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Exxon Mobil Corporation (XOM)

In a note published in July 2018, we reviewed Exxon's recent underperformance and the major capital spending plans announced by management. You can read this analysis here.

ExxonMobil is one of the world’s oldest oil companies, founded in 1870. It’s also the world’s largest publicly traded integrated oil conglomerate, with nearly 30,000 oil & gas wells on six continents. In fact, thanks to its refining and petrochemical business, Exxon has a presence in almost every country on earth.

The company operates in three distinct but interconnected business segments: upstream oil & gas production, downstream refining, and specialty chemicals.
The logic behind such an integrated business, in which Exxon controls all aspects of the fossil fuel business (from production to refining to retail gasoline sales), is that it diversifies Exxon’s sales, earnings, and cash flow.

For example, low oil prices resulted in almost no profits from upstream oil & gas production in recent years. However, these low commodity prices resulted in cheaper input costs that allowed the midstream refining and chemical divisions to report stronger earnings and help Exxon still generate billions of dollars in profit.

Business Analysis

Exxon’s primary competitive advantages are its scale, diversification, and conservative approach to capital allocation. These factors have helped the company pay uninterrupted dividends since 1882 while raising its payout each year since 1983.

Starting with scale, Exxon's numbers are eye-popping. If Exxon were its own nation, its total liquids production (see below) would have made it the 8th largest oil producer in the world in 2016, greater than even Middle East nations such as the UAE, Kuwait, and Qatar.
Sources: Exxon Earnings Report, Energy Information Administration
More important for long-term investors is the fact that Exxon’s proven reserves are enormous, meaning that its massive energy production is likely to continue for decades to come.

Specifically, the company’s vast resource base of more than 91 billion oil-equivalent barrels provides solid visibility; Exxon has a long reserve life of 13 years at current production rates, which leads all competition.

Exxon’s track record of profitably replacing its resources is also impressive. Like clockwork, Exxon has added around 1 billion to 2 billion oil-equivalent barrels of resources to proved oil and gas reserves each year, replacing more than 80% of production over the past decade. 

To fully appreciate the company’s substantial resource base, if Exxon were a sovereign nation, its proven reserves of 20 billion barrels of oil equivalent would be the 15th largest on earth.
Source: ExxonMobil 10-K, Earnings Release, EIA
Exxon's impressive size is a competitive advantage because the oil business is highly commoditized, meaning that the price a company can get for its products is almost entirely at the mercy of international markets.

Due to the highly volatile price of oil & gas, integrated oil companies are also faced with inevitable boom and bust cycles, in which sales, earnings, and free cash flow can swing wildly from one year to the next.
Source: Simply Safe Dividends

As a result, maintaining profitability can be highly challenging, even with large economies of scale such as Exxon’s. While Exxon’s profitability may have declined substantially in recent years as oil prices crashed, it still boasts the best margins of its large integrated peers.

This is courtesy of Exxon’s quality management team, which has a long track record of excellent capital allocation decisions, far above those of its rivals such as Chevron (CVX), British Petroleum(BP), Royal Dutch Shell (RDS.B), and Total (TOT).

Management’s focus is primarily on long-lived assets in each of its business segments. Exxon focuses on assets that can return the highest profitability in all types of energy price, interest rate, and political environments, which has helped the company enjoy higher returns on capital than all of its major peers.
Source: ExxonMobil Investor Presentation
Exxon’s high returns are also thanks to its integrated business model, which enables it to react more effectively, efficiently, and quickly to changes in the business environment.

The company’s diverse asset base provides market optionality and operational flexibility while allowing Exxon to optimize profits throughout various commodity cycles better than most of its peers.

The company’s scale further helps it maintain lower costs than its peers. For example, Exxon’s Downstream and Chemical businesses generated over $50 billion in earnings over the last five years, nearly twice as much as its nearest competitor thanks to its cost and feedstock advantages.
Source: ExxonMobil Investor Presentation

While the industry is mature and dealing with low commodity prices that challenge the return on many capital investments, Exxon’s current growth pipeline still includes over 100 global projects. These are mainly focused on two key areas right now.
Source: ExxonMobil Investor Presentation
The first is liquified natural gas (LNG) projects, such as those in Papua New Guinea, Mozambique, and Australia. The reason that Exxon, as well as many of its rivals, are so excited about LNG is that their production tends to decline slower than oil.

In addition, demand for LNG, especially from Asia, is expected to grow enormously in the coming decades because natural gas-fired power plants are far cleaner, less carbon intensive, and more cost effective than coal plants.
Source: GasLog Partners Investor Presentation

The other key area Exxon is actively investing in is low-cost shale production in the Permian basin, which is estimated to hold 75 billion barrels of recoverable oil equivalents, and in very favorable geological formations.

Specifically, this means that the largest and most cost-effective pockets of oil & gas are located in shale layers that are tightly stacked on top of each other and often overlap; a single well can tap several pockets simultaneously.

Combined with state of the art fracking technology such as super-spec rigs (which can move and drill up to eight wells per drill pad), horizontal laterals of two miles or more, increased fracking stages per lateral, and up to 10,000 tons of frack sand per well (which props open shattered rock and increases oil & gas flow), the cost of production in the Permian has fallen to levels once thought impossible.

