By Allen Good
ConocoPhillips (NYSE:COP) began trading as an independent exploration and production firm on May 1, after completing the spin-off of its downstream assets into a new company, Phillips 66 (NYSE:PSX). Considering that this is the first split of a major integrated energy company, finding comparable companies proves difficult. While its growth prospects are less appealing relative to other independent E&Ps given its size, ConocoPhillips offers a juicy dividend not available from its peers. Share repurchases using proceeds from asset sales could further boost shareholder returns. Phillips 66 remains primarily a refiner, but also holds interests in chemical and midstream assets, which boast higher returns, add earnings stability, and differentiate the company from its peers. It also pays a relatively generous dividend and holds the potential for share repurchases.
However, each firm has its downsides. ConocoPhillips' low growth rate and diversified asset base result in a valuation discount relative to its new peer group. Phillips 66's near-term prospects remain tied to refining profits, which are notoriously volatile and remain at potentially cyclical highs, holding the possibility of a return to midcycle levels. As a result, we think there is little upside for either company's shares, but each could prove compelling to those looking for yield in an E&P or a refiner.
ConocoPhillips' Size Presents Obstacles to Growth
With the spin-off of its downstream businesses, ConocoPhillips is the largest U.S.-based independent E&P. Based on production volumes, it is nearly twice as large as its closest peer. However, with its size come challenges, most notably its low growth rate relative to its new peer group. With a target of a 3%-5% compound annual growth rate, ConocoPhillips matches up well with its former integrated peers, but falls short with respect to its smaller rivals. In this respect, it closely resembles Marathon Oil (NYSE:MRO), a former integrated firm now operating as an independent E&P, with a growth target in the low single digits. Both also have diversified asset profiles--onshore, offshore, liquefied natural gas, oil sands, and so on--which are potentially less attractive compared with peers with much more concentrated portfolios.
That's not to say ConocoPhillips has no opportunities to increase production and add reserves. Also, future production additions will largely add liquids volumes or natural gas volumes from LNG projects, whose prices are indexed to oil. In North America, ConocoPhillips plans to drive production growth through development of its positions in the Eagle Ford, Permian, and Bakken, as well as its Canadian steam-assisted gravity drainage operations. Internationally, growth will come from major projects in the North Sea, Malaysia, and its LNG project in Australia. In addition to contributing production of about 550 thousand barrels of oil equivalent per day by 2016, these projects are also higher-margin (assuming the current commodity price environment holds) versus current producing assets. Ultimately, though, ConocoPhillips' size will dilute the impact of these projects, as total production is expected to be 1.8 million boe/d in 2016. The rest of the production will come from the lower-quality assets that resulted in ConocoPhillips' weaker upstream returns compared with its integrated peers. As a result, the company would probably benefit from a continuation of asset sales beyond its current planned program of $8 billion-$10 billion over the next 12 months.
ConocoPhillips' Moat Remains Narrow
We believe ConocoPhillips maintains a narrow economic moat after the spin-off. We previously only attributed a portion of its moat to the chemical and midstream assets, while concluding that its refining assets were not moatworthy. Re-examining ConocoPhillips using our E&P moat framework based on asset quality -- resource potential and production costs -- we think a narrow moat is justified, given the firm's ability to continue generating returns in excess of its cost of capital. The company benefits from a large resource base, with proved reserves of 8.4 billion barrels of oil equivalent (58% liquids), a relatively high portion of which is developed (71%). It holds large acreage positions in the Eagle Ford, Permian, and Bakken that can be developed with attractive economics (low finding and development costs) while delivering high cash margins. Also, its SAGD assets in Canada are the lowest-cost, best-performing in the region. Internationally, the firm has several offshore projects under way that also should deliver liquids volume at attractive returns. Its LNG project in Australia requires significant up-front investment, but should produce at plateau levels for decades, generating strong cash flow over the duration of the project. Long term, we believe ConocoPhillips should benefit from an increase in natural gas prices, as it still holds a large amount of Lower 48 natural gas reserves (14% of total reserves).
