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ConocoPhillips (NYSE:COP)

Q2 2007 Earnings Call

July 25, 2007 11:00 am ET

Executives

Gary Russell - General Manager, IR

Jim Mulva - Chairman & CEO

John Carrig - EVP, Finance & CFO

Analysts

Neil McMahon - Sanford Bernstein

Robert Kessler - Simmons & Co.

Arjun Murti - Goldman Sachs

Bernie Picchi - Wall Street Access

John Herrlin - Merrill Lynch

Paul Cheng - Lehman Brothers

Doug Leggate - Citigroup

Dan Barcelo - Banc of America

Mark Gilman - Benchmark

Nicki Decker - Bear Stearns

Presentation

Operator

Good day, ladies and gentlemen, and welcome to the ConocoPhillips Second Quarter 2007 Earnings Conference Call. My name is Jen and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session towards the end of today's conference. (Operator Instructions) I will now turn the presentation over to Mr. Gary Russell, General Manager of Investor Relations. Please proceed, sir.

Gary Russell

Thanks, Jen. Let me welcome everybody on the conference call and the webcast this morning to our second quarter 2007 earnings conference call. Joining me today is Jim Mulva, our Chairman and Chief Executive Officer, along with John Carrig, our Executive Vice President, Finance and CFO.

We have prepared presentation material that will follow that will help us explain and review the financial operating performance of the Company during the second quarter of this year. You can find this presentation on our website, www.conocophillips.com.

If you turn to page 2, you will find our Safe Harbor statement. This statement indicates that the presentation today along with the responses to your questions will contain forward-looking statements that are based on our current expectations. The actual results could differ materially from those expectations. And you can find a list of the items that could cause these material differences in our SEC filings. So with that being said, I'll turn the conference call over to Jim Mulva.

Jim Mulva

Gary, thank you and I appreciate those who are participating in our conference call today and I'm going to start my comments on the third page. The second quarter of 2007, our net income was $301 million. This includes a $4.5 billion impairment associated with the expropriation of our assets in Venezuela. If you exclude this impairment, then our earnings for the second quarter were about $4.8 billion.

Our operations in the quarter generated $4.8 billion of cash. We purchased $1 billion of our stock. We funded our capital program and other investments, increased our cash balances by about $600 million and reduced debt by $900 million. So our debt to cap ratio of 21% at the end of the second quarter is about 1% lower at the end of the first quarter.

We produced 2.38 million BOE a day in the second quarter and this includes an estimated 473,000 BOE a day from our LUKOIL investment segment. We have more information on this in the subsequent slides. In the downstream, our refineries ran at 93% of crude processing capacity, which is just a little bit lower than in the first quarter. I am going on to page 4.

Second quarter earnings, as I said, were $4.8 billion after you adjust for the impairment associated with the expropriation of assets in Venezuela. This is $1.3 billion higher than the first quarter net income of $3.5 billion. You can see on the slide what contributed to the quarter-over-quarter variance and I am going to cover this in a little more detail when I go through the business segments.

I will just take a few moments to review the major variances on this page. If you start with the red bar on the left, our first quarter 2007 results included a $490 million benefit from the impact of our asset rationalization program. We also had a net benefit in the second quarter from this program, but it is quite a bit smaller and I will cover that here in a few moments.

Moving to the right. Prices, margin, other market impacts improved net income in the second quarter by about $1.8 billion. We had lower sales volume and that reduced income by $76 million. As I said earlier, we had a net benefit of $87 million in the second quarter from our asset rationalization program. The other items which reduced our income in the second quarter were $122 million made up of many items, such as higher compensation benefit costs, our operating costs, asset retirements, our equity earnings. And if you include the Venezuela impairment in the second quarter, the net income goes down to $301 million.

Moving to page 5, talking about cash flow. The yellow bar on the left shows that we generated about $4.8 billion of cash from our operations in the second quarter. Now this is about $2.1 billion lower than the first quarter, but remember first quarter included about a $2 billion benefit from working capital, which is largely attributed to taxes payable in Norway. Now we made a sizable tax payment in Norway in the early part of April.

Our cash from operations along with our cash balance at the beginning of the quarter allowed us to spend $2.6 billion on our capital program, pay $668 million in dividends, reduce debt $856 million and buy back $1 billion worth of our shares. The proceeds from our asset rationalization program second quarter $900 million that left us with a cash balance of $1.4 billion and that's $600 million higher than the end of the first quarter.

Moving on then to page 6. The pie chart on the left shows the total cash available during the first half of the year was $13.9 billion. About 84% or $11.6 billion is generated from operations, so 16% came from asset sales. If you look at the pie chart on the right, this shows what did we do with the $13.9 billion. We spent $5.6 billion on our capital investment program, reduced debt by $4.3 billion, bought $2 billion of our stock back and paid $1.3 billion in dividends. Then we had the increase in our cash balance by $600 million.

Moving on to page 6, our debt ratio. If you look at the bar chart on the left, the equity remained at $86 billion, which is the same as the first quarter and this is really a result of the Venezuelan impairment offsetting the earnings from operations. The bar chart in the middle shows progress we made -- have made over the last several quarters reducing our debt that now stands at $22.8 billion at the end of the second quarter. That is nearly $1 billion lower than the end of the first quarter. And on the right, you see our debt to capital ratio at 21% at the end of the second quarter. Now if you take our cash balances and look at our debt ratio on net cash balances then it would reduce the number from 21% to 19.9%.

Moving on to slide or page 8, talking about E&P. Our worldwide realized crude oil price second quarter was $61.97 a barrel. Now that's up $8.59 a barrel higher than the first quarter. The total worldwide realized natural gas price was $6.44 per Mcf and that is $0.09 higher than what we realized in the first quarter. Consistent with our previous guidance, E&P's production and sales were lower than the previous quarter and I'll talk more about that in a subsequent slide. Our asset rationalization program negatively impacted our second quarter results. As I mentioned earlier, we recorded the impairment in the second quarter as a result of the expropriation of our assets in Venezuela.

