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A Supermajor Set Apart

Erik Kobayashi-Solomon

Erik Kobayashi-Solomon: Hi. I'm Erik Kobayashi-Solomon, one of the editors of Morningstar OptionInvestor, and I'm here with Morningstar's analyst covering Exxon, Allen Good. Allen, thanks for coming today.

Allen Good: Thanks for having me.

Kobayashi-Solomon: We recommended a bullish position in Exxon when Exxon's stock price dropped some when they announced the XTO acquisition. I just wanted to ask you first of all about that acquisition and Exxon in general. So, XTO is a natural gas producer focused in North America. Do you think that this strategy is a good one for Exxon? What is Exxon saying about their business?

Good: This is certainly a bold move by Exxon to move so strongly to natural gas. But for Exxon, it should seem to work out for several reasons. First of all, Exxon right now is a heavy oil producer in the sense that about 65 percent comes from oil.

Kobayashi-Solomon: Right.

Good: Oil resources are becoming less and less available to these large international oil companies.

Kobayashi-Solomon: This is where they're having to go further offshore.

Good: Further offshore, having to work with unfriendly governments, those sorts of situations. So, with XTO, Exxon is going to be able to create a platform for future acquisitions into unconventional natural gas resources. They should be able to create a lot of opportunity to add reserves and add production for them, not only in the U.S. but also in Europe, where they started to acquire unconventional acreage. So, Exxon is going to be able to put their financial backing behind a smaller player like XTO, really use their expertise, their experience, and really build out this incredibly large platform that ultimately could lead to them controlling a lot of natural gas production here in the U.S. and Europe.

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Kobayashi-Solomon: So, really diversifying their revenue sources away from strictly oil and kind of taking some political risks away and so forth?

Good: Absolutely. Also, natural gas has a large backing behind it. If you look really at the carbon legislation that's coming out throughout the U.S., throughout the world, natural gas is much friendlier as far as electrical...

Kobayashi-Solomon: Cleaner.

Good: ... generation than coal is. So, really the future of natural gas, regardless really what happens with prices, is they're certainly going to be a lot more demand there for natural gas in the future.

Kobayashi-Solomon: I see. So, you know, I was talking to one of your colleagues, and he was thinking that there's probably going to be more of these types of acquisitions, that maybe Exxon's looking at some other players. So, how does that affect me in a bullish position? Should I cringe when I hear about more acquisitions if they come up?

Good: I wouldn't think so. There are two things to keep in mind with future acquisitions. One is that Exxon is very deliberate in their capital allocation strategy. If you look at their acquisitions, it was 10 years previous before another acquisition was made after the large Mobil purchase in 1999. So, they're very slow, they're very deliberate.

Kobayashi-Solomon: In other words, they work on kind of integrating what they've got and really making sure that that's working before...

Good: Exactly. And they do a lot of research. They want to place bets that aren't necessarily price dependent on what's going to happen with natural gas or oil prices. So, they're going to be very slow and very deliberate in how they go forward with these acquisitions. I would look for more smaller bolt-on acquisitions using that XTO experience and expertise to evaluate certain E&P companies, certain acreage, before they go ahead and add these companies on. So, this could be a multi-year progress as far as them adding future E&P companies.

Kobayashi-Solomon: Now, in the options world, we really like to think about sources of uncertainty. What do you think are kind of the main sources of uncertainty for Exxon, and do you think these kind of mainly weigh on the bullish side or the bearish side for them?

Good: Well, the first and most obvious risk I would say is oil and gas price volatility. A lot of that is out of the control of Exxon's hands. The second relates more to their downstream presence. They are the largest refiner in the world. They are a top five chemical company also in the world. So, relying on what these chemical and refining margins do could also strongly affect profitability. The third and most obvious risk I would say relates to what we call their mega projects. These are very large projects, up to 10 years from early discovery to production that Exxon, and other large integrateds, are relying upon to grow production. With these projects there's a lot of risk involved. One, you're normally working with these national oil companies that are controlled by governments.

Kobayashi-Solomon: Like a Saudi Aramco or something like that.

Good: Like a Saudi Aramco, like a Qatar, like a Kuwait. The projects also last for seven to 10 years so within that time you have a lot of risk as far as what goes on with the oil prices. It may make these projects uneconomical from the time you start them until the time they're completed. There's also the worry of price inflation as far as materials are concerned. So, working on these very large projects, it's a lot of risk associated with that. Now, as far as Exxon is concerned, they are the best in the business as far as delivering these projects on time and under budget. So, if you're saying that one company is relying on these larger projects, it's certainly Exxon who, you know, this is their cup of tea. This is what they really...

Kobayashi-Solomon: They kind of developed a real expertise in it then.

Good: Exactly. This is where they're strong. So, while they rely on these projects, it's certainly bullish that they are the best operator in the business at this. Also, as far as the refining goes, they have the most exposure to Asia of any large integrated company.

Kobayashi-Solomon: Boy, that sounds good.

Good: It does.

Kobayashi-Solomon: I think the Chinese and the Indians probably want some more refined oil products.

Good: Exactly. They're the only ones who actually are going to see growth coming, as far as gasoline demand is concerned, where the U.S. and Europe are on a secular downtrend.

Kobayashi-Solomon: Right.

Good: So, having exposure to these growth areas should certainly boost margins, combined with the fact they have the largest, most complex facilities in the world.

Kobayashi-Solomon: Yeah. Now, one of the sources of uncertainly that you mentioned was oil prices. You know, a lot of people, when I talked to them and tell them that I'm looking at Exxon, they say, "Well, that's just a bet on oil prices." And how do you respond to somebody? Is it really a bet on oil prices if I'm betting on Exxon?

Good: I would say in Exxon's case it's less of a bet on oil prices than your typical pure play E&P, which is relying strictly on exploration and production. With Exxon, you get all the downstream business I talked about earlier--largest refinery in the world, top five chemical company--would certainly offset any declines you may see in prices or profits from declines of prices of oil. So, while you're producing about two-and-a-half million barrels per day, and upstream is contributing about 65 percent, 75 percent of your net income, it's certainly a huge part of ExxonMobil, but with the integrated business, you're less reliant on the oil and gas prices, as you were if you were doing a pure play E&P.

Kobayashi-Solomon: Well, Allen, thanks a lot for explaining a little bit about Exxon to me, really interesting stuff.

Good: Thanks for having me.

Kobayashi-Solomon: And thank you for joining us. Please stop by the Morningstar OptionInvestor site where we have more option ideas based on Morningstar's fundamental research.