The Reports Of Oil’s Death Are Greatly Exaggerated
A Brief History Of Standard Oil
In 1887 John Rockefeller and Henry Flagler started a company called Standard Oil. To say they were ruthless bastards probably underplays it but they squeezed everyone that didn’t get with the program as far as they were concerned. The first way they did this was by what is called horizontal integration. This is where you buy all of the like for like facilities (say petroleum refineries) and then set about charging monopoly prices. The second way they got on top of people is by taking this game to the next level; vertical integration. They simply bought up facilities that produced the oil, processed it, and sold it to the customer. This is the definition of vertical integration. They used their length and breadth of business interests to force customers to pay what they wanted. They ramped charges on railways, jacked product prices and lowered prices to squeeze competitors. When the competitors were crushed they swooped in and bought them. So, basically, they played the game of capitalism and won.
The fiendishly clever ways that John Rockefeller made his money work harder didn’t end there. He used to pay $2.50 for a barrel in which to put his oil. After a while he sat down and realised that he could make his own barrels, in house, for the sum of $1, allowing him to pocket the difference. In so doing he also realised he could cut the timber in half in his workshop and lighten the weight of the barrel. This allowed him to pack even more oil on storage vessels and boost his profits once again. Even where his company was based in Ohio wasn’t an accident. By having a business that could transport oil by water he forced the rail companies to the negotiating table to strike a better deal.
The long and the short of this story is simply; Standard Oil got to be so big by 1911 that the courts ruled it to be a sheer dominant monopoly. In order to correct for this the company was broken into 34 smaller companies that would, by virtue of capitalism, be forced to compete with each other. Some of those companies include Exxon and Mobil (that went on to become ExxonMobil), Chevron, Amoco (bought by BP), ARCO (bought by BP), Conoco (now part of ConocoPhillips), and Marathon Oil. To truly put the scope of Standard Oil into perspective you need to look at John Rockefeller. When the companies were split apart he had to console himself with shareholdings in each of the 34 companies. By the time he died in 1937, Mr Rockerfeller had an estimated, inflation adjusted, net worth of US$350 billion. For a full history of John Rockefeller, his exploits, work ethic and ruthless business mind I highly recommend you read Titan by Ron Chernow.
Who’s Who In The Zoo?
If we are looking at the oil and gas industry we need to first address the elephant in the room; Saudi Aramco. At a market cap floating around $1.9 trillion this is the biggest player by far in the market. However, there are some structural problems that handicap Saudi Aramco. The major drawback here is that the company is used as a slush fund to pay for all of the largesse in Saudi Arabia. That isn’t a problem per se, as far as sociopolitical structuring goes but it does limit the effectiveness of Aramco as a business. Over time you tend to keep making decisions that lead to ever greater profits and ever greater payoffs to the people of Saudi Arabia. This in part explains why it was floated on the local exchange instead of the far more liquid and deep pocketed exchanges in the west. Although the doubling down on oil and gas isn’t a bad thing, as I will explain later, the need to produce large amounts of cash flow to feed into the government is. It can, and does, cause you to limit expansion, maintenance, and diversification in order to maximally utilise your current cash flow. If you would like a window with which to view the kingdom under the new Mohammed bin Salman I can thoroughly recommend MBS by Ben Hubbard.
This process of tribute paying and the fact that the listed equity is a very minor part of the overall company leaves shareholders somewhat captured by the Saudi royal family. This isn’t a super great spot to find yourself in under normal conditions, let alone panicked ones, and it is, in part, why we have taken a look today at the next biggest oil supermajor, ExxonMobil (NYSE: XOM). With a market capitalisation of US$185b, it is US$14b clear of its nearest rival Chevron. ExxonMobil’s head office that houses the senior executives is called the “God Pod” because orders from that office can be as sharp as thunderbolts. Looking past the dubious naming it must be said that ExxonMobil has an extremely long track record of recruiting, nurturing, and promoting talent from within their ranks. I’ll just go through the previous three CEOs of ExxonMobil to prove my point. Lee Raymond joined Exxon in 1963 and became CEO in 1993. Mr. Raymond finished in the job in 2005 where he handed over to Rex Tillerson. Mr. Tillerson joined Exxon out of university in 1975 and ran the company as CEO from 2005 until 2017. In 2017 the reigns were passed on to Darren Woods who began working at ExxonMobil in 1992.
