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ConocoPhillips: The conservative

ConocoPhillips, like all the majors, is feeling the pinch of petro-nationalism. It's prepared to wait it out, writes Derek Brower

"WE COULD make 3% by spending more. But 2% seems better for us." If you wanted a snapshot of the ConocoPhillips approach to business, Jim Mulva's words about the firm's new output-growth target would offer it. The chief executive and chairman's statement last month at a meeting for analysts worried his audience and hardly gave a boost to ConocoPhillips' share price.

For a company whose upstream business accounts for 70% of the total, reducing production targets by a third looks bold – but it underlines ConocoPhillips' essentially conservative approach. Do not set goals you will not meet, do not lure shareholders with spurious claims about the future, and remember: the oil business is cyclical. "They think the rise in costs will peak soon," says one analyst, "so are happy to wait it out."

Compare the Houston-based company with its peers and it looks positively staid. Mulva pointed out recently that the firm is the least exposed of its rivals to production-sharing contracts (PSCs). They might have seemed good vehicles for investments in the past, but from Russia to Venezuela, cost inflation and high oil prices have turned many PSCs into liabilities.

Heavy loss

Not that ConocoPhillips has avoided political problems. The firm has pulled out of Venezuela, alongside ExxonMobil, having refused new terms designed to hand state-owned PdV a controlling stake in Orinoco heavy-oil projects. ConocoPhillips had been the largest shareholder in Ameriven (Hamaca) and Petrozuata, as well as the largest investor in the area. By refusing the new terms, it lost both projects, as well as minority stakes in two other fields in the country.

Analysts expect the company to receive compensation for the assets, but no-one knows how much. "It could be $1bn or it could be $12bn," says one analyst. ConocoPhillips took a $4.5bn charge in its accounts last year for the assets, which reduced its 2007 income to $11.9bn. If the compensation matched that charge, it would scarcely represent fair value. Assessing what that might be is difficult – analysts say the progressive tightening of the tax regime on the Orinoco assets has gradually transformed them from one of ConocoPhillips' most profitable plays to one of the least profitable.

But perhaps more important is that while other majors, such as Total and StatoilHydro, have agreed to deal with Caracas, ConocoPhillips has walked away from a lot of oil: its reserves replacement ratio in 2007 was 159% without accounting for the "expropriation" in Venezuela, but just 29% when its departure from the country was included.

The rising cost of exploring for and developing resources is another problem – and one that is partly the result of resource nationalism. "We'd like to be competing in low-cost areas," such as the Middle East, says Mulva. But he says the shortage of upstream opportunities is forcing the firm into pricier regions, such as the Canadian oil sands; last year, the company entered a 50:50 venture with EnCana (at the Foster Creek and Christina Lake permits), it already had a 50:50 joint venture with Syncrude and operatorship of the Surmont field.

The lack of upstream access is not just a problem for his company, says Mulva; it is a problem for the world. "It's going to be difficult to get to 100m barrels a day [of supply] because of the cost issues and also climate change." In the US, cost inflation could also make it difficult to increase gas supply beyond the country's 23 trillion cubic feet a year, he predicts, putting a cap on demand – and affecting the US' ability to use cleaner-burning fuels in place of coal. This is disquieting for ConocoPhillips, which has been one of the US energy companies most willing to join the fight against climate change.

The company's response is to concentrate on the assets it has, cut costs (its emphasis is on returns from the average barrel of oil equivalent [boe], by which measure it claims leadership among its peers), keep debt low and return spare cash to investors. A new emphasis on share buy-backs is now a priority over capital expenditure (capex), which this year will be just $15.3bn.

The response of the analysts to this approach is mixed. Neil McMahon, of Stanford Bernstein, suggests the relatively relaxed approach to capex could leave the company trailing its rivals upstream and in the liquefied natural gas (LNG) business. Others say buy-backs fit the firm's conservative approach. "If they see the oil price staying at $100/b, they'll probably become more willing to invest again," says one. "But, for now, giving money back to the shareholders is sensible."

Mulva is convinced: "If we have more cash coming in it will go towards share repurchase." And while the company might spend "a couple billion dollars" on developing an ethanol business in the US, an investment like 2006's $34bn of Burlington Resources is unlikely.

Reserves potential

Reserves replacement, meanwhile, will be more than 100% – but only aggregated over the next five years, says Mulva, suggesting that in the near term it could be lower. And it will not involve new acquisitions or any expansive exploration programmes. ConocoPhillips says it has all the oil it needs for now: 50bn boe of "captured resources", with a heavy concentration in Canada, the US and Asia.

Elsewhere, ConocoPhillips' 20% stake in Russia's Lukoil could be a source of growth. The partners are planning projects "upstream and downstream". That could involve an investment in refining, probably within Lukoil's extensive position in Russia and Europe. And the Russian firm's interest in Iraq's West Qurna field could be useful.

But the value of its stake in Lukoil is the foothold it gives ConocoPhillips in Russia. Mulva says the firm is there "for the long term" and notes that the Russian authorities have done "everything they said they would do [to us]". But its conservative approach makes a more creative use of the Lukoil stake unlikely. Paul Cheng, an analyst at Lehman Brothers, says ConocoPhillips could retain its strategic advantage in Russia even if it cashed in by selling half of its stake in Lukoil. Mulva says the company has not even considered it.

Meanwhile, its integrated position in North America – from the oil sands to its 12 US refineries – and North Sea assets will remain a "platform for growth", claims Mulva. Biofuels may be another growth area, but only from non-food sources. Growth may also come in the Middle East; ConocoPhillips has a presence in the chemicals industry in Saudi Arabia and Qatar and is a shareholder in the Qatargas 3 LNG project. It also recently emerged as the preferred partner in a $10bn project to develop Abu Dhabi's Shah gasfield.


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