Now I am going to move on to slide -- page number nine, our Company production. Production from our E&P segment in the second quarter totaled 1.91 million BOE a day. This is 110,000 BOE a day lower than the first quarter, so the performance in the second quarter is better than the guidance that we gave, which we previously said we would be down about 150,000-160,000 BOE a day in the second quarter.

The second quarter was negatively impacted by our exit from Dubai. Our asset rationalization program, we did have planned maintenance in the North Sea, along with planned maintenance and seasonality in Alaska. Adding 473,000 BOE a day, which is the estimate of our equity share of LUKOIL's production, then the total for the Company comes to 2.38 million BOE a day in the second quarter.

On my final slide and the outlook, I will discuss our views on our production going into the third quarter and our update for the entire year of 2007.

Moving on to page 10. E&P's second quarter earnings were $2.1 billion when you adjust for the Venezuelan an impairment, about $200 million lower than the previous quarter's net income. If we look at the first part on the left on the chart, you can see that first quarter net income benefited by the impact of our asset rationalization program. That program also impacted second quarter net income and I will address that in a minute.

Moving to the right, you can see prices and other market impacts contributed $272 million to second quarter results, but we had lower sales volume and that reduced income by $81 million. The second quarter asset rationalization program negatively impacted income by $71 million. For other items in the aggregate improved first quarter by $14 million and then with the Venezuelan impact -- impairment, our net income from E&P for the quarter was a loss of $2.4 billion.

Moving on to the downstream on page 11. In refining and marketing, worldwide refining and marketing margins were higher than the previous quarter. In the US, I realize crack spread was $19.59 a barrel and that is $7.72 a barrel higher than the first quarter. Our international refining was $9.68 a barrel, which is $4.62 a barrel higher than the first quarter. Our US marketing margin of $2.36 a barrel was $1.05 a barrel higher than the first quarter.

And our international marketing margin was $7.78 a barrel and that is $0.60 a barrel higher than the first quarter. Our US refining system ran at 93% of stated capacity. That is two percentage points lower than the previous quarter mainly due to some unplanned downtime at our Sweeny and Trainer refineries, as well as a turnaround at the Borger refinery. Our international refining system ran at 93% of stated capacity. That is an improvement of 3% compared to the first quarter.

Our total worldwide crude oil capacity utilization for the second quarter was 93% and that is about one percentage point lower than the prior quarter for the reasons I just went through. Turnaround expenses were $58 million pretax. That's $17 million lower than the first quarter. Our asset rationalization program impacted second quarter results and I will cover that in the next slide.

I am on page 12. The downstream net income the second quarter was about $2.4 billion. That's $1.3 billion higher than the first quarter. Moving to the red bar on the left, you can see that first quarter included a benefit of $135 million from our asset rationalization program. You will see in a moment that the second quarter included a similar benefit. Moving to the right, prices, margins and other market impacts improved second quarter by $1.2 billion and volumes added an additional $5 million improvement.

If you recall back when we went through on our conference call in the first quarter, we said that we were adversely impacted by trading and inventory results and the timing of the trading cost us about $0.04 a share. That was around $70 million. Well that has reversed and that amount -- a little bit more -- is included -- has benefited our second quarter in our downstream results.

As I mentioned, there were a $158 million benefit from our asset rationalization program and then other reductions to the second quarter income totaled $29 million as predominantly lower equity earnings from the downstream business venture with EnCana is the result of the Borger refinery turnaround in the second quarter.

Before I leave this slide, we mentioned in our first quarter conference call that there was market movement in downstream and the refining margins and from the fourth quarter of last year to the first quarter of this year, that market movement and crack movement is 4.50, but in the first quarter, we captured only $0.40 of it at only 10%. In the second quarter, the market movement was $8.50 and went up to $12.26 and so we captured we believe in the second quarter not 10%, but we captured 70% of that market movement.

For planning purposes going forward, I mean normally we capture about 85% of the market movement, but as we look in the third quarter and going forward for the short term, maybe you could be, in running your models, be thinking of market capture closer to about 75%.

But now I am going to move on to page 14. You can see the vast majority of our earnings come from our domestic refining business and it is also supported by international refining. In fact, I will just give you two numbers. Domestic refining, we earned $1.757 billion. International refining, we earned $287 million. When you add that up, it is a little over $2 billion. So a predominant amount of our earnings in the downstream comes from domestic and international refining.

I'm moving on to page 14. Our estimate of equity earnings for the second quarter from LUKOIL is $526 million. It is $270 million higher than the first quarter mainly due to higher realization from crude oil and refined product sales and slightly offset by higher extraction taxes and the net impact from the alignment of our estimates to LUKOIL's actual reported results.

Earnings from midstream was $102 million compared to $85 million in the first quarter mainly due to higher natural gas liquids prices. Our Chemicals joint venture contributed $68 million, down from $82 million in the last quarter, mainly due to a $21 million asset retirement, which was partially offset by better olefin and polyolefin margins. Our emerging businesses lost $12 million in the second quarter compared to $1 million loss in the first quarter. That is due to lower power generation earnings in our corporate costs of $337 million, only slightly improved from the previous quarter as lower net interest expense was mostly offset by higher compensation and benefit costs.

Moving on to page 15, E&P income per BOE. And you can see on the chart, it shows our income per BOE for the years 2003 through 2006, as well as the first quarters of 2007. Our E&P income per BOE remains competitive and when we talk about the peer group, we're talking about ExxonMobile, BP, Shell, Total and Chevron. Of course, we don't have information available for the second quarter until all the results are reported.

Moving on to slide 16, income per barrel for the downstream. Similarly for our downstream, our income per barrel is quite competitive with peer groups, same peer group I just mentioned, same periods of time and we believe that we will continue to be competitive as we go through 2007.

