ConocoPhillips-Phillips 66 Split Was The Right Move

(Bloomberg Gadfly) -- This hasn't been a great year if you own ConocoPhillips.

Conoco split off its downstream refining and marketing business into separately listed Phillips 66 in 2012. Since then, it has tried to chart an unusual course of being a large exploration and production company promising growth while also offering a competitive dividend, traditionally the preserve of integrated rivals such as Exxon Mobil Corp.

Earlier this year, Conoco came unstuck and was forced to slash its dividend. That led to some criticism that, in hiving off its downstream business, the company had lost a useful hedge against the oil-price crash (refiners process crude, so a lower price lowers their cost).

But there's another way of looking at this. Here's how Conoco's stock has done since the split (all of these charts are through Friday's close):

It still looks pretty grim, apart from that surge in 2014. But the comparison is a bit unfair because, after all, Conoco's investors also got shares in Phillips 66 when it was spun off in 2012. Here's how that chart looks when you add Phillips 66 back in:

For a true comparison, you have to factor in dividends and buybacks. So imagine an investor holding $1,000 worth of Conoco shares back on April 30, 2012, just before the spin-off took effect, whereby they got 1 share in Phillips 66 for each 2 that they held in the surviving parent company. We can count up the dividends earned since then pretty easily. For buybacks, let's assume that in each quarter, if the buyback was done at a price above where ConocoPhillips and Phillips 66 were trading at the time of the split, our investor sold into it. And that they sold some of their shares equal to the proportion of each company's shares outstanding that were bought back. We can do the same for Exxon and Chevron Corp. Here's how $1,000 in each looks now:

This comparison might seem a little unfair since, hey presto, our ConocoPhillips shareholder suddenly had $1,312 worth of shares the day of the split, rather than just $1,000. But even if you assume the Exxon and Chevron shareholders had that amount invested, they are still only sitting on roughly $1,500 of payouts and remaining shares, versus north of $1,800 for the ConocoPhillips shareholder.

Comparing the internal rates of return -- which factor in the timing of cash flows from each investment -- the contrast is even clearer:

Obviously, making that return depended on hanging onto those Phillips 66 shares. And given that part of that stock's success reflects it finding its way into the hands of investors focused on downstream companies, you might wonder if anyone did. Then again, both companies can be found in the SPDR S&P Oil & Gas Exploration & Production ETF (granted, somewhat incongruously), so why not?

In any case, the bigger point is that splitting ConocoPhillips wasn't such a bad move when it comes to delivering gains to its investors compared to the two U.S. giants that stayed integrated. The reasons for this can be debated, but besides offering investors a more focused way to target different bits of the business, the two companies were able to chart separate courses in terms of strategy, capital allocation and management focus.

Doug Terreson, ISI Evercore's head of energy research, points out that ConocoPhillips was the least-recommended integrated oil stock at the time of the split. So just having it covered by a fresh set of E&P analysts was more likely than not to be positive for it.

But he also highlights a more fundamental advantage of Conoco's decision. At the time, Big Oil was plowing ever-increasing sums into a limited set of competitive upstream projects (and plenty of uncompetitive ones), which trashed their return on capital and, in the downturn, has raised big doubts about the business model itself. When he announced the split in July 2011, Conoco's then-CEO, Jim Mulva, recognized the threat:

The environment as we've gone through this period of time and here more recently in the last several years has changed from that 10 years ago. And the downstream part of the business doesn't support necessarily gaining access to new opportunities for resources around the world. We see increased competition, more challenging terms, and that comes from competition from IOCs, independents, extra oil companies. So accretive growth is not only competitive, but it's more and more difficult to achieve, particularly in a value-creating way. So, when you look at the large integrated oil companies, they are more difficult to value compared to the pure plays, upstream and downstream.

In resetting its strategy last week, ConocoPhillips' current management echoed those thoughts, emphasizing the need to focus on value rather than volume in challenging times. Once again, the company is trying to preempt the pressures bearing down on the itself and the entire sector. Shares in Exxon and Chevron may have done better this year, but, strategically, it's harder to say they are ahead of the game.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story: Liam Denning in New York at ldenning1@bloomberg.net.

To contact the editor responsible for this story: Mark Gongloff at mgongloff1@bloomberg.net.