I make this point for two reasons; the first is that change happens within ExxonMobil slowly and deliberately. They have a long track record of utilising internal talent to fill key executive positions. This means there is a low risk of an external candidate taking the top job and destructively pivoting the business to areas that are the new, new thing. I will discuss this in more detail later but rest assured this is a good thing for your financial health. This contrasts well with a recent Australian CEO resignation from Woodside. With Peter Coleman stepping down from the role after, what will be, ten years in the job it will be interesting to see if they appoint an internal or external candidate. The contrast here is in the succession planning. At ExxonMobil there is very little doubt over who will take the role once the CEO has breached the 10 year mark whereas at Woodside there appears to be a power vacuum at the top. Touching on the first point, and diverting our interest from ExxonMobil for a moment, it will be a great study to see if the new Woodside CEO attempts to pivot the $22b business away from oil and gas, towards a more diversified energy company. This move would have precedence, as we will discuss later, and appears for now to offer huge riches to equity holders.
Circling back around we can see that ExxonMobil is the second largest oil and gas major by market capitalisation, is driven by market forces (and not political fealty), and has a long track record of stable internal management candidates. This is the beginning of what I hope to prove is a good investment opportunity in a company that has been ‘run out of town’ in a sense. Current shareholders losses stemming from a move away from oil and gas are seemingly your gains to be had if you are brave enough to take them.
What Are They Good At?
ExxonMobil are at the pointy end of the list of companies that can find top flight assets and put them to work. Even during a nine month period that covers an actual pandemic Exxon have pumped 3.8 million barrels of oil equivalents. Oil equivalents by the way is how the accounting departments rationalises oil plus gas into one accounting number. This also allows quick and easy comparison between companies. This production rate is down 3.7% on the year prior. Given that diesel demand is off 10%, petroleum is down 20%, and jet fuel is down an incredible (but believable) 60% from the year prior this is, in fact, a reasonable result. Another factor that has led to the lower output numbers is the government mandated rig shutdowns coming out of the middle east. With OPEC members looking to limit supply Exxon was essentially told to shut down their rigs in order to aid a supply side restriction in light of the pandemic.
While we are talking about reductions in production this is probably a good point at which to talk about how oil companies in general, and Exxon specifically, avoid dropping to zero production. From the very limited amount that I understand, over time the extraction of oil and gas becomes harder and harder and each well gradually produces a lower level of production. The most prolific modern day example of this would be the shale fields where companies are constantly having to drill new wells in order to avoid the rapid decline in existing well production. This is a large reason why the investment activities portion of the cash flow statement has such big numbers in it. For example, ExxonMobil in the last full year (2019, reported in 2020) made a $24b investment in property, plant and equipment. In order to find new reserves and, over time, replace constantly reducing production rates Exxon has to find and develop new resources.
Here is where we get to one of Exxon’s great strengths; finding resources. Partly because of a resource I am about to describe, Exxon has won the Explorer of the Year award for three year running. This should go to further underline that Exxon knows how to find oil. Exxon has drilling rights to a block of land 6.6m acres in size off the coast of Guyana in South America. With the most recent results available Exxon has discovered, in the “Stabroek Block” as the area just off the coast of Guyana is named, just short of nine billion barrels of oil equivalent. The first phase of production, called the Liza Phase 1 plant, is producing 120 thousand barrels a day, with the Liza Phase 2 plant set to bring this to 340 thousand barrels a day. By 2026 when all 5 phases are set to be in place this area is set to produce just shy of one million barrels a day.
