The Conoco Philips Refining Spinoff: Another Warning Signal for the Oil Refiners

Includes: COP, MPC, MRO, TSO, VLO
by: James Shell

This week's announcement of the split of Conoco Phillips (NYSE:COP) into two stand alone companies comes on the heels of a similar move by Marathon Oil (NYSE:MRO)(NYSE:MPC) that has just reached the marketplace.

A lot of the detail on exactly how the spinoff will occur is still forthcoming, so there will be plenty of time to try to figure out the ramifications, but for the moment, there are two main questions: Is there any money to be made on the deal for the average investor, and what does this say about the state of the refining industry?

Using COP's first quarter refining segment earnings of $480M annualized, and the current prevailing industry PE ratio of 8 [for Valero (NYSE:VLO) and Tesoro(NYSE:TSO)] we can estimate the value of the spinoff's refining assets:

1Q Downstream Segment Earnings 480,000,000
Annualized Earnings Est 1,920,000,000
Industry PE (Valero and Tesoro) 8
Market Cap 15,360,000,000
Refining Capacity (bpd) 2,700,000
$ per BPD capacity 5,688.89
Click to enlarge

When I did a similar calculation for MPC's refining capacity a few weeks ago, I arrived at a value of just over $13,000 per BPD capacity, and the current values for Valero and Tesroro are just under $8,000 per BPD so the conclusion is that this refining capacity of the COP spinoff is relatively cheap at 8 times earnings.

Side point: Since the number of shares to be spun off in the MRO/MPC deal had already been announced, we were able to estimate a market price of about $41 per share for MPC which until the last day or so proved to be right on the money, so the methodology is correct.

To back out the value of the upstream business:

EPS Estimate 8.19
Shares outstanding 1,410,000,000
Earnings Est 2011 11,547,900,000
Refining Segment Earnings 1,920,000,000
Est Earnings Upstream Business 9,627,900,000
PE of upstream business 10
Est Market Cap of Upstream Business 96,279,000,000
Est Market Cap of Downstream Business 15,360,000,000
Upstream plus Independent Refiner 111,639,000,000
Actual current market cap: 106,880,000,000
Click to enlarge

Using the current COP earnings estimate of $8.19 per share, per Google Finance, subtracting the earnings for the downstream segment that we estimated above, and multiplying by a slightly more generous PE of 10 gives an estimated market cap of the upstream business of about $96B and then adding the estimate above to it, the combined value of the two spinoff companies of about 5 percent higher than it is now in the marketplace, so perhaps there is still a little money to be made on this deal, particularly if the investor thinks that the upstream business should be trading at a multiple above 10.

A second side point: The theory behind the MRO/MPC split was exactly that, and thus far it has not worked out that way, MRO is still trading at a PE of about 8.

So, the refining capacity looks relatively cheap, and as soon as we know what the exact nature of the spinoff will be, we can finish the calculation.

The second question: What does this say about the Oil Refining segment in general? We all know that this is a tough business. You have to go back over 10 years to find a week in July where unleaded gasoline demand was as low as it was last week. The industry is running at 88 percent capacity in what should be the peak driving season, which is below reinvestment economics, and if it were not for the historical anomaly that is currently present in the marketplace in the form of the unusually high WTI/Brent spread, which is propping up refining margins, this industry would be considered at overcapacity.

What is says is that two of the biggest and most conservatively run companies in the industry think that right now is the point at which the maximum value can be extracted for their shareholders by spinning off their refining groups and getting them off of the books before the next downturn.

We will have to wait to see if the strategy pays off.

One possible alternative for an investor right now would be to buy the company before the spinoff, and sell the refining segment shortly after the issuance of the new stock, and use the proceeds to go long on the upstream segment. You'd be able to take advantage of the maximum value of the refiners, and also benefit from some appreciation of the upstream segment if, and it is a big if, the market starts to value it at a higher PE once the refining segment is divested.

As I am so fond of saying, the world is chaotic, and there are no guarantees on anything.

Disclosure: I am long CLMT.