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In our last review of ConocoPhillips (NYSE:COP), we took the opportunity to reduce our exposure to the company. This was primarily due to a diminishing risk reward profile following the stock’s price gains and the outlook for generally flat production. Given that the stock price has since pulled back considerably, however, the risk reward profile is beginning to look more favorable.

This week we review the company’s third quarter production report and consider whether the time has come to increase our exposure.

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ConocoPhillips benefited from oil’s price strength during the period to deliver earnings of $5.2 billion for the three months to 30 September. This represents growth of 41 percent over the $3.7 billion the company earned in the same period last year. The table below shows the company’s net income for the three months to 30 September 2008, broken down by division for both 2007 and 2008.

E&P: Exploration and Production, R&M: Refining and Marketing

As the data shows, the Refining and Marketing division was the sole detractor from the company’s earnings (the other category includes corporate expenses). The division’s earnings weakness was primarily a result of the Gulf of Mexico’s hurricanes, which forced the closure of ConocoPhillips’ refineries in the region.

Nevertheless, the company’s main profit engine is the Exploration and Production division. The division delivered phenomenal earnings growth of 89 percent in comparison to the same period last year. However, average daily production of 2.2 million barrels of oil equivalent (boe) has remained essentially flat throughout the last twelve months.

In terms of the latest quarter, the hurricanes that ripped through the Gulf reduced production by around 17,000 boe per day. The hurricanes were an unwelcome headwind for ConocoPhillips given the fact that many of their production assets are already in natural decline.

Management were able to offset these negative factors through the addition of several new projects that came online during the period. Norway’s new Alvheim Field contributed an additional 19,000 boe per day, while a further 15,000 boe came from Siberia’s YK Field. The start-up of the Britannia satellite fields provided a boost to the company’s UK production.

Even so, the company’s formidable earnings growth is a reflection of the record oil price achieved through the period, rather than production growth. And with the price of oil having come down considerably from the highs, the market is now discounting lower future earnings.

As such, there has been a significant deterioration in the technical outlook for ConocoPhillips. As evident on the daily chart, since reaching an all time high of $95.96 in June, prices have declined rapidly, touching a low of $45 on 27 October. While it is encouraging that downward momentum has slowed during the past two weeks, the five-month downward trend remains the dominant feature on daily charts.

In the near-term we anticipate further consolidation around current levels. However, any attempts to rally will encounter substantial resistance in the region of $54.90 to $57.66, as indicated by the region of former support.

From a broader perspective, there has been a clear change in direction of the longer-term trend over recent months. In our opinion, a sustained period of consolidation and base building is required ahead of the emergence of a sustainable revival of upward momentum.

We don’t know how long the price of oil will remain at these lower levels. However, the fact remains that the underlying fundamentals that supported oil’s break through $100 early this year have not changed. Much of the world’s production is from mature fields that are in a state of natural decline. Major discoveries are few and far between and those that are made tend to be very deep, far offshore, or both.

Estimations for the oil industry’s marginal cost of production are around $80 per barrel, which includes all exploration and development costs. If oil prices remain low then further exploration and development will cease, placing additional pressure on supply and therefore prices.

Indeed, CEO Jim Mulva recently commented that oil’s recent price weakness has prompted management to monitor project costs very, very closely. Management are adopting a more conservative approach to drilling and next year’s exploration budget is likely to remain flat at around $15 billion.

From a valuation perspective, the company trades on a 2008 price to earnings ratio of around 4.2, rising to a little over 5 times 2009 earnings as lower oil prices flow through to earnings.

At these levels the market is in our view pricing in an overly pessimistic view of future oil prices. However, we consider the prudent course of action is to await stabilization in the stock price before we consider increasing our exposure.

Disclosure: ConocoPhillips will remain held in the Fat Prophets Portfolio.

Source: ConocoPhillips: Oil Majors Out of Favor for Now