CONOCOPHILLPS SPLIT: Vertical Integration on the Chopping blocks?

IHS Global Insight

A Supermajor Super No More?In an effort to build shareholder value, the US-based supermajor said yesterday it plans to break into separate companies—one for exploration and production (E&P), the other for refining and marketing (R&M)—in a rejection of the oil industry's model of vertical integration.

In a move that firmly rejects the notion that vertical integration is the best business model for the hydrocarbon industry, US-based ConocoPhillips announced yesterday that it plans to split itself into two companies, one focused on exploration and production (E&P), the other focused on refining and marketing (R&M).

ConocoPhillips, the third-largest US oil company, revealed its plans as a way to improve value creation for its shareholders, many of whom have been disappointed in ConocoPhillips's share price growth relative to its peers among the supermajors. Indeed, ConocoPhillips, since its creation via the merger of Conoco and Phillips Petroleum in 2002, has seemingly been permanently mired in third place (behind ExxonMobil and Chevron) in terms of oil and gas production and net profits, but also consistently at or near the bottom of the wider group of multinational supermajors, also including BP, Shell, and Total.

ConocoPhillips's share price growth has lagged behind that of ExxonMobil and Chevron since 2005, with the Wall Street Journal citing the 27.8% overall increase in ConocoPhillips's share price since then, compared to the 46.8% and 85.1% growth, respectively, for those two firms since then. For one day at least, ConocoPhillips edged out its US rivals, as shareholders reacted positively to the company's announcement yesterday, sending its share price up USD1.21/share (1.63%), to close at USD75.61/share, whereas Chevron's share price dropped USD0.42/share on the day to USD104.17/share and ExxonMobil's shares closed lower at USD82.24/share, down USD0.24/share on the day. Whether this increased shareholder value for ConocoPhillips is sustainable as two separate pure-play companies, however, is the major question mark.

ConocoPhillips certainly hopes and expects this will be the case, as the company is betting its future on being able to unlock more value for shareholders as two independent companies focus on their respective upstream and downstream sectors. The E&P entity immediately becomes the largest company in its class (at least in its new peer group among US-based companies), as ConocoPhillips's worldwide oil and gas production of 1.7 million barrels per day of oil equivalent (boe/d) far surpassed the approximately 700,000 boe/d in global oil and gas output from Anadarko, Apache, and Occidental Petroleum.

Similarly, ConocoPhillips's R&M business, on its own, will be second in the US in terms of refining capacity, with 2 million b/d, behind only Valero's 2.2 million b/d. ConocoPhillips already had the most refining capacity among its supermajor peer group, but a new R&M-only entity would be the biggest of its kind worldwide, taking account of the company's additional 400,000 b/d of refining capacity outside the US. In essence, ConocoPhillips is improving its standing in its peer group by saying it is part of a new peer group, even if it is nominally still a "supermajor"—a term that may soon be bereft of its meaning as the companies formed by the big industry mergers of the late 1990s and early 2000s transform themselves to operate in a vastly different business and operational environment today.

Jim Mulva, the CEO of ConocoPhillips, who engineered the merger of the company and led its expansion efforts over the past six years, will lead the firm's separation efforts, then retire in the first half of next year when the split—which does not require shareholder approval but does need the blessing of US tax authorities—is expected to be completed. In a statement, Mulva said that ConocoPhillips had concluded that "two independent companies focused on their respective industries will be better positioned to pursue their individually focused business strategies," adding that, "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."

Outlook and Implications

Despite ConocoPhillips's claims that the two separate companies will benefit from their size and scale, creating more value for shareholders of the two firms, the jury is still out on whether ConocoPhillips is making the right decision. Certainly, the business model of vertical integration in the hydrocarbon industry is no longer universally revered, as tighter refining margins and sluggish retail fuel sales have weighed down the lucrative upstream profits generated by the supermajors, while simply having a refining arm and retail outlets is no longer needed to help secure access to upstream oil and gas projects in an age marked by resource nationalism and more aggressive competition from national oil companies. On the other hand, just by creating pure-play E&P and R&M companies does not guarantee that ConocoPhillips will create more value for its shareholders, particularly if the companies do not learn from the mistakes it has made in the past.