However, ConocoPhillips will still probably find it difficult to add reserves to replace production, given its size and a diminishing set of global opportunities. Though the firm still possess many competitive advantages--solid legacy production assets, scale and financial resources, and technological advantages--we expect that, on average, each new barrel of oil production will generate a lower return than the legacy barrels lost each year to natural production declines. For a given level of energy prices, we expect returns on capital to be lower in the future versus historical results, as new reserves are increasingly costlier to develop and produce. Additionally, increasing resource nationalism will probably result in governments capturing a greater portion of the rents from global oil and gas production.
The company still has a large resource base that should provide opportunity to create proved reserve bookings and maintain production, albeit at higher costs or lower returns, in our opinion. ConocoPhillips is currently also suffering from its large exposure to U.S. natural gas, but a long-term recovery in gas prices should improve returns. Development of its liquids-rich domestic resource plays, which remain in the early stages, could boost returns. Returns should improve as the company high-grades its portfolio through asset divestitures. Also, the capital budget will focus on the highest-returning exploration and production projects.
Dividend Yield a Source of Differentiation
Despite a lower growth profile, ConocoPhillips plans to differentiate itself by focusing on shareholder return. It plans to return about 20%-25% of cash flow from operations to shareholders, primarily though dividends. ConocoPhillips has a 4.9% dividend yield that is unrivaled by any other independent E&P. Additional returns will come from share repurchases supported by asset sales. Also, ConocoPhillips plans capital spending of $15 billion per year, well above previous years' levels. As a result, operating cash flow will need to be supplemented with cash on hand to support both capital spending and dividends. Long term, ConocoPhillips is counting on target production growth and margin improvement to increase cash flow. However, lower commodity prices would probably result in the issuance of debt to support the dividend, absent any reduction in capital spending.
We think ConocoPhillips is worth $58 per share, or 4.0 times our 2012 EBITDA forecast of $20.9 billion and 3.7 times our 2013 EBITDA forecast of $22.4 billion. We forecast ConocoPhillips to meet its production growth targets, which include a compound annual growth rate of 3%-5% over the next five years and production of 1.8 million boe/d in 2016. However, actual volumes will probably be lower once the asset sale program is complete. We adjust 2012 production to account for potential asset sales based on management guidance, but do not alter other years in our forecast, given the uncertainty regarding the specific assets to be disposed and timing of sales. Sales of lower-quality assets, particularly high-cost domestic natural gas, would lower volumes but result in an overall higher-quality portfolio. Primary growth drivers include the aforementioned Lower 48 unconventional plays, Canadian SAGD developments, and select international projects.
In our discounted cash flow model, our benchmark oil and gas prices are based on Nymex futures contracts for 2012-14. For natural gas, we use $2.45 per thousand cubic feet in 2012, $3.40 in 2013, and $3.82 in 2014. Our long-term natural gas price assumptions for 2014 and 2015 are $6.50 and $6.70, respectively. For oil, we use Brent prices of $118 per barrel in 2012, $113 in 2013, and $106 in 2014. Our long-term oil price assumptions for 2014 and 2015 are $95 and $98, respectively. We assume a 10% cost of equity and an 8.9% weighted average cost of capital.
Phillips 66 Aims to Improve Its Refining Operations
While primarily an independent refiner, Phillips 66 also holds interests in chemical and midstream assets, which boast higher returns, add earnings stability, and differentiate the company from its peers. Despite the attractiveness of these nonrefining assets, Phillips 66's near-term fate will largely be determined by the performance of its refining and marketing segment, which contributes the bulk of earnings and has the most invested capital.
To Phillips 66's benefit, the refining segment is currently producing strong earnings, thanks to a relatively healthy operating environment. While we expect conditions to moderate and earnings to return to midcycle levels, Phillips 66 is in the process of selling underperforming assets on the East Coast and Gulf Coast and initiating improvement plans that should bolster its overall competitive position. At the same time, invested capital will decline in the refining segment and grow in the midstream and chemical segments, allowing those segments to become larger contributors to company-wide performance. Phillips 66 also sets itself apart with strong cash flow generation, one of the higher dividend yields in its peer group, and the potential for share repurchases.