Moving on to page 17, return on capital employed. Again the same peer group is shown in the shaded area from the lowest to the highest and it shows for our Company, our ROCE with no adjustments for purchase accounting. We made some adjustments with peer group, reflect purchase accounting, included in the attached table two, what those adjustments are. So you can see our annualized ROCE for the second quarter is 18%. It's an improvement over the first quarter. I will give you some ROCEs annualized for the second quarter. E&P was 12%, downstream 42%, midstream chemical 21%, LUKOIL 21%, blended 18%.

Moving on to the last slide. The last slide is the outlook. We remain on track to deliver $3 billion to $4 billion in proceeds by the end of the year from our asset rationalization program. If you remember at the end of '06, our closed deals, we captured $500 million in asset dispositions and so far in the first and second quarter this year, $2.2 billion and then we have agreements, but we haven't closed transactions, that will be into the third/fourth quarter of $800 million and then we are marketing some others such that we see no problem in doing the $3 billion to $4 billion.

We continue negotiations with Venezuela concerning appropriate compensation for the expropriation of our oil projects and we reserve our legal rights. We do believe and expect that we are working towards an amicable solution and settlement on compensation. If we don't, then we resort to international arbitration.

Looking at the third quarter, we expect E&P's production to be lower than the second quarter as a result of loss of production from Venezuela, unplanned downtime in the UK, as well as the result of a disruption of third-party pipeline, as well as planned downtime of Timor Sea in Alaska.

Let me give you a few numbers to help you with those comments. When you look at J-Block and the impact of the CATS pipeline being down, added to or not on production to our plan on the East Irish Sea and then the planned shutdowns that we have for maintenance in Australia for the LNG project, production Alaska in the North Sea. All of that in the third quarter compared to the second quarter amounts to about 90,000 BOE a day.

Venezuela, we won't have production in Venezuela in the third quarter and so that all in total amounts to about 90,000 BOE a day. So you can be looking at about 180,000 BOE a day third quarter compared to the second quarter.

Now for the full year. When we initially came out, we said for the full year, including the LUKOIL segment, that we would do 2.375 million BOE a day for the entire year. Well, if you back out an expected 100,000 barrels a day for Venezuela for the third and fourth quarter on an annualized basis, that is 50,000 BOE a day. We expect for the full year adjusting that 50,000 for the full year, we will be doing 2.325 million BOE a day. That is going to be our average for all four quarters of 2007.

In our downstream, capacity utilization is expected to be similar to the second quarter with turnaround costs of about $40 million pretax. As a result of one of the major reasons of the CATS pipeline being down, we have seen much higher -- high quality crude oil in the North Sea in the price of high quality crude oil in the North Sea. This is having an adverse impact on our Wilhelmshaven refinery because it is essentially a visbreaking refinery and until we put in deep conversion, it is not a real sophisticated refinery. Because of the high crude oil prices, we are backing off our volumes for market reasons.

For that reason is why you are going to see capacity utilization down potentially somewhat on the international and the total Company because we have taken an economic decision to cut back runs at the Wilhelmshaven refinery because of the run-up in high crude prices and the impact on margins.

And then we expect, as we recently announced, new share repurchase program is going to be 15 billion. That is the third and fourth quarter through all of the four quarters of 2008 and we expect our third quarter share repurchases to be between $2 billion and $3 billion. Then we continue to pursue and evaluate alternative fuels. The latest example, a recent announcement that we made I think just a day or two ago with Peabody to explore development of commercial scale coal to substitute natural gas using our E-Gas technology.

Those really conclude all the prepared statements, comments on the slides that we have put on the Web and so we will now move to taking questions and observations that you may have of us and we will try to respond.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes form Neil McMahon with Sanford Bernstein.

Neil McMahon - Sanford Bernstein

Hi, guys. Just wanted to run over a number of questions. The first is really on your refining number. You mentioned that you were capturing more of the crack this quarter than you were last quarter. How much of this do you think is sort of self-help or ConocoPhillips-specific versus more of the industry margin improvements that we have seen in the second quarter?

That is the first question and maybe Jim, you could give us an idea or indeed John, and idea for what your plans are for asset rationalization efforts in 2008 now that we have gone through half of the year 2007 in terms of your outlook for that in the future? Thanks.

Jim Mulva

Okay, first of all, it is kind of difficult for me to say just how much was self-help, but we definitely ran quite well in the second quarter and we also saw that the crack spreads and all the differentials were somewhat better and we captured those. So it is kind of hard to say how much was self-help. We continue to run really well. I think it is just the differentials were somewhat better in the second quarter for us than the first quarter.

We captured that. We expect to continue to do that. The important thing though is to continue to run well. Asset rationalization going beyond 2007. Well, I think for a company with our asset base, we should continue to look at some amount of asset rationalizations as an ongoing program for each year subsequent to the one we just announced.

So the amount of that in all, exactly which assets they might be is something that we are putting into our refining program and our operating plans for 2008 and 2009 and we will share that with the market when we are ready to and certainly no later than when we have our analyst update early part of next year.

Neil McMahon - Sanford Bernstein

Maybe just one quick extra question. You mentioned the very high North Sea crude costs at the minute because -- I think it's the CATS pipeline that is dying -- I would have thought that was a gas pipeline -- but could you just go through the local impact of that? Are you seeing all the refiners reducing their runs within the North Sea basin or local area that receives the crude?

Jim Mulva

It's kind of hard to say, but I think the less sophisticated refineries such as Wilhelmshaven obviously are subject to, for economic reasons, some cutbacks in runs.

Neil McMahon - Sanford Bernstein

Great. Thanks a lot.

Operator

Your next question is from Robert Kessler with Simmons & Co.

Robert Kessler - Simmons & Co.

Good morning. Jim, having cut your Canadian capital budget by about $1 billion heading into this year, it looks as though we subsequently have seen some abatement in costs up there. Just curious at what point you might start to think about reversing course and starting to drill a few more wells?

Jim Mulva

Well, it's what you said is what we have experienced. We have seen some modest reductions in the cost of drilling in Canada, but then the issue for us is going to be just where do we allocate all of our capital spend, where do we think the opportunities are best in our worldwide E&P portfolio.

