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ConocoPhillips splits and the experiment begins

The demerger of the upstream and downstream businesses of ConocoPhillips is intended to be a win-win situation for both sides, but will it really all work out for the best?

On 2 May, Greg Garland rang the opening bell on the New York Stock Exchange floor and in doing so also rang in the first day’s trade for the new company of which he is chairman, Phillips 66.

The company is the newly independent hived-off mid- and downstream business of former supermajor ConocoPhillips, which is now solely an upstream concern. The split was achieved by giving ConcocoPhillips shareholders one share in Phillips 66 for every two shares they held in ConocoPhillips, though a tax-free distribution.

The net result is that ConocoPhillips is now an independent exploration and production firm of formidable size, with a market capitalisation of around $70 billion. Meanwhile, Phillips 66 is a major player in its sector, with a capitalisation of around $22bn.

For ConocoPhillips, the split enables the company to focus on boosting investment in undeveloped shale assets and deliver on significant untapped growth in the US and elsewhere. Phillips 66 meanwhile instantly becomes one of the largest downstream players in the US, a sector that is ripe for consolidation as oil demand falls.

The supermajor’s break-up reflects the differing fortunes and prospects of North America’s upstream and downstream sectors, and underscores the rapid changes in supply and demand dynamics in the world’s biggest oil consumer.

Much has changed in the US since Conoco and Phillips merged in 2002. Not only has the continent’s supply dynamic altered, but, perhaps more crucially, the growth potential in North American unconventional plays far exceeds the limited returns offered by refining, as US consumption looks to have entered permanent, structural decline.

Effectively, ConocoPhillips’s formal split is the logical extreme of a trend that has seen ExxonMobil, BP and the rest of the supermajors scale back their refining operations. Ryan Lance, new chief executive of the upstream firm says the demerger was just the most financially beneficial way for investors to achieve such a refocusing.

If Phillips 66 has been left with the wrong end of the deal, then Greg Garland is putting in a spirited effort to persuade investors otherwise. He says the creation of Phillips 66 represents an opportunity to ensure that his company is in a strong position to make the best of the uncertain conditions in the downstream sector.

The Energy Information Administration estimates US oil demand fell 3.5% in the first quarter, a rapid decline on the 1.8% overall decrease in 2011. That has freed up processing capacity on the Atlantic seaboard and Gulf of Mexico, much of which would be idled without off-take from foreign shippers.

The tough environment for refining – and Phillips 66’s desire to streamline its refining operations – was reflected in the sale of a ConocoPhillips refinery in Philadelphia to Delta Airlines for $180m on 1 May, in a deal bolstered by £30m of assistance from the Pennsylvania state government. The company had been considering closing the plant. Other firms, including Valero Energy and Sunoco, have also been scaling back their operations closing or selling refineries. 

That hardly sounds like a propitious business climate for new company. But Garland insists Phillips 66 is well placed to succeed. On unveiling the de-merger, he said the company would be “clearly differentiated from pure-play refining companies”, in part because of its significant chemicals and midstream presence.

As well as having 2.2m barrels a day (b/d) of refining capacity and more than 10,000 service stations across the US, Phillips 66 will also market 7.5bn cubic feet a day of natural gas and manage a 15,000 mile pipeline network on its own account, as well as another 40,000 miles through the DCP Energy venture it co-owns with Spectra Energy. In addition, Phillips 66 partners Chevron in the Chevron Phillips Chemical Company joint venture, which produces olefins and other petrochemical products from plants around the world.

All this should bring in around $200bn of revenues a year, making the company roughly as big as Valero Energy, the largest refiner in the US.

So Phillips 66 will certainly have the advantage of size on its side, but it will be a completely different prospect for investors than the upstream entity from which it has been spun off. While the downstream company is likely to produce steady growth at best, ConocoPhillips will be hoping the demerger will help it to boost returns from its upstream investments to match some of its better performing peers. ConocoPhillips’ return on capital in upstream of around 16% in 2011, compared with competitors such as Exxon that achieved figures of 25% and more.

The room for growth is clear, especially in the domestic market. ConocoPhillips says it expects to produce around 1.55-1.60m barrels of oil equivalent a day (boe/d) in 2012 from the Gulf of Mexico and the North Sea to Libya and China, but the most significant expansion is coming from North America, where gains are helping to offset problems elsewhere in the world. The Eagle Ford, Bakken and Permian plays currently contribute about 135,000 boe/d to output, but the company says this can be expected to grow more through the rest of the year.

ConocoPhillips has about 4.6m acres in Montana and North Dakota and is aiming to double its Bakken output to 40,000 b/d by 2016, still a relatively small amount given its acreage. It has an additional 2.5m net acres in Texas, including 1m acres in the Permian basin, as well as production in the Eagle Ford and Barnett shales. ConocoPhillips is now a company that needs cash to fund new drilling in its home country, more than abroad, at present.

ConocoPhillips’ split is unlikely to start a new trend for demerger among the majors. It is more a reflection of one company’s view that being big is not necessarily the best way to do business. The company hopes that the demerger will improve its ability to increase North American unconventional production base, while Phillips 66 will be better able to capitalise on its options to maintain a steady income stream from mid and downstream operations.

Time will tell if the sum of the parts proves to be bigger than the whole once was.

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