Still Making Integration Work: ExxonMobil Maintains Its Wide Moat

Historically,  ExxonMobil (XOM) has delivered returns on capital well above its peers', garnering itself a wide economic moat. However, during the past decade, competitive pressures on all of the integrated oil and gas companies have increased, resulting in sliding returns. At the same time, the gap has narrowed between Exxon's and its peers' returns, particularly in the upstream segment. All this raises the question: Does Exxon deserve to be the lone wide-moat oil and gas producer in our coverage universe? We believe it does. Exxon earns a wide moat by integrating its low-cost upstream segment and its downstream business 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 in their lower margins and returns. The superior returns Exxon generates 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 produce excess returns greater than peers'. Accordingly, we have greater confidence that Exxon can continue to deliver excess returns for longer, earning it a wide moat compared with its peers' narrow moats.

Upstream Returns Benefit From Low Costs and Integration
We think Exxon's upstream segment holds a low-cost position. Exxon clears the low-cost threshold in each metric, based on our analysis of its oil- and gas-producing operations and using our exploration and production moat framework to evaluate its reserve and operating cost position. In that regard it is comparable with its peers. However, Exxon is able to create additional value through integration with its downstream operations, setting itself apart from peers and delivering leading margins and returns.

Upstream Returns on Average Capital Employed

In the past, Exxon's low-cost resource base and integration have delivered returns on capital in excess of its cost of capital and greater than those of its integrated peers. However, returns have slipped in recent years as spending has increased while production growth has stagnated. Additionally, earnings have suffered with greater exposure to low-value U.S. natural gas, resulting in Exxon's returns falling below those of oil-weighted peer Chevron (CVX).

Employing Our E&P Framework to Assess Exxon's Cost Position
What's in the ground, and what does a firm have rights to? These questions focus on Exxon's proved reserves. Reserves ultimately represent cash flows that a company can use to fund growth. We prefer to see companies with a high percentage of developed reserves and a reserve life index of at least 10 years. We also look at revisions to previous estimates in the standardized measurement calculation, to get a sense of the price levels where certain reserves become uneconomic. Based on these measures, Exxon easily qualifies as low-cost.

Exxon's reserve life has actually increased during the past decade, all the while remaining far above our threshold of 10 years. Both liquids and natural gas reserve lives have increased. At the same time, the portion of developed reserves has remained high, continually above 60%, lending greater certainty to the standardized measure and its ability to capture future capital requirements despite potential cost inflation.

Recorded changes, resulting from revisions to the yearly changes to the standardized measure, give an indication of Exxon's reserve base price sensitivity. Revisions can also include not only changes due to an evaluation or revaluation of new or existing geologic, reservoir, or production data, but also the effects of changes in average prices and year-end costs. During the past 10 years, we can see that Exxon has largely avoided any negative changes resulting from revisions in reserves or the value of the standard measure. This provides a good indication of its low-cost upstream position, as we've seen commodity prices fluctuate over this period. Exxon even avoided negative revisions in 2008, when the oil price at the end of the year was $45 per barrel.

How much does it cost to produce? The answer to this question lies with two metrics: finding and development costs and operating costs. In both cases, relative costs are usually better than absolute levels for measuring efficiency; a firm whose cost structure is well below the marginal cost of production will benefit from a pricing umbrella, which generally ensures long-run viability.

Like its peers, Exxon has seen its F&D costs rise during the past 10 years. However, relative to commodity prices and measured against peers, Exxon remains highly competitive. F&D costs for Exxon have remained relatively stable during the past 10 years despite increasing in absolute terms. If we look at Exxon's F&D as a percentage of oil prices, it has actually fallen. However, that measure ignores the shift toward natural gas in the reserve base. Measuring F&D as part of revenue per barrel of oil equivalent of production, however, takes into account the shift to natural gas as percentage of reserves and production during the past 10 years. By that measure, Exxon still appears competitive, suggesting it should continue delivering excess returns on capital in its upstream segment.

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Another way to measure its relative competitiveness is by comparing its F&D costs with peers'. Lower F&D costs suggest Exxon is not the marginal producer, and therefore would enjoy the aforementioned pricing umbrella that generally ensures long-run viability.