But we did say that we would expect to increase our spending or capital in Canada compared to what we did this year. But given the prices and all, we will continue to evaluate that. One thing we want to make sure that we do is we never lose the optionality of ultimately drilling those wells whether we increase our drilling for this drilling season coming up in 2007, early 2008 or we do it in a subsequent year.

Robert Kessler - Simmons & Co.

Is there any kind of guidance you can provide in the near term then on production in Canada? Clearly down 6% year on year on the natural gas side, about 2% sequentially. Would you expect that to continue to fall off and maybe accelerate on the declines until maybe next year sometime when spending picks back up?

Jim Mulva

Well, first, I think you're probably talking about natural gas production and it really is -- the fall-off is dependent upon how much we are going to spend on our capital program. We pretty well adjust that to what we want, but as I said, we don't forego or give up the optionality.

So it is a detailed question that really don't have -- not prepared to go into as it relates to 2008, 2009 production. That is something that we normally do and we share with you early next year. But it really is dependent upon how much capital we want to spend what the production levels are going to be with respect to gas. Now in oil, we expect that to ramp up as we develop our oil sands joint venture with EnCana.

Robert Kessler - Simmons & Co.

Okay. Thank you.

Operator

Your next question is from Arjun Murti with Goldman Sachs.

Arjun Murti - Goldman Sachs

Thank you. Jim, maybe just a follow-up on the natural gas question. Certainly recognize that ConocoPhillips and certainly many of the larger companies are unlikely to react to the very short-term volatility. Is there a threshold gas price that we should be thinking about in terms of maintaining activity levels in and around where they have been or how are you thinking about the risk of lower gas prices, natural gas prices in the U.S.?

Jim Mulva

Well, obviously, there is a lot of seasonality and it seems to really swing, Arjun, as you know probably better than myself, with respect to weather.

Arjun Murti - Goldman Sachs

Yes.

Jim Mulva

And of course the weather -- we have not had really a warm summer season, which is good for the American consumer and we have had essentially no weather issues impacting production, which is also good in that regard.

But I think what we do as a company is we will -- we are constrained -- we constrain ourselves on how much capital we really want to allocate to the Company whether -- I recently gave a speech in Washington and said that we could expect our capital spend maybe to reach as high going into 2008 as much as $15 billion.

Now we've said $13.5 billion and that is what we expect we are going to spend in 2007, but that doesn't necessarily mean that we are ramping up drilling programs in Canada or the lower 48. What we do recognize is that everything is costing us, committed projects that we have underway, everything is costing us more than we thought it was going to cost.

This is the part of cost inflation, but then that will back into -- if we, as a company, are going to spend $14 billion or $15 billion in 2008, then we back down and we look at our opportunity. So it is not a specific gas price that we look at. We just start looking at how do we want -- do we start at a more macrolevel?

How much money do we want to allocate toward growth and development of the Company and we have already announced our share repurchase program, then we back in and rank our opportunities. Obviously with a lower gas price, as I said earlier, we don't want to give optionality, but we are patient and we will wait.

We feel quite strong and bullish about the North American gas markets, but if we retain optionality, we don't feel we have to drill the wells in the immediate future.

Arjun Murti - Goldman Sachs

That's really helpful. If I can ask one other, can you just give an update on how -- or the status of some of the Middle East refinery projects you have been associated with? I think Saudi is the key one and I believe the UAE one is maybe longer term or down the road. Can you give an update on the status of those projects?

Jim Mulva

Well, first, on working in Abu Dhabi with IPIC, we continue to really work very well with them and working and developing alternatives by which ultimately a project of some sort could be developed at Fujairah, but that is quite a bit longer term in nature. Whether we participate or not is something to be determined in the future.

The one that is a little further along obviously is working with Saudi Aramco at Yanbu and all these projects are realizing increased pressure on costs and so what we are doing is we are going through very elaborate engineering study work on how we can best get these projects to the finish line, but, Arjun, it is premature at this point in time.

We just have to do a lot more engineering work and we have to do a lot more discussion on the commercial terms before we get to the point of sanctioning this project. I think that it's going to take quite a few more quarters. I can't recall the exact date, but I think sanctioning and all going forward is more of a 2008 decision; it is not a 2007 decision.

Arjun Murti - Goldman Sachs

And it is still a question mark in terms of decision because, as you said, you are doing all the work at this point to study it?

Jim Mulva

We obviously with Saudi Aramco we want to do the project, but we want to make sure that when we make the decision to go forward that we have done enough engineering and all and we have evaluated all the cases and the cost that is creating value for both Saudi Aramco and ourselves and it is premature to say that we have reached that point yet or not.

Arjun Murti - Goldman Sachs

That's really helpful. Thank you very much, Jim.

Operator

Your next question is from Bernie Picchi with Wall Street Access.

Bernie Picchi - Wall Street Access

Good morning, gentlemen. Could you comment, Jim, on your likely interest in the Shtokman development in light of Total's recent decision to get involved in that project? I gather the Gazprom has said that they'd consider another non-Russian strategic investor in the project. But based on your understanding of what Total is signing up for, is that something you would be interested in doing?

Jim Mulva

Well, we have had quite an interest in competing for equity ownership and participation in Shtokman and in the middle of last year, Gazprom, as you know, decided to do the project themselves and then subsequently have come back and said well, we think there is a role for a participant, but not direct ownership, in the field, but ownership in the company that will operate it. Total has been selected to have a 25% participation and what we hear in working with Gazprom is there may be an opportunity for a company like ourselves to participate and have participation maybe less than Total.

But if we continue to talk, discuss this opportunity with Gazprom and whether we participate or not is premature because we are not that far enough along to make that decision. But I would I would like to say is we continue to discuss this and I think following the guidelines that Gazprom has said this would be decided here certainly through the remainder of 2007. So we are interested and we are discussing and talking with Gazprom and whether we ultimately participate or not is premature to say at this point.

