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ConocoPhillips Splits in Two: Value Creation or a Marketing Gimmick?

By Jim Fink on July 14, 2011

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Strong fundamentals in the refining industry have also provided an important tailwind for major integrated oil companies. Refining generally accounts for 20 to 30 percent of the Super Oils’ revenue mix.

– Elliott Gue, The Energy Strategist

Are two better than one? Integrated oil company ConocoPhillips (NYSE: COP) thinks so, announcing today (July 14th) that it plans to spinoff its refining operations into a separate company. After the split, ConocoPhillips will be a pure-play on “upstream” exploration and production (E&P) and the yet-to-be named spinoff will be a pure-play on “downstream” oil refining and marketing.  According to CEO Jim Mulva, the company is splitting because:

we have concluded that two independent companies focused on their respective industries will be better positioned to pursue their individually focused business strategies.

Is this true? If so, why aren’t all “integrated” oil companies (i.e., those that include both upstream E&P and downstream refining operations) doing the same thing? I can find no evidence that specialized oil companies perform better than integrated ones. Take a look at the following five-year graph comparing the relative performance of ConocoPhillips with both integrated oil – represented by the S&P Select Energy ETF (NYSE: XLE) – and specialized E&P and refining companies – represented by PowerShares Dynamic Energy Exploration & Production ETF (NYSE: PXE):

Source: Bloomberg

The integrated oils have performed the best, barely beating the specialized energy companies and trouncing ConocoPhillips. This makes sense to me, since integrated oil companies are diversified. Diversification smoothes out investment returns, so that when E&P is down, refining is up, and vice versa. Vertical integration represents control over all aspects of the energy value chain; what’s wrong with that? The refining operations have a guaranteed supply of raw material inputs and the E&P operations have a guaranteed buyer of their output.  Furthermore, the company can spread its fixed overhead costs over a larger revenue base.

Refining Stocks are Hot

The real reason ConocoPhillips is doing this is very short-sighted: oil refining stocks are on fire right now and it wants a pure-play company to capitalize on the high stock valuations afforded by this temporary fad. You know the refining sector is hot because a fund company is rushing to issue an oil refinery ETF. Refiners make money on the crack spread, which is the difference between the cost of crude oil and the selling price of refined products like gasoline. Right now, the crack spread is more than $35 per barrel, the largest spread in at least 25 years!

Imitation is the Sincerest Form of Flattery

ConocoPhillips is looking enviously at Marathon Oil (NYSE: MRO), which split into two on June 30th by spinning off its refining operations into a company called Marathon Petroleum (NYSE: MPC). Since Marathon announced its split-up plan in mid-January, the stock has significantly outperformed the integrated oils (including ConocoPhillips) by more than 20 percentage points:

Source: Bloomberg

ConocoPhillips wants a similar price pop. The problem is that refining is a very volatile business that often loses money when the crack spread is narrow. Just last year, energy companies were suffering “huge losses” from refining and were forced to shut down refineries as a matter of survival. Those times will come again. And when they do, I doubt that the combined value of the two stand-alone ConocoPhillips progeny will be any higher than if the company had stayed integrated. 

Looming CEO Retirement a Factor?

As one Wall Street analyst puts it: “Doing this doesn’t change anything. It’s monkeying with pieces of paper.” ConocoPhillips CEO Jim Mulva will lead the separation effort, which is expected to be completed during the first half of 2012. Mulva, who is 65, will promptly retire after the separation is complete. Does this corporate separation plan – with the expected short-term price pop — have any effect on his retirement package? Just asking . .

Invest in Oil Stocks with the Help of the Energy Strategist

Elliott Gue, editor of the market-beating Energy Strategist investment service, is a big fan of integrated oil companies and recommends a select few in his “Proven Reserves” Income portfolio. He also likes some well-positioned specialized energy companies in his “Gushers” Aggressive Growth portfolio. In fact, he has strong buy recommendations on several oil and natural gas stocks right now.

To find out the specific names of the stocks he likes best, give the Energy Strategist a try today!

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