COP is banking on a 20% stake in Russian Lukoil to shore up its dwindling North American oil well production. A full 10% of production is expected to come from Lukoil.
The divestiture of wells in Canada is negligible (less than 30,000 bpd) and is part of the Burlington Resources acquisition agreement. The BR acquisition was an expensive North American natural gas play coming in at $3 per 1000 cubic feet (Mcfe). As time goes on the BR deal may turn out to have been a real bargain. The re-entry into Libya should provide handsome profits on 45,000 bpd at a production cost around $5 per barrel! This should more than make up for the Canadian loss. COP is counting on natural gas prices remaining above $6.55 per Mcf; otherwise the BR acquisition becomes mathematically problematic. We estimate that the average price per Mcf to be $7.30 in 2007 and $8.05 in 2008 providing COP with ample margins. COP is the largest natural gas producer in North America.
Venezuela is no longer considered a viable reliable option for replacing existing production sites. American companies are not going to invest $50 billion, give or take 20%, to develop the Orinoco region as long as Chavez is in power. Chavez is counting on China’s thirst for oil to step in and replace the Americans and French. There is plenty of heavy crude down there but right now no one is willing to risk spending billions to develop these new fields. As the Chinese would say, Chavez flipped on the Americans, what’s to stop him from flipping on us in ten years from now.
The new refinery project in Yanbu, Saudi Arabia, in conjunction with Aramco and Halliburton, should contribute to the refining division earnings as of H2 2011. This single new 'Saudi sour' refinery project will have the capacity to supply 2% of U.S. consumption. Chances are though that the refined product will end up in Iran (U.N. sanctions?), India, China and other countries in the region. Iran exports crude yet imports refined product.
Historically refining operations have had far lower margins than crude production. In 2005 production accounted for only 27% of sales yet was 62% of earnings. This was not the case for 2006 as reflected in earnings. COP has a 36% stake in the Alaskan Prudhoe Bay consortium. Prudhoe Bay represents approximately 15% of COP’s global oil production (136,000 bpd out of 916,000 bpd). Excluding Q1 2007, we do not foresee further production issues emanating from Alaska.
COP’s historical financial performance depicts a classic rollercoaster ride. Over the past decade the energy sector has been highly volatile and COP consistently exemplified this to an extreme, more so than some of its competitors. For this reason alone, COP has been trading at a lower multiple to its peers. Though natural gas, in comparison with oil, is highly volatile we believe that NG will remain above $6.55 throughout 2007 thus COP should fair better than its competitors due to its heavier reliance on natural gas.
The question that an investor might ask is whether COP is the best of the breed. On the surface COP looks very attractive. The stock is trading at a low multiple (6.8) and is paying a nice dividend. However further analysis reveals a slightly different and somewhat complicated picture.
Fundamentals: (from our proprietary research/analysis)
2006 Proven Reserves Replacement
COP = 109% (including Lukoil, official figures were not released for 2006)
Chevron Corp. (CVX) = 80% (80% is an estimate as we dispute the official PRR figure of 101%)
ExxonMobile (XOM) = 119% (we dispute the official PRR figure of 129%)
Anything above 100% is good as it enables future growth. Capital spending was $15.6B in 2006 and COP has allocated $13.5B for 2007. This leaves $2.1B to shore up the bottom line in 2007 in comparison with 2006.
Reliance on U.S. Economy
COP = 73%
CVX = 45%
XOM = 31%
On the one hand upon a slowdown in U.S. consumption COP is more likely to take a hit than XOM or CVX. On the other hand, the recent decline in Canadian natural gas production cushions COP against possible consumption reduction as imported supply dwindles. This is not an exact science as we are mixing together crude, refined product and natural gas; a sure remedy for a headache!
Risks? - Russian Roulette
All those familiar with the Yukos travesty know that Vladimir Putin can not be trusted to abide by international standards of commerce. The entire dismantling of Yukos was due to mafia style politics. This is factually confirmed from the current events. Yukos could have done exactly what the Russian government is doing now; sell off assets and pay off the (alleged) tax bill and still be a viable business. We call this dormant disease Putinitis. The question is when will the next outbreak occur? The market currently assesses a high risk premium on Lukoil, though this risk factor may never materialize.
Unforeseen? - Prudhoe Bay
Only one COP refinery relies on Alaskan oil for its supply and that refinery is being supplied from other sources. COP took a hit on production profits from the Alaskan fiasco in 2006. However, with refinery margins up and refining and marketing contributing over 65% of revenue, COP still came out ahead on a YOY (year over year) basis. Had the Alaskan problem occurred a few years ago it would have been a different story. 2007 production profits should recoup somewhat as Alaska represents a full 15% of COP's production. We believe that Standard & Poor's analyst Tina J. Vital has overlooked the Alaskan contribution to earnings or at the very least expects further supply disruptions throughout 2007. We do not.
At CrossProfit, we emphasize fundamental analysis and delve into technical analysis only upon completion of rigorous fundamental analysis. Current (1 to 4 weeks) technical trends are bearish verses the bullish intermediate (1 to 6 months) and long term (6 to 24 months) fundamentals. The CrossProfit evaluation line is based primarily on fundamentals.
CrossProfit Evaluation Line
For traders; buy below the line and sell above the line. For investors; use as guidance for fair value / overpriced equity. [The evaluation line is not for day traders.]
For those who are unfamiliar with the term, EOL = end of line. The evaluation line is a twelve month forward looking line that specifies a risk/reward evaluation factoring in market volatility and determines whether or not an investment opportunity exists. Towards the ‘end of the line’ the line is usually less accurate as the evaluation was based on data available a while ago. In plain English, the XOM evaluation line is the least reliable because it ends at the end of this month (03/07).
Based on the above;
COP has a 6-7% upside within a 3 month time frame.
CVX has a 4-5% upside within a 6 month time frame.
XOM is too close to the EOL, however the new 12 month forward looking evaluation line's EOL is approximately at $81.
All data excludes dividends.
So what does all this mean?
1) Higher margins similar to 2006 should benefit COP refineries.
2) Canadian/Libyan production cancels out each other with a 15,000 bpd increase.
3) Paid what was considered a high price for the BR acquisition resulting in lower PE multiple for 2006.
4) Increased natural gas capacity from acquisition stays profitable and contributes to earnings growth as long as Canadian production continues to decline.
3) Positive reserves replacement.
5) Pipeline investment in Venezuela but no new production or refinery projects.
6) Yanbu not relevant for now.
7) Prudhoe Bay is statistically relevant for 2007.
8) Lower capital expenditures for 2007.
COP is a gamble on geopolitics, including internal Russian politics. COP could turn out to be the best of the three by far. A 73% reliance on the U.S. for revenue is most likely a positive factor and natural gas prices will probably stay above $6.55. Should the Russian based geopolitical risk diminish, a higher PE ratio is in order.
As of today, there is little downside risk. Should Putin decide to play his hand tomorrow the market has already factored in most of the collateral damage from Putinitis. Either way COP is a stock to buy and hold for long term gains and dividends.
The investment outlook for the oil and gas industry is positive. CrossProfit analysts conclude that oil prices are expected to remain relatively high in 2007 and 2008. We use the term 'relatively high' for oil above $45 per barrel.
Disclosure: This article was written by a CrossProfit analyst and does reflect the opinion of CrossProfit.com.