Bernie Picchi - Wall Street Access

Jim, is it your understanding that Total is going to be able to pick up their share, their proportionate share of the reserves in Shtokman and if that were not the case, would that be kind of a no go for you if you couldn't book the Shtokman reserves?

Jim Mulva

We think -- had this question from others in different venues, not on a conference call, but as a company, ConocoPhillips, we like to have equity participation and aren't particularly interested in being a player in a project just as a service provider. We always like to have equity. So my understanding is there may be a possibility or way by which the reserves could be booked. But in terms of how that is done and the amount of that's done with respect to where Total is at this point in time, I think you really have to talk to them. But for us to comment, again, it is premature for us.

Bernie Picchi - Wall Street Access

If I could ask just one more question, Jim, on Russia just on the other side with your equity interest in LUKOIL given the fact that the Iraqi Congress is mulling the oil legislation I guess as opposed to go to parliament and be passed sometime before the end of the year, could you talk a little bit about maybe some of the aspirations that you might have here on your own or through LUKOIL in participating in some exploration or more specifically I suppose development programs within Iraq?

Jim Mulva

Well, there's really maybe three ways. One, we continue to work with LUKOIL with strong support of the Russian government, that the West Purna contract should be confirmed and that is a very significant opportunity for participation for both LUKOIL and ourselves and we would like to do that.

Another way is that, through partnership with LUKOIL, that we can do some other things in Iraq with LUKOIL and the third way is that we continue to work with the Iraqis in terms of training in communication and whatever, that we could be looking at doing some things in Iraq when security is sorted out and the rules and regulations of oil and gas policy are sorted out in Iraq that we can be doing things with the Ministry of Iraq. So there's really three ways we can participate. Great province, we'd like to be there. We'd like to invest, but of course obviously, as you know, things have to sort out first before we can do that.

Bernie Picchi - Wall Street Access

Thanks, Jim.

Operator

Your next question is from John Herrlin from Merrill Lynch.

John Herrlin - Merrill Lynch

Yes, good morning, Jim. Two quick ones and then maybe one not so quick. Alaska LNG sales seem to be a little bit lower. Was that just for lack of demand and have you had any more indications for greater demand given the quakes in Japan?

Jim Mulva

Well, I can't respond what has happened in Japan with respect to the earthquake. In terms of our LNG sales, it is not constrained because the market is not there. It is because the fields are starting to become more mature and we do have maintenance, we do have turnaround and that is really primarily why there might be several cargoes less than in prior years. But it is not because of willingness on behalf of the buyers to take the cargoes. I can't really comment on what has happened in the marketplace in Japan because of the earthquake.

John Herrlin - Merrill Lynch

Okay. That's fine. You have had a lot of gas questions given Conoco's North American production exposure. Could you address basis differentials and your position on the REX line?

Jim Mulva

On the REX line?

John Herrlin - Merrill Lynch

The Rocky Mountain Express.

Jim Mulva

Maybe, John, you might want to comment on that. You might be a little closer to that. I think what we know is that what is important about the REX pipeline is once in place, the basis differentials are really going to contract and that is going to be very beneficial for our production. That is why we are so supportive of it and taking an equity ownership interest.

John Carrig

Exactly. We have seen some near-term softness. We have a number of exit mechanisms out of the basin, but still there is -- overall, there has been some softness in the Rockies and we expect that to improve as the REX pipeline -- each stage of the REX pipeline becomes operational and in-service.

Jim Mulva

So what do we want? We want the REX pipeline, but it is always great when you have production and you can trade around your assets, your production, have multiple evacuation routes. So REX is really important for us in long term our strategy in play, but on the other hand, we are also looking for -- is there some other evacuation alternatives, potentially even going south.

John Herrlin - Merrill Lynch

Great. The last one is the longer question so to speak. In your news release today, you had comments about changing policy or the need to change energy policy. Would you mind addressing that and also how rapidly do you think the government could actually respond to having a more comprehensive energy policy?

Jim Mulva

Our country has not had an energy policy for decades. Everyone on this conference call I think pretty well recognizes that we have quite an energy challenge ahead of us in terms of providing energy that runs our economy and our standard of living. We really think best that instead of punishing US Congress and administration, we should really be looking at the oil and gas industry as really the industry that can provide the energy and provide the solution versus looking at legislation that constrains us, restricts us or punishes us or puts on windfall profits tax.

We need to develop infrastructure. We need access and so that is why we are speaking out so strongly is because we really need an energy policy and we need leadership in Washington and that is why we went through the four important principles that we feel that should be incorporated into a national energy policy.

We also know that the oil and gas companies in the industry and companies like ourselves, we have to be at the table, be participant. We can't have everything our way; we have to give and take. But it is time for leadership, time for us to have an energy policy and these are the important principles that we believe we need. We are not just going through a cycle. We are really facing a very dramatic challenge in terms of providing energy and we really think the oil and gas industry is the industry that the American public and our Congress and our leaders should look to help provide the solutions. We have done it in the past. We can do it in the future.

John Herrlin - Merrill Lynch

Thanks. I guess the last one for me is on the Peabody deal. Will there be any sort of CO2 sequestration advantage with the gasification?

Jim Mulva

That is the plan. We're working hard with our technology and engineering studies that we can take coke and coal, use our technology and make synthetic gas, put it in pipelines, it goes right through to existing pipelines and takes the CO2 as a result of our technology and sequester it. So for all these reasons of course it is challenging from a commercial point of view, we have got to work on that.

But another thing, part of our national energy policy, we have no framework, there is no framework, rules, regulations on how you actually sequester CO2. So if we have a project like this that we want to develop, we have got to make sure it doesn't get held up because we have a plan of how to sequester CO2, but we don't have rules and regulations to get a permit to sequester it. So that is something we will be working on.

John Herrlin - Merrill Lynch

Great. Thanks very much.

Operator

Your next question is from Paul Cheng with Lehman Brothers.

Paul Cheng - Lehman Brothers

Hi, good morning. Jim or maybe John, can you tell us then how much you earned in the Venezuela operation in the second quarter?

