Long term value

As we reported in our last review (FAT72), oil heavyweight ConocoPhillips (COP) recently fell victim to the global trend of strategic resource nationalization. The company opted to walk away from their oil assets in Venezuela, rather than agree to a government-imposed takeover.

"...which could see Conoco retain some exposure to the Venezuela's extensive oil reserves."

Conoco had been Venezuela's largest foreign investor, with several billion dollars worth of assets in the region. In fact, the country contributed around 5 percent of the group's production last year. And as one would expect, Conoco's exit has weighed on production and earnings.

For the three months to 30 September 2007, the company generated net earnings of $3.67 billion, down 5.2 percent on the $3.88 billion earned in the same period last year. In addition to the loss of Venezuela, the company also suffered from tightening refining margins.

The refining margin is the difference between the price of crude oil and the price of the refined product. Although crude has risen strongly over the period, the price of the refined product (such as gasoline) has been weak.

As the graph below shows, the average refiner margin thinned considerably through to the end of September, from more than $20 at the beginning of the period.

The chart represents the spread between Nymex gasoline and crude oil prices.

Source: Bloomberg

As a result, the Refining and Marketing division's earnings fell 11 percent on the same period last year, to $1.31 billion.

Nevertheless, we believe the price of refined product should eventually increase in line with our expectation of ongoing strength in crude oil prices. Moreover, if the refiner margin were to continue weakening, it is likely that the nation's supply of refined product would fall. This would in turn place upwards pressure on gasoline prices, benefiting the refiner margin.

Meanwhile, in contrast to the company's refineries, the Exploration and Production division directly benefits from higher crude oil prices. For the three months to 30 September, the division generated earnings of $2.08 billion, compared to $1.9 billion in the same period last year.

Even so, the increase was in large part due to new tax legislation that negatively impacted last year's result. Indeed, both lower production and natural gas prices served to offset the benefit of a higher crude price.

Conoco's production for the three-month period averaged 1.8 million barrels of oil equivalent a day. This fell from 2 million barrels last year following the company's exit from Venezuela.

In respect of which, CEO Jim Mulva recently stated that Conoco could move to arbitration within the next few weeks, in order to secure compensation for the Venezuelan assets. Nevertheless, both Conoco and the Venezuelan government have stated that they would prefer to reach an amicable solution.

Either way, it is likely to be some time before the receipt of compensation. However, the company took a $4.5 billion write down in respect of the South American assets and the balance sheet therefore already reflects the loss.

As Members may recall, Conoco holds a 20 percent stake in Russian oil company Lukoil. During the period, Conoco's share of the company's earnings fell more than 20 percent on the same period last year, to $387 million. Lukoil's earnings fell following higher operating costs.

However, Lukoil is currently organizing a joint venture with state owned oil company PDVSA. Should this go ahead, Conoco would retain some exposure to Venezuela's extensive oil reserves.

In terms of the outlook for the fourth quarter, management expect daily production to lift by between 50,000 and 60,000 barrels, following the completion of various maintenance projects.

Based on Bloomberg consensus estimates, the stock trades on a 2008 price to earnings ratio of less than 9 times. Given our expectation of continued oil price strength and an eventual recovery of the refiner margin, we continue to see value in the stock.

Indeed, from a charting perspective the outlook for Conoco is promising. Following a break above resistance at $74.89 in May, the company's share price rallied to a new all time high of $90.84 in July. This represents a gain of 47 percent since the beginning of the year.

Although the longer-term upward trend has paused for consolidation since July, upward momentum remains firm. As such, we believe that downside risks are limited with firm support located in the region of $75.

Accordingly, Conoco Phillips will remain firmly held in the Fat Prophets Portfolio.