Exxon are also reaping the tailwinds of sector wide cost cutting and efficiency drives with the cost of offshore construction and deepwater drilling falling. Since 2013 the cost to Exxon of offshore construction has fallen by 25%. This reduction in expenditures both puts Exxon in a better bargaining position when undertaking construction contract negotiations but also adds to their bottom line over time as they have fewer up front costs to cover before reaching profitability. The second leg to this industry wide slump in spending is the cost of exploration. The cost of deep water exploration has fallen a striking 70% since the heady days of 2013. This again is great news for Exxon shareholders as one of two things (or a combination thereof) happens. Either Exxon spends the same amount and drills three times as many holes or they drill as many holes and have a lot more cash left over, maybe to drill holes in some other place, who knows?
One thing that is for certain is that this pandemic and resultant drop in demand for hydrocarbons has spurred on executives at every level of the business to carve out savings in their budgets. Nothing acts as good a motivator as having the possibility of losing your job or your company (along with those very valuable shares/share options). So with this unprecedented event serving as the background to an efficiency drive what can we see so far as a result? Well, in the first nine months of this year Exxon has managed to pull $6b out of their exploration budget from $22.6b in 2019 to a 2020 spend of $16.6b. Now I know you are concerned about the need to replace falling production but this fall has a few knock on benefits. The first is that it forces the team within Exxon to get smart about how they extract resources. One of the ways we have seen this take shape is at the Permian tight oil (or fracking to the rest of us) division. Through an increased upfront spend the team at Exxon have found that laying cube developments, where they drill every depth of rock and at every width, they have been able to extract the highest level of resource recovery which greatly increases their profitability.
Another area of the Exxon business that is generating cash that will be repurposed is the divestiture (sale) of assets that are no longer considered core to the business. Since 2008 Exxon has sold 14 refineries, 4,000 miles of pipeline, and 10,000 retail sites (think service stations). The divestiture program will benefit from an upturn in the oil price as, understandably, the asset values are often calculated based on the current spot price or a proxy thereof. There is a distinct possibility that with a number of COVID-19 vaccines being made available that the demand for hydrocarbons will increase. This demand side increase would be expected to pull the price of oil up with it. If you happen to hold a series of assets you want to sell then a rising commodity price cycle is the time to do it. This too could produce valuable cash to the Exxon balance sheet.
With the oil and gas sector having weathered a global pandemic and the dramatic reduction in demand, coming out the other side alive might actually be considered a victory. With weaker and more poorly capitalised competitors out of the market or severely weakened an upturn in demand while supply is constrained may prove the old oil and gas adage true; low prices cure low prices.
What Could Go Wrong?
Plainly speaking the most likely outcome, as judged by the investing public and according to market capitalisation, is for electric vehicles to take over the world. Now I’m a huge fan of electric vehicles in and of themselves but I have a hard time with their economics as they stand today. Toyota is not a company that would be considered a laggard in the green car revolution. Being the first to make mainstream hybrid technology work with the Prius, which was then rolled out across the range, it is dragging its heels on a launch into large scale battery storage electric vehicles. Last year it stated that these vehicles simply couldn’t be done profitably at a mass manufacturing level. Given how expensive they are Toyota also has no plans to delve into that market until 2025. Although always a notion fraught with danger (as many a short seller will tell you); the Tesla story has more than a whiff of a bubble like mania to it. It simply could be that EV demand, along with solar cells, direct car software upgrades, and premium in-car subscriptions will launch Tesla into becoming the most profitable company ever. If this is to be the case then the base case for automotive fuel use will, over time and as households update their vehicles, reduce substantially.
Another reason, and one far more likely on a day to day basis, is the risk of a Deepwater Horizon like event that sees Exxon swamped in litigation and remediation payments for a decade, much like their fellow Supermajor oil producer BP has been since April 20, 2010. This is a very real risk that all oil and gas companies run. The nature of the work, the areas they operate in and the extreme conditions under which the equipment must function make for a volatile mix. The Deepwater Horizon spill took BP from a $180b company in 2010 to a $55b company today. There are more than enough moving parts in the sprawling Exxon empire for an event to take place that leads to a cataclysmic outcome for shareholders.