Overall, we think the return improvement initiatives--selling underperforming assets, increasing cost-advantaged feedstock processing, and increasing exports--should eventually improve Phillips 66's competitive position. As it stands now, we view its assets as a mixed bag. Its Mid-Continent refineries are some of the company's best positioned, given their access to discount domestic and Canadian crudes. The three Gulf Coast facilities currently constitute the largest concentration of the company's refining capacity, but will become a smaller portion with the divestment of Alliance. These facilities are some of the most attractive in the portfolio, given their size and complexity. However, they have suffered with the relatively high waterborne crude prices and narrow heavy differentials. Adding export capability and the eventual flow of Canadian heavy barrels to the Gulf Coast should improve the facilities' performance. Meanwhile, two refineries in California are the most complex, but face higher costs and environmental regulation, which weighs on their value. Efforts to boost cost-advantaged feedstock should help, but a weak economy in the short term and regulatory capital spending in the long term will be headwinds.
On the East Coast, the company's remaining refinery is low complexity and relies on high-cost imported oil for feedstock while competing with lower-cost imports from the Gulf Coast and foreign refiners. Eventual sale or closure would further high-grade the portfolio, and though management has indicated additional asset rationalization may be necessary, it has not mentioned specific facilities. The two European refineries face similar competitive pressures and could also be candidates for divestiture. However, the Humber refinery is the only coking refinery in the United Kingdom and is the world's largest producer of specialty graphite cokes, while Whitegate is Ireland's only refinery. As a result, the two refineries do possess some competitive advantages. Given the economic weakness in Europe and an overall secular decline in refined product demand, we expect a challenging operating environment to persist.
We think Phillips 66 is worth $34 per share, or 4.5 times our 2012 EBITDA forecast of $6.2 billion and 4.4 times our 2013 EBITDA forecast of $6.3 billion. We assume currently strong margins to persist through 2013, thanks to a continuation of the West Texas Intermediate discount, an improving economy, and a robust export market, all of which should benefit Phillips 66 directly or indirectly. Any change in these assumptions, particularly the WTI discounts and the economic conditions, would threaten our valuation. Long term, we assume a return to midcycle margins, specifically in the Mid-Continent, as a result of planned pipeline capacity, which should significantly reduce the current WTI discount. We think Phillips 66's planned improvement projects and closure or sale of underperforming facilities should result in better company-wide midcycle margins relative to historical levels. Continued low natural gas prices should keep operating expenses from rising significantly. Considering the notorious volatility of refining margins and that the refining segment contributes the bulk of Phillips 66's earnings, our fair value uncertainty rating is very high.
For the midstream segment, we anticipate earnings to grow over our forecast period. Higher oil prices and growth projects should support earnings, though lower oil prices could pose a threat to our estimates. We expect volume growth, thanks to DCP expansion projects like Sand Hills and Southern Hills. We think the midstream segment would probably garner a higher valuation as an independent entity than it would as part of Phillips 66. As a result, we think management will eventually push forward with a master limited partnership structure for Phillips 66's non-DCP midstream and transportation and logistics assets.
For the chemical segment, we forecast continued earnings growth for the next few years as the global economy recovers and as volumes rise with the startup of additional capacity at the Cedar Bayou chemical complex. CPChem should also benefit in the near term from low-cost sources of feedstock in the United States. However, earnings moderate toward the end of our forecast as we assume a return to midcycle levels. Beyond our forecast period, though, CPChem should benefit from continued capacity additions in the U.S. and the Middle East.
With modest capital expenditure plans (about $1.5 billion per year with sustaining capital at $1 billion) and the chemical and midstream segments self-funding, we anticipate Phillips 66 should generate significant free cash flow. The free cash flow should go toward shareholder returns, as debt repayment remains a relatively low priority given the company's low cost of debt and target debt/capital ratio of 25%-30%. With a dividend of $0.80 per share and an implied yield of 2.2%, Phillips 66 compares favorably with peers. The relatively low capital spending and strong cash flow generation should ensure the dividend remains intact in the event of a drop in refining margins, while allowing management to increase it at about 5% per year. In contrast, peers that rely solely on refining may have to cut their dividend if conditions deteriorate. Meanwhile, share repurchases will be the preferred mechanism to return excess cash to shareholders when the refining environment is particularly strong.
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