Indeed, there is a case to be made that ConocoPhillips is taking the action to split into two companies to enhance shareholder value because it attempted to do too much, too soon following the merger that established the firm as a supermajor in 2002. Looking back, ConocoPhillips clearly erred in trying to vault itself higher on the list of the world's top global energy companies by engaging in a series of acquisitions that bolstered its output and expanded its project portfolio but left it with a mountain of debt. The company's acquisition of a 20% stake in Russia's LUKoil in 2004 was designed to give ConocoPhillips access to Russia's vast oil and gas reserves, but after the strategic alliance with LUKoil failed to translate into more access to Russian oil and gas, the alliance was unwound last year, with ConocoPhillips divesting of its stake in LUKoil.

Similarly, ConocoPhillips paid more than USD35 billion to acquire US gas producer Burlington Resources in 2006, but the deal was roundly panned. Critics argued that ConocoPhillips overpaid to add gas reserves to its portfolio, and consistently lower US gas prices since that deal have proven the sceptics right. ConocoPhillips also paid USD8 billion to join Origin Energy's Australia LNG project in September 2008, just as the global financial crisis erupted and the bottom fell out of crude oil prices. The US firm was forced to write down more than USD31 billion in losses at the end of that year, and the company has arguably never fully recovered. ConocoPhillips's earlier accumulation of debt forced it to shift its focus with a multi-billion-dollar divestment programme in 2009–10. Even with a streamlined portfolio and resurgent oil prices this year, ConocoPhillips has been unable to take full advantage, as the company's output has been negatively affected by the civil strife in Libya.

Hence, ConocoPhillips may have been pushed to separate itself into two entities by problems that are unique to the company rather than inherent flaws with the business model of vertical integration. Nevertheless, if the US supermajor's split into E&P and R&M companies manages to provide the increased shareholder value that ConocoPhillips is hoping for, there is a strong likelihood that other members of its soon-to-be-former peer group may seek to replicate the move. Both Chevron and ExxonMobil have already embarked on programmes to divest certain, unprofitable parts of their retail fuel operations, so if ConocoPhillips can demonstrate that being a "less super" E&P supermajor (and R&M supermajor) can achieve greater value for shareholders than the current supermajor model can, expect the oil industry's traditional herd mentality to kick in. The era of not-so-supermajors may not be far off.

Source: http://www.ihs.com/products/global-insight/industry-economic-report.aspx?ID=1065930061

IHS World Markets Energy Perspective
Significance	ConocoPhillips said it plans to split into separate upstream and downstream entities next year in order to create new value for shareholders who have been disappointed with the company's share price growth in recent years relative to the firm's peer group.
Implications	By splitting in two, ConocoPhillips—which has perpetually been at or near the bottom of the supermajor rankings in terms of net profits and hydrocarbon production growth—will at a stroke become the largest pure-play exploration and production (E&P) company among US-based firms, as well as the second-largest pure-play refining and marketing (R&M) company in the country.
Outlook	ConocoPhillips's decision to separate is an outgrowth of the company's unique problems—many of which are the result of aggressive expansion strategy that left the firm with a mountain of debt when oil prices collapsed in late 2008—but the move could reverberate in the industry and prompt similar actions by other supermajors.

NUTSHELL:

The ConocoPhillips split is a test case for Vertical Integration; or isn't it? Some argue that this is about maximizing shareholder value while others are of the opinion that ConocoPhillips is making an effort to end its reign as chief pretender to the Supermajor throne. The Jury is still out on this. I welcome you to send in your analyses of this move. Ground-shaking, bold move...; that's my take. If I were to choose which business to run, i would opt for the Exploration and Production business. Any takers for the Refining and Marketing business?