ConocoPhillips' (NYSE: COP) decision to spin off its refining and marketing arm into a new business made Standard & Poor's keep the second-largest U.S. oil refiner on CreditWatch. The negative implications didn’t seem to bother investors, as the stock rose 6.2% after the announcement. I agree that the spinoff makes sense for Conoco. Here's why.
Where does the company stand right now?
ConocoPhillips reported strong second-quarter earnings a few days after announcing the spinoff of its downstream business in July. The spinoff will also include the well-performing midstream and chemicals operations of the company.
ConocoPhillips is undertaking the move to boost its exploration and production, or E&P, operations. What's remarkable about this segment is that it contributes 23% to the revenue and 80% to the company's earnings. So when operating on a stand-alone basis, it should be a more profitable business. The spinoff will also allow the company to reallocate its capital and invest in E&P operations to increase its earnings further.
The refining and marketing -- or R&M -- segment contributed around 77% to revenues and 20% to earnings in 2010. The refining industry is subject to lower margins because of movement in crude oil costs and sale prices of refined products. The recession has hurt midstream companies. However, demand for refined products has been improving, pushing margins up. Demand is expected from the Asia-Pacific region or from the emerging markets. The new entity will be the largest independent U.S. refiner, pushing Valero Energy (NYSE: VLO) to the second position.
I feel the step should make investors happy, as it will lead to higher income for both the companies. The E&P industry, which is expected to see a hike in demand for natural gas in North America, will present ConocoPhillips a good opportunity to enhance its market position and consequently its earnings.
In 2010, ConocoPhillips was a top performer among the integrated oil companies. Industry experts projected the company to earn $7.75 per share and an annual rise of 10% in dividends from 2011 to 2012. The spinoff should create synergies for both the companies, helping them compete with oil majors like Chevron (NYSE: CVX), ExxonMobil (NYSE: XOM), and Royal Dutch Shell (NYSE: RDS-A) (NYSE: RDS-B).
Recently, Marathon Oil (NYSE: MRO) also spun off its R&M business to focus solely on its E&P operations. I don't see any reason why ConocoPhillips cannot accomplish what Marathon did.
The Foolish bottom line
Oil and gas companies have created spinoffs to become leaner and more profitable. It makes operations smoother, creates capital appreciation, and increases investors' returns. Given the potential in the industry, I feel ConocoPhillips will definitely prove itself worthy of Mr. Market.
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