DBRS Changes Trend on ConocoPhillips “A” LT Debt to Stable from Positive, Confirms CP at R-1 (low), Stable

DBRS has today confirmed the Commercial Paper rating of ConocoPhillips (COP or the Company) at R-1 (low) with a Stable trend, and also confirmed the long-term debt ratings of COP and Burlington Resources Inc. (BR – COP’s wholly owned subsidiary) at “A” with the trends changed to Stable from Positive. The BR rating is based on the guarantee of COP.

The change of the trend on the long-term debt ratings to Stable from Positive, which was assigned on August 25, 2008, reflects the Company’s weaker financial profile and higher cost structure, partly driven by the debt-funded Origin Energy joint venture (Origin JV) formed in October 2008 in a sharply lower commodity pricing environment and a global recessionary climate. Debt-to-capital at 35% is relatively aggressive and above the 20% to 25% target range maintained from 2005 to 2007, with debt-to-cash flow at 1.8 times for the last 12 months to June 30, 2009. However, the former ratio was depressed by goodwill impairments of approximately $34 billion in Q4 2008, although all non-cash, primarily in the BR and LUKOIL assets, depressing the equity base. The write-downs were precipitated by sharply lower commodity prices and substantially lower asset valuation in a global recession. DBRS expects that COP will restore its financial metrics over time, given its ability to grow production and reserves. Furthermore, COP has taken considerable measures to curtail capex (down 37% from 2008) and to cut operating costs (by 10%), while its sizable share repurchase program was suspended in Q4 2008. These measures should provide financial flexibility as COP strives to optimize operational efficiency in a difficult operating climate.

The Company maintains sufficient liquidity through its credit facilities, and through debt issuance during H1 2009 which also improves its maturity profile. Potential asset monetization could provide further liquidity. In addition, the ramp-up of development projects and start-ups in 2008 and 2009 should result in incremental production in 2009 as evident in a 4% rise in volumes in H1 2009 and an estimated 122,000 barrels of oil equivalent per day (boe/d) of production added in the past year. These include two key North Sea projects, Britannia Satellites and Alvheim, and the Su Tu Vang project in Vietnam, which commenced production in 2008. Furthermore, the Bohai Bay offshore China (49% interest) and the Qatargas 3 liquefied natural gas (30% interest) projects are expected to be in service in 2009. COP’s investments in LUKOIL (20% interest) remain favourable; LUKOIL accounted for a steady 20% of production volumes for the last 3.5 years.

The Company faces similar challenges as its peers from softening crude oil and weak natural gas prices, aggravated by slowing demand, especially for distillates. The October 2008 closing of the Origin JV (approximately $5 billion cash up front, with another $2 billion in milestone payments and AUD1.5 billion in carry over the next few years) on the heels of sharply lower natural gas prices added to COP’s debt and cost burden, following the loss of production and reserves (4% and 10%, respectively) as a result of the expropriation of COP’s Venezuelan assets in 2007. On a three-year average basis, both reserve replacement and finding and development (F&D) costs shot up in 2008 (to $17.27/boe and $31.07/boe, or $15.75/boe and $24.02/boe adjusted for price-related negative revisions in 2008). Production costs ($18.89/boe in 2008, up from $13.06 in 2007) remain relatively high. COP’s rising cost base is a concern as more than half of its production comes from the higher-cost North American and North Sea areas. As a result, upstream returns lag those of its peers.

Despite the benefits of being the second largest refiner in the United States, the Company is more exposed to the sharply declining refining margins and narrowing heavy/light crude oil pricing differentials. Among the mitigants are the Company’s proprietary coking technology and carbon upgrading capabilities, coupled with its plans over the next five years to upgrade its refining capacity to handle heavier crude oil, principally from Canadian oil sands, which should provide a competitive edge and a measure of stability over the longer term, although downstream returns were depressed in H1 2009.

Access to reserves in developing countries has also been increasingly difficult as seen in Venezuela, with the attendant political and business risks in many countries, including uncertainties regarding regulatory, legal and taxation systems. A case in point is COP’s investments in LUKOIL, which are subject to a high tax burden (generally more than 60% of its cost base). Furthermore, while equity earnings contribute substantially to profitability (an average of 28% from 2006 to 2008), cash distributions have been more limited. It is important that the Company strike a balance between its leading gas and growing heavy oil portfolios in North America and legacy assets in other stable Organization for Economic Cooperation and Development (OECD) countries (principally the British and Norwegian North Sea) and the geopolitical risks in certain outlying regions, including Russia, which present high growth potential.

On a positive note, COP has built a relatively balanced portfolio through a series of acquisitions and joint ventures, principally the BR purchase in 2006, investments in LUKOIL and joint ventures with EnCana Corporation starting in 2007, which should provide a platform for substantial organic growth in the medium and longer term versus acquisition driven expansions in prior years. These assets pave the way for lower cost, high growth opportunities in unconventional natural gas (once gas prices improve in the medium term), a lucrative international venture and an integrated in-situ oil sands operation, the latter providing cost-advantaged bitumen feedstock to its Midwest refineries (Wood River and Borger – close to 25% of COP’s U.S. refining capacity). Upstream remains the focus, which is expected to consume about $10.3 billion (82%) of the 2009 capex of $12.5 billion, with 16% ($2 billion) for downstream, including the Wilhelmshaven refinery upgrading project. The bulk of the capex is designated for growth projects to enhance production. The Company has also achieved most of the cost reduction initiative (10% cut) planned for 2009, although the bulk of the savings resulted from market forces and some are expected to be imbedded in capital costs.

DBRS expects COP to achieve its target to grow annual production by 2% (3% previously) and to replace 100% of reserves on a five-year average basis (183% for 2003 to 2008, including the Venezuela reserve write-downs and adjusted for the price-related negative revisions at year end 2008) through 2013, based on its track record. However, market forces, such as the current low natural gas prices, could affect production as a result of temporary shut-ins, although significant resource re-allocation to the higher return crude segment has been seen. Other underpinnings include major development projects, mostly in lower cost, high growth regions in Asia-Pacific, the Middle East, Russia and the Kashagan field in the Caspian Sea of Kazakhstan. Most of these projects, scheduled for start-up in the next five years, should offset natural declines in mature basins in North America (including Alaska) and the North Sea. However, these two regions remain core operations (54% of production and 47% of proved reserves in 2008), providing a stable stream of cash flow to fund the growth projects mentioned above. Longer-term projects include Origin JV’s coalbed methane and LNG developments, Arctic gas, Canadian oil sands and the Shah gas project in Abu Dhabi, for which an interim agreement has been signed.

Over the long term, the Company is striving to achieve above-average financial performance from its upstream operations, similar to its superior downstream performance prior to 2008, both measured on a cash flow per barrel basis. The Company’s investments in major midstream infrastructure projects, primarily the Rockies Express gas pipeline (REX), and contractual shipping arrangements with Keystone crude pipeline, with full start-up expected in 2009 for REX and 2010 to 2012 for Keystone, should provide transportation for stranded gas from the Rocky Mountains, where COP has several major development projects, and for heavier Canadian crude oil to the Gulf Coast, where close to 25% of the Company’s refining capacity resides.

Notes:
The Senior Unsecured Notes and Debentures of Burlington Resources Inc. are guaranteed by ConocoPhillips.

All figures are in U.S. dollars unless otherwise noted.

The applicable methodology is Rating Oil and Gas Companies, which can be found on our website under Methodologies.

This is a Corporate rating.