Why That Likely Won’t Happen
Although, as we noted earlier, jet fuel demand is down 60% year on year we have to be a little more honest with ourselves when we look at the future consumption of airlines. With an estimate that 5 billion of the world's population will be in the middle class by 2040 the idea that plane travel will diminish over the longer term is nigh on fanciful. To add to this it is easy to say that air travel, even in ten years time, will still rely on jet fuel as even the most ambitious environmentalists won’t predict solar, wind and battery power to be able to take the load of 400 tonne planes leaving the earth and travelling at 1,000 km/h.
While we are speaking about transport that uses petroleum we should take a look at vehicle transportation. Now we mentioned earlier that the rise of the electric car, if it is total and inevitable, will crush the oil industry. However, what if it isn’t nearly as complete a transition as we are currently thinking? Even if it is, what sort of timeframe would that sort of change happen over? It isn’t unreasonable to think that the average family might still be buying a petrol powered car as their next new car. It also wouldn’t be unreasonable to assume that they would see ten to twenty years off effective use from it too. Then you have the people who only buy second hand cars. The market is dramatically tilted towards petroleum powered cars in this market and will likely be for the foreseeable future. Then we have to make the one comment that might just hurt the most; electric cars, kilogram for kilogram, are bloody expensive for what you get. Yes, your Tesla will take you on a 400km jaunt and yes, it is a very fine piece of tech, but we need to talk about the price. For the price of an Tesla Model 3 ($67k) we can buy a Hyundai Sonata for $19k and get $48k worth of petrol. At a price of $1.50 per litre that’s 32,000 litres and given the Sonata’s fuel economy of 8.3L/100km you can travel around the globe 9.6 times, or 385,542km. This is a long winded way of saying that there will be a use for petroleum as a transport fuel now, and even as a legacy fuel if EVs are to take over, well into the future.
Another leg that ExxonMobil has to stand on is the chemicals division of their business. Although they capture far less attention than their flashy fracking, deep sea and onshore oil and gas production counterparts they are an important source of income for Exxon. In fact, the production of packaging plastics, new vehicle plastics, and performance fibres for clothing have been the one bright spot in this year of misery for the Exxon team. Over the last 4 quarters this division has added US$917m in earnings to the groups bottom line. With the expansion of the middle class expected to increase demand for all of these products the chemical division will be looking to have a greater positive impact on the business in the future.
Since the scare of the Deepwater Horizon spill sent shockwaves through the industry and forced a period of self reflection and honest self assessment ExxonMobil has reported 4 major oil spills. The first was a 2011 spill of 1,500 barrels of oil in Montana which saw a fine of US$135m levied against Exxon. In 2012 there was a 1,900 barrel oil spill and a benzene spill in the same year. In 2013 a pipe burst in Arkansas releasing 3,190 barrels and leading to a US$5m fine. To place this into context, the BP Deepwater Horizon spill is set to cost BP US$65b. There is also a simple reason that the spill could have happened to BP and is less likely to happen to other majors, including Exxon. BP for the years leading up to the spill was a rag to riches story of a second rate petroleum outfit that was transformed by the charismatic wheeling and dealing of John Browne. Not only was Mr. Browne and expert in buying up existing businesses to boost the bottom line he also pioneered BPs way into new and exciting markets. In addition to this he was a ruthless cost cutter. It would appear that the pressure he brought to bear on the financial side may have contributed to the spill. With line managers looking to please the boss and cut budgets as ruthlessly as they could safety and maintenance tasks were missed. To confound this story we also have the fact that Mr. Browne conducted a very poor process of internal succession planning that saw a lot of senior staff leave the business. This is almost in direct contrast to the way Exxon has managed their succession planning over the last 30 years. For an in depth analysis of the lead up to the Deepwater Horizon and the after effects with a particular eye to the management tier I cannot recommend In Too Deep by Stanley Reed and Alison Fitzgerald highly enough.
