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ConocoPhillips' Sweet Spots

By Tina Vital Energy outfit ConocoPhillips (COP; recent price, $61) has benefited from high oil and natural gas prices through its exploration and production operations. But even in the event that oil prices should drop, Standard & Poor's thinks the company's earnings are protected by its diversification into downstream refining and chemicals businesses.

According to our valuation models, ConocoPhillips' stock (which features a dividend yield of 2.1%) currently trades at a discount to its peers in both the major oil and supermajor ranks.

BROAD CAPACITY. We believe this discount is unwarranted, given our view of its prospects for strong upstream oil- and gas-production growth, and the considerable ability of its downstream operations to refine heavy sour crude oil feedstocks (i.e.,heavier weight oils with a high sulfur content), which offer significant pricing discounts to light sweet crude oils (lighter weight oils with lower sulfur content).

The stock has had an impressive run. For the past 1, 10, and 19 years (as of June 30, 2005), ConocoPhillips has outperformed the S&P 500 on a total return basis, yielding 54.0%, 16.4%, and 18.0%, respectively, vs. 6.3%, 9.9% and 11.2% for the broader market. But we think there is room for further appreciation in the shares, and we have assigned ConocoPhillips our highest investment ranking of 5 STARS (strong buy).

Formed through the 2002 merger of Phillips Petroleum and Conoco, the company ranks as the third largest integrated U.S. energy outfit, based on market capitalization, oil, and gas reserves and production. ConocoPhillips has business operations in exploration and production (E&P; 25% of 2004 sales, 70% of 2004 segment net income), refining and marketing (R&M; 72%, 34%), midstream (2%, 2.9%), chemicals (less than 1%, 3.1%), and emerging and business (less than 1%, -10%).

KEY RESERVES. The company operates in more than 40 countries, including the U.S. (71% of 2004 sales), the U.K. (11%), Norway (3%), Canada (3%), and elsewhere (12%). During 2004, it formed a strategic alliance with the Russian integrated oil company, Lukoil, and as of mid-July 2005, it had acquired a 12.6% stake in Lukoil's shares, with an option to purchase up to 20%.

ConocoPhillips explores for and produces crude oil, natural gas and natural gas liquids (NGLs), and mines oil sands to produce synthetic crude oil, known as Syncrude. The table below breaks down key reserve and production data for the past two years:



Proved crude oil and NGL reserves (mil. bbl.)



Proved natural gas reserves (tril. cu. ft.)



Crude oil production (bbl./day)



Syncrude production (bbl./day)



NGL production (bbl./day)



Natural gas production (bil. cu. ft./day)



Production costs (barrel of oil equiv.)



*Three-year avg. thru 2003.

We believe the company is the largest U.S. refiner and the world's fifth-largest, based on crude unit capacity. At the end of 2004, ConocoPhillips owned or had interests in 12 U.S. refineries, 4 European refineries, and another in Malaysia, with total capacity of 2.601 million barrels per day. Crude throughput averaged 2.455 million b/d in 2004, vs. 2.488 million b/d in 2003. Product sales averaged 3.141 million b/d (85% U.S.) in 2004, vs. 3.045 million b/d (86%) in 2003.

INCREMENTAL INCREASES. The company's refineries are able to process lower-quality crudes (about 50% of feedstocks are sour). In April, 2005, ConocoPhillips unveiled a five-year, $3 billion program to expand its ability to refine heavy-sour crude oils and other low-quality feedstocks. ConocoPhillips is reshaping its midstream segment to focus on its 30.3% interest in Duke Energy Field Services (DEFS), one of the largest U.S. natural gas and NGL gathering, processing, and marketing companies.

The company participates in the chemicals sector through an equally owned joint venture partnership in Chevron Phillips Chemical (CPChem). It also has four emerging businesses under development: fuels technology, gas-to-liquids (GTL), power generation, and other technologies (such as renewable energy).

Excluding contributions from Lukoil (about 0.2 million barrel of oil equivalent per day), first-quarter hydrocarbon production was about flat at 1.6 million boe/d, in line with our estimate. We expect second-quarter production to decline about 4% sequentially (in line with company guidance). However, we anticipate full-year 2005 levels rising only about 1% (excluding its Lukoil investment; less than the 3% increase projected by ConocoPhillips).

RUSSIAN DEAL. With large development projects under way in Venezuela and Asia, and increased investment in Russia, we expect a 5% compound annual growth rate for 2003-06 (without Lukoil), and 3% thereafter -- in line with company guidance.

While we calculate the company's 2003 organic reserve replacement (i.e., from existing operations) at 132%, we estimate its 2004 rate dropped to 87%, reflecting a negative revision of proved crude oil reserves for the Surmont project in Canada. However, since 2004, ConocoPhillips has purchased about 12.6% of Lukoil shares held by the Russian government, which the company believes will boost its reserves and production by over 10%, and it has the option to increase its interest in Lukoil to 20%.

