Why Would ConocoPhillips and BP Team Up in the Gulf of Mexico?

ConocoPhillips and BP are betting heavily on the Gila well in the deep-water Gulf. Considering they're both limiting capital spending going forward, the Gila discovery is hugely important.

Feb 24, 2014 at 9:45AM

Exploration and production giant ConocoPhillips (NYSE:COP) just wrapped up a successful year by most standards. The company increased its adjusted earnings by 5% to more than $7 billion. Conoco was particularly successful in the emerging markets. Its Asia Pacific and Middle East segment accounted for half the company's earnings last year.

At the same time, ConocoPhillips' success in the upcoming year will be highly dependent on its U.S. operations. Specifically, the deep-water Gulf of Mexico represents one of Conoco's most important oil plays.

Big Oil teams up at the Gila well
ConocoPhillips announced its fourth major discovery in the Gulf of Mexico late last year, at its Gila well. ConocoPhillips owns a 20% interest in Gila, which is operated by oil and gas peer BP (NYSE:BP). Conoco needs the Gulf to pay off, because even though it's doing very well in the emerging markets, it's allocating less than half its 2014 budget to international development.

As much as ConocoPhillips needs to succeed at its Gila well, so too does BP. The past four years have been extremely trying for BP as it struggles to restore itself following the 2010 oil spill in the Gulf of Mexico. The Gila well is not only important for BP from a purely operational standpoint, as BP needs to keep boosting upstream production just like ConocoPhillips, but it's also important for BP to demonstrate it can compete in the Gulf once again.

Just a few years ago, BP announcing any significant discoveries in the Gulf of Mexico would have seemed absurd. Today, however, is a different story. BP stated that it considers its oil discovery at the Gila prospect to be significant, and in all this represents the company's third major discovery in the Gulf of Mexico in the last few years.

Moderating capital budgets place stress on existing projects
BP and Conoco succeeding at the Gila well is particularly important for 2014 because both companies are trimming capital spending. This isn't an issue specific to these two companies. Rather, it's a trend unfolding across Big Oil. Companies are seeing less potential from new opportunities, and due to strong growth in capital expenditures in recent years, many are scaling back their spending plans.

Consider that BP's European integrated peer Royal Dutch Shell (NYSE:RDS-B) is severely slashing its capital expenditures this year, to $37 billion from $46 billion last year. That represents a nearly 20% haircut. In addition, Shell intends to unload $15 billion worth of assets by the end of 2015. Clearly, limiting spending and asset sales are typical across the oil and gas industry.

BP plans to keep capital expenditures between $24 billion-$27 billion per year through the end of the decade. This makes sense, of course, since it's paid approximately $43 billion to date in financial penalties and damages stemming from the 2010 oil spill.

ConocoPhillips is limiting spending as well, which places particular strain on the company's existing projects. That's because Conoco is an independent exploration and production company. It spun off its refining unit, so Conoco doesn't have downstream operations to rely on if its discoveries disappoint.

Conoco plans to increase capital expenditures by just 2% this year. At the same time, management intends to keep long-term production growth at between 3%-5% per year. As a result, it's critical for the company to execute on its existing projects if it's going to hit its production goal.

The deep-water Gulf is critical
ConocoPhillips and BP together announced a major discovery at the Gila well in the deep-water Gulf of Mexico late last year. The find continued a pattern of success in the Gulf of Mexico for both companies in recent years.

ConocoPhillips and BP are each betting that the Gila well in the deep-water Gulf of Mexico will fuel their U.S. production this year and beyond. Both companies are moderating spending in light of the lack of suitable opportunities across the globe. That means that existing projects like the Gila well hold even greater importance for ConocoPhillips and BP, if they're to keep hitting their production growth targets.

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