John Carrig

$93 million.

Paul Cheng - Lehman Brothers

$93 million?

John Carrig

Yes.

Paul Cheng - Lehman Brothers

And also, John, in the share buyback, $2 billion to $3 billion in the second and in the third quarter and also again in the fourth quarter, are you expecting to fund all those debt from free cash flow or if the free cash flow is insufficient, you're going to raise some debt for that?

John Carrig

Well, our plan is to, as we indicated, to buy at that level. Of course, it is dependent upon commodity prices and the operations of the Company, but if there is some increase in debt to accommodate that, we are prepared to do that.

Paul Cheng - Lehman Brothers

Okay. So you do prepare if you need to increase the debt?

Jim Mulva

That's correct. In other words, when we announced the program that we are going to buy $15 billion over the next 18 months, we wanted to communicate to the marketplace certainty by which this is going to be done and we do recognize, yes, the marketplace may or may not be at $70 oil price and crack spreads, but we feel we have essentially accomplished our debt reduction.

We have a very strong financial position that we can fund this share repurchase program, our capital program and if debt goes up a little bit, we still have a very strong financial structure. So it is not dependent upon the marketplace.

Paul Cheng - Lehman Brothers

Okay. Perfect. John, in the LUKOIL, second quarter, your share of the earning you reported $526 million. Is there any one-time catch-up from the first-quarter actual?

John Carrig

Yes, there is.

Paul Cheng - Lehman Brothers

How much?

John Carrig

About $40 million.

Paul Cheng - Lehman Brothers

$40 million?

John Carrig

Yes.

Paul Cheng - Lehman Brothers

And then --.

John Carrig

That -- of course, that is our estimate of LUKOIL's earnings. They will report their earnings in due course.

Paul Cheng - Lehman Brothers

Right. Totally understand. And Jim, is there any update you can give in terms of the oil sands joint venture ramp-up? Are we seeing anything unusual or that's unexpected good or bad?

Jim Mulva

No, we are going -- for the year, we are going to be just a little bit less than what we planned and that is because we had some operational upsets earlier I think in the first quarter, but we are up pretty much right on plan and as we go through 2007 and then we are going to update our estimates when we get together early next year for what we expect in 2008 and 2009.

Paul Cheng - Lehman Brothers

I know, Jim, it is early. Is there any rough number that you can give us in terms of the production and capital spending for next year?

Jim Mulva

Well, I kind of went through that. I said, just earlier, that I don't think it is going to be $13.5 billion, but I think it is probably going to be somewhere in the neighborhood of $14 billion, maybe as much as $15 billion, but the reason for that is we have got some pretty significant opportunities that we are going to be adding to the program and we also see quite a bit of cost pressures on existing commitments.

So we don't want to lose our discipline on capital spend. The market is actually compared to a year ago stronger, a little more robust than we might have thought say if we put plans together a year ago, but we don't want to lose the capital discipline. We want to seize the opportunities. We have a strong balance sheet and we like annual increases in dividends and we are committed to the $15 billion share repurchase that we just announced that we have got to make sure we provide for.

Paul Cheng - Lehman Brothers

How about in terms of production or is it too early?

Jim Mulva

Well, production, as we have said, is -- obviously you have got to take Venezuela out. That has an impact on current production, but we have essentially booked the reserves that were already recognized for Venezuela. So it does not change our expectation for this year and subsequent years that we are going to replace our reserves once you back out Venezuela.

So we start with a lower base because we backed out the reserves for Venezuela, but what we expect is replace our reserves over the next five years and it can be lumpy, but when you say lumpy, I think we'll be in a neighborhood of anywhere from 80% reserve and replacement to 120%. But the average over the five years is going to be 100%.

Paul Cheng - Lehman Brothers

Very good. Thank you.

Operator

Your next question is from Doug Leggate with Citigroup.

Doug Leggate - Citigroup

Thank you. Good morning, Jim.

Jim Mulva

Good morning.

Doug Leggate - Citigroup

A couple of things. I am sorry to drag up Venezuela, but maybe just a couple of questions around that. I don't know how much you can say about the arbitration, but clearly there were several steps that were taken down there, not least the extraction tax and the moving the income tax and so on. Are you looking at the value pre any of those changes when you look at arbitration or are you looking at the value from January 1, 2007?

Jim Mulva

Well, I really think, Doug -- I appreciate the question, but it is probably not appropriate for me to get into how we would look at arbitration because from a sensitivity point of view, we really do believe and I know the Venezuelan authorities were both engaged in discussing, talking about how we agree on compensation and that is our number one objective.

And for me to start getting into the details of how arbitration may or may not work takes away from the overriding thrust, which is to get agreement in terms of amicable settlement and even if we could get to that point, I don't think it is appropriate to get into how we actually do that until that point in time comes.

So that is something that I think really is more confidential and appropriate for us to retain within the Company.

Doug Leggate - Citigroup

Okay. I appreciate that. The kind of related question is obviously the Corocoro was one of the assets. I believe it is no longer going to be in the portfolio. So as you look forward to the production targets that you laid out back in March, how do you feel about those now? And I guess a related question to what you just said about reserves.

If you are still looking to grow reserves, or sorry production, at the 3% plus level, what reserves, replacement sticks around 100%? That obviously implies a deterioration in your reserve life. Can you just make a few comments around that and how you feel about that going forward?

Jim Mulva

What was the very last part though?

Doug Leggate - Citigroup

If you reserve replacement is 100% and you are growing your production at 3% plus, your reserves' life is probably going to start to continue to move lower. I am just wondering if you could comment around that, whether you see that as an issue or not.

Jim Mulva

Well, I can confirm what you just said, you can expect that.

Doug Leggate - Citigroup

Okay. And on the production guidance? Is the 3% plus number still good without Corocoro?

Jim Mulva

Well, yes, I mean we just -- we haven't changed what we have in mind. Now a few things I would say. You just have to back out everything that relates to Venezuela. That is Hamaca, Petrozuata and Corocoro. If you look at the rest of the Company for the reasons I went through, we pretty well have booked everything associated with Petrozuata and Hamaca.

