Are Two Really Better than One?
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Within the next two months integrated energy giant ConocoPhillips (NYSE: COP) will be splitting into two separately publicly traded companies; ConocoPhillips focused on their exploration and production (E&P) assets and Phillips 66, which will own and operate their refining and marketing (R&M) assets as well as two joint ventures. As a long term investor in ConocoPhillips this breakup of the business could mean that I have a decision to make as the original thesis was to own an integrated oil company as a hedge against rising energy prices. With that original thesis no longer intact I need to decide whether to continue to be invested in the future companies going forward or move in another direction.
What I was originally looking for was a buy-to-hold integrated global energy company that had some upside over and above just the price of oil but paid a healthy and growing dividend. I knew I was asking a lot but I wanted the best of everything all rolled into one for the first energy company I added to my young portfolio. I’d looked at other much larger integrated energy companies such as ExxonMobil and Chevron but I was hoping for something not quite so large, which would then have more room to the upside. Exxon just looked too massive at the time and I still remembered the Exxon Valdez spill which tainted my view on the company. Chevron was a close second in my original research but I had to make a choice and I went with ConocoPhillips.
At the time of my original investment in ConocoPhillips they were making their initial investment in Lukoil, which really appealed to me as I’d spent some time in Russia and I was familiar with Lukoil’s brand over there. Aside from the personal interest, I saw vast potential in the Russian energy market and this investment was a low-risk way to invest in the country. In the years since, they’ve completely disposed of their 20% stake in Lukoil, which while not a significant part of my original buy thesis, does nick it a bit.
At a recent Investor Update ConocoPhillips CEO James Mulva reiterated the reasons for the spinoff. In an effort to create value for shareholders he views this as an opportunity to create differential value versus the integrated model by improving returns, strengthening their strategic focus especially at the new Phillips 66, which can now pursue new opportunities in the petrochemicals and midstream arenas. It’s well known that refining and marketing is a tough business -- the returns are just not as high and it has been a drag on the combined company. Mulva went as far to say is that the new Phillips 66 would be leaning less on the refining side and would work to grow their midstream and chemicals businesses. Both of those businesses have double to triple the returns on capital employed but are also part of 50/50 joint ventures; Chevron on the chemicals side and Spectra Energy (NYSE: SE) on the midstream.
The spinoff is all about unlocking value for shareholders. Theory being that the market values pure play investments higher on an individual basis than as a combined entity. They are not the first to go down this path either as they following the playbook by Marathon Oil (NYSE: MRO) and Marathon Petroleum (NYSE: MPC). The Marathon spin unlocked their Refining & Marketing, pipelines and retail operations from their exploration and production business. With Phillips 66, they don’t have any retail assets as those were disposed of a few years back. So in essence they have the higher margin chemicals businesses instead of a lower margin retail business, which puts them in a better position than Marathon Petroleum. As far as unlocking the value for Marathon, the jury is still out. Just recently they announced that they are looking at a possible MLP IPO of their own midstream assets. It’s possible to see Phillips 66 go down this path as well, if not sell out to their JV partner, Spectra.
As I think through my options once I receive my Phillips 66 shares I’m not yet convinced that owning both companies makes sense for me as an investor. I’m not a fan of owning the refining assets without the E&P to balance out the market volatility in both oil prices and crack spreads. As I mentioned, at the spinoff there will be three business segments but a majority of the assets (80%) are in refining and marketing and the fact that those other two higher margin businesses are joint ventures could mean that down the road investors be left with just the refining assets if more value needs to be unlocked. While that could be a stretch, and hopefully value will be unlocked and returned to shareholders, it’s a risk that wasn’t part of my original thesis.
I am going to hold my shares for the time being as I want to take a step back to learn more about the Phillips 66 business. I must admit that I know much more about E&P than R&M in general and selling into a spinoff isn’t likely to be the most advantageous time to sell. I’m watching the trends to move to natural gas as a transportation fuel, which could greatly impact refining as a business if we as a country do make that switch. I still think the company as a whole is undervalued and the dividend of 3.5% going to 4% combined will continue to provide nice income. However, as the spinoff nears completion the risk profile isn’t the same as when I made my original investment.
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