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ExxonMobil Breaks From the Pack

Allen Good, CFA

Breaking with integrated peers that have committed to restraining capital spending and increasing cash returns to shareholders,  ExxonMobil (XOM) plans to ramp up capital spending from $24 billion this year to $28 billion in 2019 and $30 billion on average through 2025, with the goal of doubling earnings and cash flow from 2017 levels by 2025 and delivering a return on capital employed of 15% compared with 7% in 2017. While investors have been clamoring for greater capital discipline from integrated oils, Exxon’s view is that it holds a host of high-return projects that can leverage its superior integrated model and thus warrant investment.

This reasoning is sound, in our opinion. We have long argued, supported by historical returns, that Exxon is the highest-quality integrated overall and that its downstream and chemical segments are key differentiators, so it stands to reason that the company should invest to maximize those advantages. Integrated oils have a spotty record of delivering on long-dated volume and return targets, and execution risk is high. That said, Exxon is one of the better operators and developers in the world, and its plan includes a high portion of operated projects, increasing the chances for success, in our opinion. Also, while oil prices are likely to be volatile during the next seven years, Exxon can cover its spending requirements and dividends at $40 a barrel, ensuring their safety.

The upstream segment will lead the charge, with plans for earnings to increase threefold and new investments to earn a 20% return on capital employed. Exxon has bolstered its portfolio in recent years through discovery (Guyana) and acquisition (Permian, Mozambique); these new resources will contribute the bulk of its estimated 1 million barrels of oil equivalent per day in net production growth. Its 2025 targeted production of 5 mmboe/d represents a 3% compound annual growth rate--not necessarily a gaudy figure, but audacious given that volumes have remained essentially flat at 4 mmboe/d over the past 10 years.

Exxon expects to double downstream and chemical segment earnings by 2025. Investments will focus on leveraging the integrated model, improving yields, and adding capacity to capitalize on low-cost U.S. feedstock and serve growing Asian demand.

Highest-Quality Integrated Firm
We continue to rate Exxon as the highest-quality integrated firm, given its ability to capture economic rents along the oil and gas value chain. While its peers operate a similar business model with the same goal, they fail to do so as successfully, as evidenced by their lower margins and returns. Exxon generates its superior returns from the integration of low-cost assets (an intangible asset that we consider to be part of its moat source) combined with a low cost of capital; this combination produces excess returns greater than those of its peers. However, given our outlook for lower long-term oil and natural gas prices, we expect Exxon’s returns to be lower than they have been in the past. Consequently, our confidence that it can continue to deliver excess returns for longer is diminished. We now rate Exxon as having a narrow moat instead of wide.

The upstream segment holds a low-cost position based on an evaluation of Exxon’s oil- and gas-producing assets, using our exploration and production moat framework. Its reserve life, finding and development costs, and forecast of $20/boe midcycle cash operating margin all easily clear our hurdles to consider the assets low cost. Exxon also delivers the greatest capital efficiency of its peers, spending the least on a per-barrel basis and posting some of the highest recycle ratios. As a result, its upstream returns on capital employed have led the group. We think this is in part due to integration with the downstream segment.

The size and physical integration between Exxon’s refining and chemical manufacturing is a unique asset that creates an unequaled advantage that cannot realistically be duplicated. Approximately 80% of its refining capacity is integrated with chemical manufacturing facilities. The integrated network delivers wider margins and returns than peers, thanks to a low-cost position derived from economies of scale and the ability to process a variety of feedstocks into the highest-value products. During the past five years, Exxon’s downstream average returns on capital employed have far outpaced the group average.

Balance Sheet Is Backstop for Volatility
For a company with global operations, geopolitical risk is always an issue. Past events in Russia, Nigeria, and Venezuela underscore the risk associated with doing business in those countries. These risks will only become greater as Exxon expands its global production portfolio through partnerships with national oil companies.

By investing in large, capital-intensive projects, Exxon also runs the risk that commodity prices will decrease dramatically, making those projects no longer economical. Deterioration of refining fundamentals in the United States and Europe may continue to damage profitability long after an economic recovery. Changes in policy related to climate change could result in higher costs, reduced demand, or stranded resources.

ExxonMobil’s fortresslike balance sheet elevates it above its integrated peers, and its size and diverse operations ensure the company will continue to generate substantial cash flow regardless of commodity price volatility. Recent investments in large, long-life, plateau production projects will ensure cash flow remains strong. While these projects require generous investment up front, little reinvestment is required to maintain production. Based on our current oil price forecast, we do not see any issues with cash flow funding Exxon’s plans to increase capital spending. Exxon estimates it can continue funding capital expenditures as well as dividend at oil prices as low as $40 a barrel.

Dividend growth is likely to accelerate back toward historical levels after a couple of years of anemic growth. We expect growth of about 5% over the next few years. As a result of low oil prices, Exxon ceased repurchasing shares except to offset dilution. We expect the company will eventually resume repurchasing shares as improved cash flow brings on higher-cash-margin barrels, spending falls, and oil prices recover. However, buybacks will probably be limited as investment, balance sheet strength, and dividend growth take priority.

Allen Good, CFA does not own shares in any of the securities mentioned above. Find out about Morningstar's editorial policies.