What Is The New, New Thing?
This is a short story of contrast and it touches, every so briefly, on market mania. In a world that sees oil and gas companies as unreservedly bad and renewable energy providers as assuredly good we find a master of marketing success story; NextEra Energy. The proud owner of the Florida Power and Lights company, NextEra Energy is touted as the next force in renewable electricity power generation. This isn’t to say that they haven’t done a great job for their shareholders as they most certainly have. Over the past 5 years where Exxon has fallen 45%, NextEra Energy has soared by 186%. The logical question is why. The answer is that NextEra Energy has an entire division that sells renewable energy into the grid as a utility. Given this part of the business makes up less than 50% of the earnings but it does contribute a fair amount. The Florida Power and Lights portion of the company contributes the lion's share of the earnings to the company and would you hazard to guess what fuel source they use to generate 75% of their electricity? If you guessed natural gas you won the prize.
More striking than the sheer guts to downrate ExxonMobil for extracting the stuff while uprating NextEra Energy for burning it, is the implied values of the two companies. If we take a look at the net operating cash flows of NextEra Energy we see that they earned a positive operating cash flow of US$3.4b in the last full year. That would give the company an operating free cash flow to market capitalisation value ratio of 43. So that’s 43 years of net operating cash flow before you have covered your cost of purchase. Now if we take a peak at Exxon’s books we will see a 2019 net operating cash flow of US$14.8b. This implies a cash flow to value ratio of 12. Sometimes it really does pay to have the wind at your back as you sail through life.
What is my downside protection?
Put simply; don’t buy in. If you just purchase an index fund it will likely scoop up a few Exxon shares and you can go about your life blissfully ignorant of the oil and gas market other than the once a week trip to the fuel bowser.
When JP Morgan's friend confided in him that he was freaking out about the equity markets at the time and was having trouble sleeping, JP Morgan just suggested he sell down his equity shares until he could sleep happily again. He called this the 'sleeping point'. Now if we admit to ourselves that index investing is, in fact, very boring and we are hardwired to seek out a more exciting (and often painful) path, then there are a few things that might allow you to sleep peacefully at night.
As we mentioned earlier, Exxon has a very healthy level of operating cash flows which will increase in line with any lift in the price of oil. To use the 2018 year as an example, net operating profits were US$7b higher at $US21.4b. Another string to the bow of restful sleep is the dividend. Currently ExxonMobil is sitting on a 37 year streak of increasing their yearly dividend. Even if this streak stops, which appears likely with the current dividend consuming the entirety of the net operating free cash flows, management have reaffirmed their commitment to the investor income stream. With the dividend yield currently earning investors a 7.96% return many Exxon shareholders enjoy a quarterly cheque reminding them to be calm over the long term.
Exxon has ventured more heavily into the debt markets in order to shore up cash reserves and weather the current low demand conditions. Even so, the 46% year on year increase in total debt see Exxon still only have a debt to equity ratio of 37%. Although over the medium term you would like to see this figure fall it is reassuring at least that the debt interest costs are at all time lows.
Do I Need To Worry About Currency Rates Now?
What happens if the Australian dollar changes?
This is probably going to be a pretty big deal for you over the short, medium and long term. Changes in the Australian dollar, when compared to the US dollar, will have a direct impact on the value of your holdings. Unfortunately I don’t know anyone smart enough to accurately predict currency prices. Fortunately, because it is the same as predicting the future, I can assuredly say you don’t know anyone that smart or precinct either. Yes, that includes your dodgy mate with the hot tip and a finance degree… but what I can say is, having this exposure might actually be another diversification benefit for you.
