in 2014/2015. So that's how we have approached it and we felt realistic expectations in what the natural gas price would be in those years.

Neil Mcmahon - Sanford Bernstein

Okay. Maybe just moving onto the US gas production, sorry if I missed this one already. Just looking at the Lower 48 production, can you give us a sense from a natural gas point of view, what the drop was as a result of the hurricanes versus natural field decline for your US gas business in the third quarter both sequentially and year-over-year?

John Carrig

What we said was over 17,000 barrels a day quarter-to-quarter was the impact of hurricanes in the Lower 48.

Neil Mcmahon - Sanford Bernstein

Right, so let's put it another way. Do you think your onshore natural gas volumes from San Juan and other areas, did they go up or down in the quarter?

Jim Mulva

There were some impact on onshore just simply because some of the processing facilities and pipelines were backed up, because of hurricane stoppage, but the majority of the impact was certainly offshore, but there was some collateral impact onshore. I don't know what the onshore number is.

Neil Mcmahon - Sanford Bernstein

Well, where I am going with all of this, in the past you have commented that you've got a very little cost base for US natural gas production. I for one have been a bit surprised you haven't sort of picked up the drilling activity there if it is such a good economic base. Are we still looking at growing or keeping US gas production at least flat going into next year from the onshore developments or can you give us any new guidance given the market conditions?

Jim Mulva

We're actually working that right at this point in time and trying to determine just how much do we might want to invest in that production. Do we want to hold it flat? Just what do we want to do? Do we want to increase it, let it go down some? So we look at what is a return and what are the priorities in the capital program? Then what is very important for us is we don't want to lose the optionality of ultimately drilling those wells. So the plan doesn't change, it's just at what time do we drill the wells? So you made good points and the points that you made is what we take into consideration.

Neil Mcmahon

Right, because I've just been surprised that if the returns are so good should this not be the opportunity to even think about stepping up activity in gas if you look forward and potentially we've got a tightening supply market into next year if everybody starts cutting CapEx, what about you quys?

Jim Mulva

Well, for a $15 billion capital program, we will be cutting back some of our capital program, discretionary capital programs in North America, but as we said, we don't want to lose the optionality of drilling the wells. The details of that is, given the market conditions that we are living with and we don't know exactly what they're going to look like not only two or three months from now as it looks in 2009 it is something that we haven't finalized our position at this point in time yet.

Neil Mcmahon - Sanford Bernstein

Great. Thank you.

Operator

Ladies and gentlemen, as this is all the time we have allotted for Q&A, I will now turn the call back to Management for any closing remarks.

Gary Russell

Thanks, Jen. We just again want to a thank everybody for participating this morning and a reminder that you can find the material that we went through this morning on our website, conocophillips.com, and there will be a transcript of this conference call available later. Good day.

Operator

Ladies and gentlemen, we do thank you for your participation in today's conference.

Copyright policy: All transcripts on this site are the copyright of Seeking Alpha. However, we view them as an important resource for bloggers and journalists, and are excited to contribute to the democratization of financial information on the Internet. (Until now investors have had to pay thousands of dollars in subscription fees for transcripts.) So our reproduction policy is as follows: You may quote up to 400 words of any transcript on the condition that you attribute the transcript to Seeking Alpha and either link to the original transcript or to www.SeekingAlpha.com. All other use is prohibited.

THE INFORMATION CONTAINED HERE IS A TEXTUAL REPRESENTATION OF THE APPLICABLE COMPANY'S CONFERENCE CALL, CONFERENCE PRESENTATION OR OTHER AUDIO PRESENTATION, AND WHILE EFFORTS ARE MADE TO PROVIDE AN ACCURATE TRANSCRIPTION, THERE MAY BE MATERIAL ERRORS, OMISSIONS, OR INACCURACIES IN THE REPORTING OF THE SUBSTANCE OF THE AUDIO PRESENTATIONS. IN NO WAY DOES SEEKING ALPHA ASSUME ANY RESPONSIBILITY FOR ANY INVESTMENT OR OTHER DECISIONS MADE BASED UPON THE INFORMATION PROVIDED ON THIS WEB SITE OR IN ANY TRANSCRIPT. USERS ARE ADVISED TO REVIEW THE APPLICABLE COMPANY'S AUDIO PRESENTATION ITSELF AND THE APPLICABLE COMPANY'S SEC FILINGS BEFORE MAKING ANY INVESTMENT OR OTHER DECISIONS.

If you have any additional questions about our online transcripts, please contact us at: transcripts@seekingalpha.com. Thank you!

Source: ConocoPhillips Inc. Q3 2008 Earnings Call Transcript
This Transcript
All Transcripts