Doug Leggate - Citigroup

Okay

Jim Mulva

Unfortunately, we have a few projects that haven't really come onstream like we thought this year. We have our participation in Alvheim in Norway. Grithatch has not come on quite as quickly as we would have expected. And we are going to have new production coming from Bohai and we have increased production coming from the oil sands in Canada and we have satellite fields and exploitation and some other BD things that we are working on.

So I think the best assessment at this point in time until we update early next year is just back out Venezuela and everything else remains essentially the same as what we have passed along to you in prior presentations.

Doug Leggate - Citigroup

Okay. I guess the final one is going back to the share buybacks. Its kind of I guess in line with the issue around Venezuela. You lost a chunk of reserves. Obviously down there is stable production. Are you canceling the shares that you are buying back and could you kind of just recommit to your recent comments about not really looking at acquisitions anytime soon?

Jim Mulva

Well, obviously when we buy back the shares that we are -- have announced, we feel pretty bullish about the Company and we also feel that the shares are undervalued and it is one of the best opportunities we have in terms of buying our own shares back. That will also translate into increased production per share both from the E&P side, as well as the refining side.

In terms of acquisitions, as I said earlier, I really think that cycle -- we have done a lot of deals, transactions, joint ventures, acquisitions, mergers since 1999. There probably will be more consolidation over the next decade, but I think this cycle has pretty well run its course, particularly for our company.

So we also look at what is available, the cost is very expensive and politically not really doable. So really haven't changed our view, which is why we have announced a very aggressive share repurchase program that fits our capital structure and we are funding our capital opportunities and it is also a direct communication to the analyst and financial community to our shareholders that when we buy back this amount of shares, we don't contemplate doing large M&A deals.

Doug Leggate - Citigroup

Would you essentially be targeting -- are you trying to I guess remove the dilution when you issued the stop for Burlington? Is that kind of where this is going eventually?

John Carrig

I think that is a fact that will happen.

Doug Leggate - Citigroup

Okay. And are those shares going to be canceled?

Jim Mulva

Doug, we don't cancel them as such. They are acquired and held in treasury. That is how it works. They don't -- they are still authorized.

John Carrig

And that mechanic I don't think applies.

Doug Leggate - Citigroup

All right. Great. Thanks very much indeed.

John Carrig

I would like to add that the math is such that if you only replace 100% of your reserves and you maintain a 3% production growth as we do then the RP ratio will decline. However, Jim's statement that we expect to replace 100% of our reserves is not our aspiration; it is just what we are willing to say now. And we certainly do -- we do hope to do better than that and that is our objective.

Doug Leggate - Citigroup

Great. Thank you.

Operator

Your next question comes from Dan Barcelo with, Banc of America.

Dan Barcelo - Banc of America

Yes, good morning. You touched on LNG a bit with comments on Shtokman. I didn't know if you could just broaden that a bit for an update on Qatar LNG, how is the development drilling going there, cost there and then also just comment briefly on the LNG strategy overall?

Jim Mulva

With respect to Qatargas 3, it is a big project, a huge project and of course there are many projects being undertaken in Qatar, of which one -- ours is one of the very large ones. But we have got a great team over there doing really well and there is no real change with respect to the schedule and the cost.

In terms of our LNG approach around the world, we would like to do more work in Qatar, but as you know for the last two years, they have rescinded or stopped any new projects. We have and continue to participate looking at what can be done with the Brass project in Nigeria. We have talked about Shtokman.

But we also look at what could be done in Timor Sea of Australia and we have some opportunities that we would like to see ultimately, a Darwin 2 and a Darwin 3, but that is going to take a development of projects and appraisal programs to make sure that we have the resources to do it. But we have the location, we have we believe the marketplace is there. We have the infrastructure location that we can do this out of Darwin.

So I think what you are really looking at is hopefully in time maybe we can get in and do some more in Qatar. But does Shtokman fit into our portfolio or not, will that come to fruition or not? Premature, don't know. But I think the likelihood of doing more LNG projects such as Darwin 2 and Darwin 3 has a higher probability.

Dan Barcelo - Banc of America

Okay, thanks. And if I could also -- if I could get an update a bit on your 2007 exploration outlook. I know you had a bunch of appraisal wells and you were drilling about five new places here and also if you could talk about the exploration maybe in the context of what your strategy would be around the U.S. Gulf of Mexico lease sales that are upcoming given your existing acreage position there.

Jim Mulva

Well, in terms of lease sales, I don't think it is appropriate or right for me to comment too much because that is always so competitive. We really wouldn't want to do that. But we are very interested in the Arctic. We are very interested also in the Paleogene, the deeper horizon in the Gulf of Mexico.

Fortunately, we have a pretty sizable acreage position, but we have been doing some transactions and deals and farm-outs by which we can commercialize or get some value from the acreage that we have in the deep Gulf of Mexico and we are just in the process of starting to drill one of those wells. So hopefully come our way in that regard, but this is an area that is pretty interesting to us. It could be really quite promising for us.

But again, like in all explorations, you are going to have to drill the wells and the probability of success, you have to be realistic about it. But we are quite interested in the Arctic and we feel that it is important for us and we will continue a consistent spend on exploration as we are this year.

We will carry forward into next year, but we are looking for the new opportunities and are spending predominately more of our money on doing the geophysical work as opposed to just drilling wells that we feel may not have the perceptivity that we would like to have in the portfolio.

Dan Barcelo - Banc of America

Perfect. Thanks very much.

Operator

And your next question is from Mark Gilman with Benchmark.

Mark Gilman - Benchmark

Guys, good morning. I had a couple of things I wanted to go over if I could. First, nuts and bolts nature. If I calculate the foreign upstream tax rate, exclusive of the Venezuelan impairment, I am looking at something in the neighborhood of about 59%, which is pretty high relative to where it has been in the past, particularly in a period where Norwegian volumes, probably the highest taxed in the portfolio, were down for maintenance-related reasons. Anything in particular going on in terms of any changes in tax rates that we should be thinking about?