Let’s look at this scenario; housing prices fall 50% (I know, it’ll never happen, right?) and the big banks are crunched which leads to a whole swag of bad stuff going down, the least of which are RBA interest rate cuts to a 0% cash rate and a further gusher of money into the capital markets. Now, the equities markets in Australia would probably do a few things all at once here. One, total freak out. Two, the banks are shagged which is pretty bad for me personally given my indexed holdings. Third, the miners and exporters (think BHP, Rio Tinto, Woodside etc.) go crazy. All of a sudden, thanks to the 0% cash rate and further bazooka sized bond purchases, the Australian dollar plummets to say… 45c against the US dollar. This dramatic fall just makes buying our goods (iron ore and gas anyone?) that much cheaper and so a boatload of capital pours in to snap them up.
But you’re probably wondering how holding Exxon would help me any given all this. I mean, the US wouldn’t even bat an eyelid if the Australian economy fell in a hole, right? You got it, the US market would just soldier on, powered by their eternal hopes and dreams that Elon Musk really is the second coming. What would change, for me at least, is the underlying Australian dollar value of my Exxon holdings. Remember, when the dollar fell and I basically lost my shirt as the banks got hammered, the value of my Exxon shares was going up in Australian dollar terms. How much? Well, if we assume that Exxon is worth US$43.70 today and the Australian dollar exchange rate to the US is 0.7630 we can start to do the math (US$43.70 * 1/0.7630 = $57.27).
So, all other things being equal (that one’s for the economists reading along), with the Australian dollar falling to 45c or 0.4500, my Exxon shares would now be worth $97.11 per share. That’s a 69% increase in value, in Australian dollar terms, just for standing still. This should act to ease the pain I’d feel as the losses start to pile up in my domestic investing. And just like that, you can see an additional benefit to diversification.
The Sales Pitch
Here is the narrative to an investment in Exxon. Oil companies have been way oversold given they still generate hundreds of billions in sales every year. It certainly isn’t popular to own them however with many universities, superannuation, pension, and sovereign wealth funds being harassed to dump them from the portfolio. This places these large, well run, diversified companies in a prime location to investors that can see past the short term pain and the long term, possibly overblown, narrative. There is a morality side to this also. As said before, I don’t presume to dictate what beliefs people should have but I do like money. If you think these companies are melting the world then you wouldn’t invest, just as many have not, but this is part of the reason that there is a buying opportunity today.
If you need further proof that the market has decided it has had enough of ExxonMobil and is walking in another direction we need look no further than a comparison to the S&P 500 index. Over the last five years Exxon has lost 45% where the S&P 500 index has gained 78%. As I’m sure you are well aware, today's S&P 500 pays homage to tech giants and up and coming industries while paying less and less mind to the old guard oil and gas companies. This is probably a mistake given the huge amounts of cash that these businesses will earn in the future. In fact, if the market were to wake from the dream like state it has been in over the last ten years and realise that paying for 1,300 years of Tesla’s profits is probably not a good idea in the long term, you might find yourself holding a valuable asset in the way of a well run and highly cash flow positive company like Exxon.
Don’t Be Contrarian Just For The Sake Of It
That only makes you look like a, difficult to get along with, wanker. The investment thesis still needs to make sense even if you are speaking to those that like to cut against the grain. Is this a chance to top up on a world class company with a top flight management team and hedge the rampant technology firms? If, in the future, we default to quality will the market appreciate the high dividend returns if they wake up and don’t like the smell coming off the new, money losing, share issues? This firm could fill the role in your portfolio of protecting your downside risks in that they have a highly lucrative product that won’t be removed from the world within the next ten years (as some have suggested) while also providing a healthy cash flow via the dividend. It is this dividend cash flow that ultimately could top up your investment fund and allow you to pursue other opportunities in the market.
Investing in single companies is probably a fools game and should be attempted by very few. The returns provided by index funds should prove sufficient. However there is a special joy to be taken from poring over society's scraps and finding the value hidden in plain sight.
Sometimes the best revenge is a meal well savoured.