This is why back in January of 2017 Exxon paid $5.6 billion in stock to acquire 250,000 net acres of prime Permian land, 95% of which is undeveloped. This acquisition also netted the company 3.4 billion in proven reserves that management believes it can achieve a 10% internal rate of return, even at oil prices as low as $40 per barrel.

Overall, Exxon’s capital discipline, quality assets, integrated operations, diverse resource base, and scale will continue to serve the company and its dividend well for many years to come.

Key Risks

While Exxon’s dividend aristocrat status suggests that it could be a relatively low-risk company to invest in, there are several factors to watch for going forward.

For one thing, Exxon still needs long-term energy prices to rise and stabilize in order to comfortably invest in future growth, as well as continue increasing its payout at a healthy clip.

For now, like the other oil majors, Exxon continues to tap debt markets, reduce capital spending, and rely on asset sales to generate more cash. The good news is that Exxon's dividend coverage remains on fairly solid ground, even with the challenging environment.
Source: ExxonMobil Investor Presentation

Unfortunately, future oil prices are impossible to predict because they are a result of international markets, which are driven by hundreds of unpredictable variables.

For example, OPEC, led by Saudi Arabia, along with Russia, agreed to extend their production cuts to allow the global supply glut to decrease and hopefully raise long-term oil prices to the group’s target of $60 to $70 per barrel.

Unfortunately for OPEC (and oil companies such as Exxon), U.S. shale producers aren’t playing ball. In fact, thanks to fracking technology becoming so much more efficient since the oil crash began in mid-2014, the number of U.S. rigs operating in the field has been soaring.

The Wall Street Journal noted that “shale producers operating in a number of fields can break even at $50 to $60 oil today,” and some companies have been able to make money at prices as low as $40 per barrel.

This is why the U.S. Energy Information Administration (EIA) predicts that U.S. oil production will actually increase in 2018 and 2019 to hit a new all-time high despite low oil prices.

In other words, U.S. shale producers, of which there are thousands of independent operators, have become the new global swing producer, one that is hindering OPEC’s attempts to end the global oil glut and stabilize prices.

The other major risk to consider is the fact that, in the long-term, an increased focus on transitioning the world to cleaner, renewable energy, such as hydro, solar, and wind, means that the age of fossil fuels may come to an end earlier than many people, and oil companies, expect.

For example, as you can see below, Exxon expects demand for oil & gas to increase at around 0.8% per year through at least 2040. This forecast is what underpins the company’s return on capital expenditure (ROCE) models that determine the long-term investment plans.
Source: ExxonMobil Investor Presentation
However, while a growing world population and fast economic growth in developing nations such as India and China mean that oil & gas demand is likely to rise for the foreseeable future, growing pollution concerns in these nations mean that an increasing amount of investment is finding its way into renewable sources.

For example, between 2016 and 2020 alone, China plans to invest $72 billion per year into renewable energy, according to the National Energy Administration.

India’s clean energy plan is even more ambitious. Specifically, that country hopes to generate 60% of national electricity capacity from non-fossil fuel sources by 2027.

Then there’s the threat to oil demand from electric vehicles (EVs). Up until now the number of EVs has been relatively small. In fact, according to the EIA, there were only about 2 million EVs in the entire world at the end of 2016.

However, the number of new EV sales jumped 37% in 2016 to over 750,000, 40% of which were in China. According to a report by ARK Research, the number of new global EV sales over the next six years will grow annually by 68% to 17 million.

Overall, the biggest risk to Exxon over the medium-term is that oil & gas prices remain depressed thanks to the adaptability of U.S. shale producers. While the company continues to cut costs and remain financially disciplined, low energy prices have forced Exxon to take on debt to continue investing in its business while paying dividends to shareholders.

In fact, S&P (SPGI) downgraded Exxon in 2016 from its coveted AAA credit rating, which it held since 1949. Specifically, the rating agency said that “credit measures, including free operating cash flow (FOCF) to debt and discretionary cash flow (DCF) to debt, will remain below [its] expectations for the ‘AAA’ rating through 2018.”

No one knows where oil prices will go from here, but the industry’s structural change with the continued rise of U.S. shale production seems likely to keep prices lower for longer compared to historical norms.

The good news is that the oil majors have stated they can now generate enough cash flow at $60 a barrel to cover capital investments and shareholder payouts, according to The Wall Street Journal. Investors holding Exxon should remain aware that the company remains reasonably safe today but ultimately needs oil prices to avoid revisiting their lows and credit market conditions to remain favorable.

Closing Thoughts on ExxonMobil

While no oil stock’s dividend is ever completely secure in today’s volatile energy environment, when it comes to dependable high-yield in the oil sector, you can’t get much better than ExxonMobil.

It’s hard to make a compelling valuation case for many of these stocks if oil prices remain below $50 or $60 a barrel, but ExxonMobil is one of the very few energy stocks to consider owning in a diversified income portfolio given the structural change that has taken place in the global oil market. 

If energy prices remain depressed, Exxon will arguably be the last company still standing and paying dividends.

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