John Carrig

No. In fact, if you back out Venezuela -- there were some other one-time tax charges in the results. It is consistent with prior quarters. So we don't think there is anything-amiss overall in the overall tax posture.

Mark Gilman - Benchmark

Okay, John, thanks. Jim, regarding the production guidance in the third quarter, 90,000 a day if I heard you correctly, incremental maintenance and downtime related hit versus the second, which was already significantly burdened by exactly those same effects and in particular, the once in three-year turnaround at Ekofisk, which I assume is certainly not going to be repeated in the third. That 90,000 number seems very, very high, particularly given that the Timor maintenance is only one month. It almost sounds if you may be low-balling the production number a little bit. Could you help me understand that 90,000 figure maybe with some additional detail?

Jim Mulva

I think we are looking at potentially in the third quarter losing nearly 35,000 BOE a day from J-Block because of the pipeline being down. That is a great deal of it and then we have got Timor Sea, Indonesia and I guess Bayu-Undan maintenance, seasonal maintenance and we have some up in Alaska. And I don't know, Gary, you --

Gary Russell

We have got some plant issues in the Irish Sea that look like it might cost us about 10. So it is nuts and bolts, it gets you to about 90.

Mark Gilman - Benchmark

Okay. Just one more if I could, please. Regarding Venezuela, I am a little puzzled by the strategy of essentially attempting to walk away and negotiate compensation. It would seem to me given your asset position that one might have opted for the strategy adopted by others and in particular your strategy seems to assume, and this is where I would like your comment, the ability to enforce any international arbitration award should it come to that that you might receive, enforce it against existing U.S. assets held by PDVSA. Is that in fact what you are assuming in terms of enforceability of any potential arbitration award?

Jim Mulva

Well, Mark, I won't get into the details of it, but what we -- essentially our decision. We look at the probability and the valuation of reaching agreement through a settlement of compensation or arbitration as a last resort as more value creation for our shareholders than staying in Venezuela. It also has issues associated with governance, governance on investment decisions, operating decisions that we felt that all were factored into our decision. But the bottom line really is that we think that we create and protect the shareholder with more value by not migrating and staying in Venezuela than following the course that we are.

Operator

Gentlemen your next question comes from Nicki Decker with Bear Stearns.

Nicki Decker - Bear Stearns

Good morning. Jim, just to follow up on your comments on Arctic drilling. Maybe you could give us an update on your drilling program around the Alpine field? Remind us of what your 2007 plan is and maybe a progress report?

Jim Mulva

Well, when I was talking about the Arctic, we have quite a bit of experience Arctic both North of Russia, Alaska, Canada and all I was really saying is we look to the Arctic as potentially a new province. It is more remote, more challenging technically and commercially, but I was just merely talking about the Arctic as something in the long-term future that on an exploration point of view we have an interest in.

Now in terms of Alpine, I think we will have to come back to you on that because I don't think any of us have the detail. Maybe Gary does, but I don't have detail.

Gary Russell

I can get back to you, Nicki.

Nicki Decker - Bear Stearns

Okay. I appreciate that. Thanks, Gary. Just on a higher level, just judging by recent announcements out of Conoco, there appears to be more emphasis on alternative fuel projects than maybe what was indicated in your past strategy presentation. Can you comment on whether that is the case and maybe your spending plans in this unit in 2007 and 2008?

Jim Mulva

As far as spending, 2007 maybe somewhat more than 2007, but I don't think it is going to be dramatically more because what we are really doing is we are going to have to do a lot of technical research, technical work, commercial work, but we want to get out that these are opportunities that we potentially are pursuing.

But in terms of its impact to the capital program, its real impact is probably going to be subsequent to 2008 because you have got to get these projects in shape that you want to do them. What we are really saying is we are working like in the case of Peabody, doing the engineering and the commercial work.

The position is we go through 2008 that maybe we could get to the point of going forward with this project, but I don't think you are going to see a lot more money allocated in the '08 program compared to the '07 program.

Nicki Decker - Bear Stearns

Well, Jim, has there been a shift in your thinking on opportunities in this business say relative to what your thinking was a year ago?

Jim Mulva

No, not really. We just look at these alternative fuels and renewable opportunities as something that we have been working on for a number of years and we are trying to bring them to fruition.

In terms of the traditional business of upstream and downstream and the E&P, access is an issue and access is becoming more competitive. National oil companies are becoming stronger and stronger every day.

There are more competitors both as national oil companies, as well as companies smaller than ourselves, larger than ourselves. It's a very competitive environment and we just want to make sure that we play that game very competitively, very aggressively. But on the other hand, we need to also be careful for the shareholder that we just don't throw money yet trying to chase access and taking opportunities that have little probability of creating value for the shareholder.

Nicki Decker - Bear Stearns

Okay. And one more very quickly. On Shtokman, did you say, Jim, that you expected a decision out of Gazprom on potential additional partners sometime in 2007?

Jim Mulva

I think that is what Gazprom has said that they would like to make this decision. So I am really -- if I am wrong, it is because I don't have -- I am not saying something that Gazprom hasn't said. I am merely reflecting and repeating what I believe they have said that they would like this decision to be made during -- by the end of 2007.

Nicki Decker - Bear Stearns

Great. Thanks.

Operator

Ladies and gentlemen, this does conclude the Q&A session for today. I will turn the call back to Mr. Gary Russell for closing remarks.

Gary Russell

Okay. Again, we thank everybody for their participation and interest in the Company and we would remind you that the presentation material that we went through this morning, along with the supplemental schedules and information, are available on our website at www.ConocoPhillips.com. Thanks again for your participation and good day.

Operator

Ladies and gentlemen, we thank you for your participation in today's conference. This concludes the presentation and you may now disconnect. Have a good day.

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Source: ConocoPhillips Q2 2007 Earnings Call Transcript
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