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ConocoPhillips Goes From Integrated to Independent

Houston's ConocoPhillips, one of the biggest integrated oil and gas producers in the world, on Thursday announced that it would become a pure-play exploration and production (E&P) independent and spin off its refining business as a new publicly traded company.

The announcement marks what may be the biggest split of an energy company headquartered in the United States. Marathon Oil Corp., which had been a integrated oil and gas producer, completed a similar spinoff late last month (see Daily GPI, July 1). Other U.S. energy companies also are splitting their companies to provide more clarity to investors. Williams is close to completing a spinoff of its E&P unit, and El Paso Corp. is readying a split of its E&P and pipeline companies (see Daily GPI, May 25; Feb. 17). Last year Questar Corp. spun off its E&P unit (see Daily GPI, June 15, 2010).

The turnabout at ConocoPhillips, which is to be completed by the first half of 2012, appeared to come as a positive surprise to most energy analysts, who dialed into a conference call with CEO Jim Mulva Thursday morning. Mulva, 65, has helmed the company since its merger with refining giant Phillips Petroleum Co. in 2002, which created the third-largest integrated U.S. energy company at the time (see Daily GPI, March 13, 2002; Nov. 20, 2001). Today, the globally integrated producer has almost 30,000 employees, $160 billion of assets and $226 billion of annualized revenues as of March 31.

Times have changed since the integrated model was considered the gold standard for global oil and gas companies, Mulva told analysts.

"In the past the view was that being integrated would give you access to more investment opportunities," he said. "We think that has changed. In the marketplace we have a number of investors who understand we are making investments for them and they want to make investments for themselves. And there's a choice if you want to invest in the downstream or the upstream. Some investors say that the downstream part of the company is holding back E&P. On the other hand, people who are interested in the downstream say we aren't giving enough recognition to the downstream.

"From an enterprise risk management perspective, having two separate companies, we think, makes a lot of sense. There's more focus and attention on clear, pure plays, not only in the market, but leadership knows clearly what business they are leading and they dedicate their attention in a value-creating way."

The decision to become an independent E&P wasn't made overnight but has been an "evolving process," said Mulva, who plans to retire once the spinoff is completed.

"We have explored every alternative you can think of," he told analysts. "We have looked at how to increase the portfolio for E&P to create value. Do you piecemeal sell off refineries, venture them? Or do you want to spin this out to the shareholder. We kept assessing and looking, and after trying and looking and talking to many people, we thought this was the best way to go...This is a big step for our company and we are convinced it is the right thing to do and now's the time to do it."

ConocoPhillips today is the smallest of a peer group of integrated producers that is led by ExxonMobil Corp., Royal Dutch Shell plc, Chevron Corp., BP plc and Total SA. Under a "bigger is better" strategy Mulva was criticized for embarking on a growth spree in the 2000s when oil and natural gas prices were high. Among the biggest acquisitions was in 2006 when it bought Burlington Resources Inc. for $35 billion. The producer also purchased a 20% stake in Russia's OAO Lukoil Holdings and paid $8 billion to join an Australian liquefied natural gas venture.

The global transactions gave ConocoPhillips a bigger portfolio, but the company was left vulnerable with a stable of noncore assets and debt. While ExxonMobil and other big competitors scooped up properties when commodity prices fell, ConocoPhillips had to cut its spending and workforce. The recession forced the company in 2009 to announce that it would sell $10 billion in noncore properties to shore up its finances, a program expected to be completed this year. Since 2005 ExxonMobil shares have risen by about 47% and Chevron's have jumped more than 85%, while ConocoPhillips' share price has climbed just under 28%.

Once the proposed separation is completed, ConocoPhillips would continue to be a global producer, but focused only on the upstream as pure-play independent, developing new resources, growing reserves and production per share. Asset sales would continue and shareholder distributions would not change, Mulva said. In terms of size, the pure-play E&P would be a giant in the United States, standing in the ranks of super independents like Apache Corp. and Anadarko Petroleum Corp.

As a separate company, the refining and marketing business of ConocoPhillips would become the largest independent refiner in the United States, with more than 2 million b/d of processing capacity. Valero Energy Corp. would be ranked No. 2.

"Both companies will continue to benefit from the size and scale of their significant high-quality asset bases and free cash flow generation, allowing them to invest and create shareholder value in a changing environment," Mulva said.

The contemplated separation does not require a shareholder vote. However, the separation is subject to market conditions, customary regulatory approvals, the receipt of an affirmative Internal Revenue Service ruling to be a tax-free spinoff and final board approval.

Oppenheimer & Co. analyst Fadel Gheit was enthusiastic about the split. "I love it!" he said. "It worked for Marathon and it will work even better for ConocoPhillips" because "ConocoPhillips is a much better company...This is so positive for them. Everyone should stick to one business."

Mark Gilman, an analyst with Benchmark Co., rated the stock a "sell" and said the split didn't impress him. "I don't think they're a strongly positioned company. Doing this doesn't change anything. It's monkeying with pieces of paper." He also thinks the company will lose flexibility in how it allocates capital. "I'm not a fan of these financial engineering maneuvers. I don't see any incremental value associated with two separate companies."

Could ConocoPhillips split signal a turning point for other integrated producers? Hodges Capital Management analyst Mike Breard said "it would make sense" for companies like ExxonMobil and Chevron to consider spinning off the refinery businesses because of conflicts inherent in the business model.

"Refiners buy oil to make into gasoline and they want oil to be as cheap as possible, but oil exploration and production companies want oil to be as expensive as possible," Breard said. Refiners are facing challenges because of efficiency measures and the potential for widespread use of natural gas as a transportation fuel.

"I'd rather see a refining pro running a refining company and an oil pro running an oil company," Breard said. The big integrateds could be watching to see how "Marathon and ConocoPhillips shares perform after the spinoffs and then that will help them make up their minds."

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