Operating earnings climbed 79% in 2004, and we expect a 27% increase in 2005, followed by a slight rise in 2006. To participate in new upstream opportunities, in December 2004, ConocoPhillips expected capital spending (excluding Lukoil) to total $6.9 billion (78% for E&P) in 2005, versus $6.85 billion (77%) in 2004. In April, 2005, the company announced it would spend an additional $3 billion over 2006-2010 to increase its ability to refine heavy sour crude.

UP -- AND STAYING THERE. With oil & natural gas supplies struggling to keep pace with demand, we have seen oil prices surge since 2003. As a result, the earnings of energy companies within the S&P 1500 Composite climbed 50% in 2004 and 39% in the 2005 first quarter, and we expect earnings to rise 28% in the second quarter and 24% for the full year 2005. Energy continues to be the best-performing sector within the S&P 1500 -- up 26.6% so far this year (as of July 22, 2005), compared to a 2.5% rise in the broader market.

Prices for the benchmark West Texas Intermediate (WTI) grade of crude oil are now trading near $59 per barrel, above our forecasts - using data from the independent economic forecaster, Global Insight - of about $52 per barrel for 2005 and $50 for 2006. We see nothing fundamentally supporting these higher than expected oil prices, and we believe the market is overly concerned about whether there will be sufficient gasoline and distillate to meet summer driving demand and later in the fourth quarter as the heating season begins. With inventories building, we believe the market is underestimating the ability of refiners to respond, and we think sufficient supplies will become available this year.

As oil prices surged over the past few years, we believe the spread between various qualities of crude (light/heavy, sour/sweet) widened -- and the wider the spread, the wider the price differential. As a result, we think refiners of lower-quality, heavy sour crude oils have benefited from strong pricing discounts. We believe this will continue, as we project crude oil prices will remain high, with WTI crude oil prices staying above $45 through 2008.

SOUR PROSPECTS. Using data from Global Insight, we expect global oil demand to rise by 2.2% to 84.33 million barrels per day (b/d) in 2005, compared to a 3.4% rise in 2004. However, increases from non-OPEC supply are not expected to match demand increases, which should place a greater call on OPEC production, in our view.

In 2005, we expect non-OPEC production to increase only 1.5% to 50 million b/d, while OPEC production is expected to rise 3.5% to 34 million b/d. With incremental OPEC crude production becoming heavier and more sour, we see increased concern in the market over the match between the quality of crude oil supplies to refineries and the market needs of increasingly sweet (i.e., lower-sulfur) transportation fuels.

Under U.S. generally accepted accounting principles (GAAP), ConocoPhillips had earnings of $8.1 billion ($5.78 per share) in 2004, 0.7% below Standard & Poor's Core Earnings of $5.83, which we believe implies a strong quality of earnings for this major oil company. The company's 2004 S&P Core EPS of $5.83 includes a 9-cent positive adjustment for pensions, the removal of a 5-cent gain on sales, and 1 cent of option expense.

For 2005 and 2006, after adjustments for pension and stock options, we estimate S&P Core EPS at $7.50 and $7.41, respectively.

DOWNSIDE POTENTIAL. Our 12-month target price of $72 per share is derived by a blend of our

discounted cash-flow and our peer multiple valuation. Using 2005 earnings before interest, taxes, depreciation and amortization (EBITDA) estimates, we believe ConocoPhillips is currently trading at 4.9 times its enterprise value (stock market capitalization plus its net debt), a 10% discount to its major oil peers (using Wall Street estimates), a 15% discount to its supermajor oil peers (using our estimates), and a 17% discount to U.S. refiners (using our estimates).

Given our view of ConocoPhillips' significant conversion capacity to upgrade heavy sour crude oils to light sweet fuels, we believe this discount is unwarranted and that the stock deserves to trade a least in line with its peer group. Using a blend of its 2005 EBITDA peer multiples (supermajor, major and refiner), we estimate ConocoPhillips' value near 5.7 times our 2005 EBITDA estimate, representing a value of about $72 per share.

We believe ConocoPhillips' corporate governance practices are generally sound, and above average for companies within the S&P 500 Energy Sector. Its board is currently composed of 14 members, and is controlled by a supermajority of independent outsiders (independent outsiders made up 93% of the board). The ConocoPhillips Board of Directors met eight times in 2004.

DOWNSIDE POTENTIAL. Each director attended at least 75% of the board meetings, and all of the company's directors attended its annual meeting. The audit, nominating, and compensation committees are comprised of independent outside directors, no former CEO of the company serves on the board, the company has governance guidelines that have been disclosed, the performance of the board is regularly reviewed, and a mandatory retirement age of 72 years is in place for directors. However, shareholders don't have cumulative voting rights in director elections, and there are no term limits for its directors.

Risks to our recommendation and target price include geopolitical risk associated with the company's international operations and interests (including its investment in the Russian firm, Lukoil), changes in economic and industry conditions (including commodity price and refining margin volatility), an inability to achieve upstream production growth and cost targets (including the company's success at replacing its reserves through the drillbit), and operational risk from several large development projects. Analyst Vital follows stocks of integrated oil and gas companies for Standard & Poor's Equity Research Services

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