Conoco gives Big Oil a “come to Jesus” moment

July 14, 2011

By Christopher Swann and Lisa Lee
The authors are Reuters Breakingviews columnists. The opinions expressed are their own.

ConocoPhillips has broken the mold. America’s third-largest energy group is splitting exploration from production and downstream operations. With investors quickly adding as much as $5 billion to Conoco’s value, the message to other integrated companies like Exxon Mobil and Royal Dutch Shell is getting louder.

The current model is an article of faith. For decades, oil companies have claimed it provides a hedge against fluctuating oil prices, offers operational benefits and helps pry open foreign energy reserves. Yet in a one-hour phone presentation Conoco Chief Executive James Mulva renounced one of the guiding principles of his career. He was right to recant his faith.

Combining racy exploration operations with more sedate refining and marketing businesses no longer makes sense. Mulva conceded there were no meaningful operational synergies. And since oil-rich nations can build their own refineries, offering downstream expertise gives Big Oil little leverage in accessing new reserves.

Judging from recent history, the initial burst of enthusiasm from Conoco shareholders should be sustainable. Smaller rival Marathon built on its early gains after it announced a similar split in January — outperforming Conoco by over 20 percent. It would be no surprise to see Conoco catch up now. As Mulva pointed out, the breakup will give investors a clearer choice and enable management to focus more clearly.

The valuation gulf is pronounced. Integrated firms trade on a multiple of about nine times 2011 earnings. Independent U.S. refiners fetch valuations closer to 13 times while exploration and production firms command a punchier multiple of 20. Big players can’t hope to match the growth of smaller explorers. But getting even part of the way to these multiples, according to a Breakingviews sum-of-the-parts analysis, could ultimately be worth an extra 20 percent — in Conoco’s case, an extra $20 billion of value.

Conoco isn’t the first to split, but is by far the largest to do so. Having a true peer break with the integrated model may finally encourage the likes of Chevron and Exxon to find some religion, too, and unlock similar storehouses of value for their shareholders.

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