Exploring Hydrocarbon Depletion
Page added on March 16, 2017
If Saudi Arabia’s saber-rattling leads to renewed price warfare in the oil market this year, then everyone involved will suffer — except you drivers, of course.
And Exxon Mobil Corp.
Exxon does not actually like getting lower prices for its primary product; its cash flow has been cut in half over the past two years. As an investment, though, Exxon’s attractions come to the fore when the wider market is in retreat:
It’s hardly a shocker that the higher the leverage, the bigger the fall and subsequent rebound. Long-time investors who held onto Exxon through the worst of the storm, steeped in the history of oil cycles, may well just shrug their shoulders at a year of underperformance.
A lot has changed in this particular year just gone, though. First, Exxon’s reputation has had a few dents put in it. Second, Exxon has a new CEO. Third, the U.S. onshore oil sector has proven more resilient to lower oil prices than many expected.
Exxon’s new chief, Darren Woods, has certainly taken that last point to heart. At his first strategy presentation, he laid out a big shift in the company’s spending priorities back home to the U.S.
While this raises questions about how a traditionally returns-focused oil major squares that model with the capital-intensive shale business, it could make sense on several fronts. Shale’s shorter investment cycle provides flexibility to nudge spending up or down, mitigating the risk of multi-year mega-projects sucking in capital during a downturn — the big strike against the majors in recent years. This also acts as a partial hedge against any medium-terms fears of slower or peaking oil demand and the habit of foreign governments and geopolitics in general to mess with Exxon’s plans.
More importantly, success in shale is about access to capital and the application of technology (see this). Exxon has both in spades.
What it lacks is a compelling valuation.
Despite the trials of the past year or so, Exxon still trades at a 63 percent premium to its peers — Chevron Corp., Royal Dutch Shell Plc, BP Plc and Total SA — on price-to-book multiples. Exxon’s enterprise value of $383 billion is almost a third bigger than that of its nearest rival, Shell. Yet the latter is forecast to make more in terms of Ebitda and free cash flow than Exxon over the next three years, according to consensus forecasts compiled by Bloomberg.
Granted, Exxon has not made as many missteps as its rivals over the past decade. And its return on capital, while much diminished, remains higher. Still, that valuation gap looks more questionable now than it has in a very long time.
The big swing into the Permian basin actually throws it into starker relief. It was striking to see a slide in Woods’ deck comparing Exxon’s drilling efficiency to the likes of Diamondback Energy Inc. and Parsley Energy Inc.; usually, those rankings are reserved for the global majors, not the homegrown upstarts. With companies such as EOG Resources Inc. and Pioneer Natural Resources Co. laying out ambitious plans of their own, it isn’t a given that Exxon will lead the pack in shale.
That notion may help explain why Woods talked repeatedly about the benefits of Exxon’s integration; only if the whole really is greater than the sum of the parts can the company justify trading at twice its book value. After all, if you like shale, then why necessarily own Exxon when you can own much faster-growing, but still substantial, focused companies such as EOG?
If you wanted, you could still mix in some other stocks to replicate other aspects of Exxon, such as its oil sands, international E&P and downstream businesses — but with the added benefit of tweaking your exposure to each over time. Using the Bloomberg Terminal’s custom index function, here’s a stab at what this might look like:
The exact portfolio is entirely debatable, of course, but the point is that, as Exxon’s strategic focus shifts, it shouldn’t simply assume investors will follow.
This is where a renewed bout of panic over oil prices could help.
The natural role of a company like Exxon in the mosh-pit of the Permian is to bring some order via consolidation, as it has been doing already with a string of deals. This offers a clearer path to bringing Exxon’s economies of scale to bear. But it can be an expensive proposition when real estate is as hot as it is in West Texas.
The Achilles heel, such as it is, of the E&P sector is its reliance on external funding. One of the reasons it held up so well during the crash, other than cutting costs, was the willingness of equity investors to step in when credit froze up. This lifeline, as well as boundless stores of optimism, also meant suffering E&P companies didn’t just run into the arms of the first oil major who would have them. And debt markets have come back from the brink: Junk bonds in the energy sector now yield much the same as they did before oil prices collapsed:
(As an aside, that chart should terrify the likes of Saudi Arabia.) Exxon, though, could draw some comfort from the recent uptick in yields toward the far right. While E&P companies have retrenched aggressively, they are still stretched. Margins are thin. Surveying 55 U.S. companies with a market cap greater than $500 million, collectively their net debt to trailing Ebitda has exploded from 1.7 times at the end of 2014 to 9.9 times at the end of 2016, according to figures compiled by Bloomberg.
Another lurch down in oil would take many E&P stocks with it, while Exxon’s likely would attract some investors seeking a haven. At that point, Exxon’s highly priced currency would be a strategic advantage rather than just a reason not to buy it.