I'm looking at a couple of hypotheticals on the Conoco Phillips (COP) Refining Group spinoff which was announced on July 14th. The spinoff will create the world's largest independent oil refining company, and obviously tempt some investors looking for an opportunity. Most of the excitement on this deal lasted for exactly one day when the analysts figured out, like I did, that there is a little upside on the deal. But a lot of questions remain, some of which I discussed in my article recent Seeking Alpha article, titled "The Conoco Philips Refining Spinoff: Another Warning Signal for the Oil Refiners".
Thanks to the excellent interactive earnings reports by segment that are presented on the COP website, and due to the fact that the past five years have represented both the best and worst years in the history of the oil business, we can do a couple of calculations and perhaps try to figure out what the real motivation was behind the deal in the first place. I've posted the raw data for this article on my instablog.
There were a couple of adjustments. In the second quarter of 2007, the company took a $7.3B write-off of their Venezuelan operations. In the abominable fourth quarter of 2008 the management cleaned the skeletons out of the closet, and took a write-down of $21B in "goodwill impairment" along with a lot of other things. For those two quarters I used the previous quarter earnings as the impacted segment. Also, I attributed all of the administration charges to the upstream business, presumably the refining business will inherit some portion of this charge when the spinoff happens.
Based on the above data, below is a graph of net income by quarter for each of the segments:
click on images to enlarge
The upstream portion of the business benefited from the $147 oil price in mid-2008, and suffered from the crash to the 30's in late "08 and '09, and since then has been about where it was in 2007. The exceptionally good results in the second quarter of 2010 were driven by good earnings.
The refining and marketing segment was marginally profitable or money-losing from the second quarter of 2009 until the fourth quarter of 2010. The last two quarters have been good ones, as we all know, despite low utilization rates the unusually high refining margins have driven good earnings in most of the companies in this group.
I calculated annualized earnings by multiplying quarterly earnings by 4, and then using the number of shares outstanding at the time and the stock price at the end of the quarter was able to deduce an annualized PE ratio for each quarter for the above period. The PE ratio has averaged about 9.8. Based on this, I calculated the expected stock price for COP's upstream business for each quarter, and it results in the following graph:
The important piece of information here was that the presence of the refining group was either neutral or a net drain on the stock price for the period between the second quarter of 2009 and the third quarter of 2010. Clearly this situation has recovered somewhat in the last quarter this quarter will be a little better still and if I am not mistaken, is a clear signal that the management does not think we are headed back for a repeat of 2007. The shareholders of the stand-alone upstream company can expect a company with a slightly more stable price, not benefiting from the refining group's good years, but also not suffering when they lose money.
I did one other calculation, that is the hypothetical price of the upstream business at a PE of 12 instead of 10. One of the typical hopes of management in a split like this is that the remaining business, stripped of its volatile refinery segment, would actually trade at a higher multiple. Similar to some of the other companies that we all know, such as Occidental Petroleum (OXY) that trades at 17 times earnings.
Using a relatively conservative estimated PE of 12 rather than the actual 9.8, the green line above is a stock that does about what it would have done when times were bad. However, when boom times happen such as in mid-2008 and early 2010 have a chance to be really attractive.
So to summarize:
- The splitting off of COP's refining group will have at the very least the effect of getting rid of some of the downside in the share price, and make the remaining upstream company a more stable stock.
- The fact that the spinoff is occurring suggests that the management does not think another 2007 is around the corner.
- Investors in the stand-alone refining company can expect much more volatility in their stock, similar to the other independent companies in this group.
- The strategy will be all the better if the stock of the upstream company can start to trade at a higher multiple than COP, particularly if there are some periods of very high oil prices.
- Tough question: Does this strategy reflect the company's attitude toward peak oil? In that view of the world, global oil reserves are limited or shrinking and there will be a premium on exploration and development activities as well as reserves ownership. Additionally, the refining segment will be increasingly squeezed by lower demand and higher feedstock costs.
- Other tough question: How many of the other integrated oil companies will make the decision to become dis-integrated? This has already been the subject of some speculation, in the case of BP.
Of course, the world is chaotic and there are no guarantees on anything, and in this case the estimates above are made based on some hypothetical assumptions that might or might not come true. But, deals like this don't happen by accident, and they're based on an underpinning of logic and a certain view of the future.