Compared with peers, Exxon continues to replace reserves at a competitive cost. In fact, it has registered improvement since 2009. It's worth noting that although BP (BP) has delivered best-in-class F&D costs, it has failed to replace reserves, while Exxon has expanded its reserve base since 2009.

Cash operating costs indicate how efficiently an E&P can pull oil and gas out of the ground and bring it to market once a well is drilled and completed. As with F&D, Exxon's cash costs have increased, although the entire industry has experienced cost inflation. More important is that measured against revenue, costs remain in line with historical levels. In fact, most of the increase is attributable to production taxes, which are largely driven by oil prices. Exxon's production taxes have increased to 16% of revenue in 2012 compared with 9% in 2002 as oil prices have jumped, but oil exposure has fallen. Meanwhile, operating costs fell to 14% of revenue in 2012 compared with 19% in 2002. With cash operating costs averaging 30% over the past four years, Exxon's 70% cash margins more than clear our hurdle of 50% cash margins necessary to be considered a low-cost position.

Exxon's ability to keep its cash costs under control during the past 10 years also likely speaks to other competitive advantages: size and scale. Even as many E&Ps are ceding economic rents to service firms because of consolidation, Exxon's size gives it the power to negotiate better terms with service companies and negate, in part, leverage that service companies might otherwise have with small E&Ps when capacity is tight. Additionally, given its project queue and financial strength, Exxon continually invests throughout the cycle, allowing it to capitalize in times of oversupply when prices are lower. Given the steady state of investment, service firms are less likely to be able exert significant pricing pressure on larger firms like Exxon. Being the biggest of the big solidifies that advantage.

What can it be sold for? The answer to this question focuses on production mix and price realizations or basis differentials. Typically, we prefer oil-weighted firms, given the higher price for oil than natural gas on an equivalent barrel basis. Exxon's production is split evenly between the two. However, Exxon is a global firm and produces natural gas from all over the world. Outside North America, natural gas is in shorter supply and prices are typically linked to oil, resulting in higher prices. Though not equal to oil prices on an energy equivalent basis, international natural gas project economics remain attractive. Although Exxon is the largest producer of natural gas in the United States, it remains a small part of its overall portfolio at 15%. Total North American production is approximately 16% of total production.

Thanks to integration, Exxon faces fewer challenges when looking to maximize price realizations and minimize basis differentials. Basis differentials typically emerge because of quality differences, regional takeaway capacity, and proximity to end markets. Exxon attempts to mitigate many of these issues through development of its resources, involving downstream management and personnel in the planning stages to maximize resource value.

Most of the integration benefits lie with Exxon's assets, however. With a large global refining footprint with high complexity, Exxon is able to recapture quality differentials in its refining segment. For example, the company plans to run the bulk of production from its Kearl oil sands project through its own refineries. As a result, Kearl production has a guaranteed offtake while its refineries realize the benefit of the crude quality discount in its margin. The crude discount may wax and wane, at times accruing the upstream and other times to the downstream, but in either environment Exxon benefits.

Takeaway capacity is normally less of an issue for Exxon as well. The size of its projects usually requires midstream infrastructure as part of the initial development plan. By owning this infrastructure, Exxon can recapture any rents from transportation costs that an individual onshore E&P might otherwise lose. Also, as the world's largest refiner, Exxon can either process its own crude produced in remote parts of the world or trade against its own portfolio to maximize upstream realizations and downstream differentials, negating many of the issues associated with proximity to end markets.

Measuring the Benefits of Integration
The aforementioned benefits of integration and Exxon's ability to execute on them are easy to point to but difficult to quantify. Depending on the price environment, rents can accrue to either segment, and in different forms. The idea behind integration is that Exxon will capture those rents wherever they appear. However, other integrated firms aim to do that as well. Comparing Exxon's upstream margins with peers', though, shows that it does it better and a clear advantage exists.

Upstream Segment Margins

Exxon posts superior performance despite not having an advantage in operating or F&D costs. Given the discrepancy, we have concluded the higher margins are attributable to integration with downstream assets, superior operating performance, higher-quality/lower-cost non-oil- and gas-producing upstream assets. The combination of these three factors, along with low-cost oil and gas production, results in the peer-leading returns on capital.

Unique Assets Set Exxon's Downstream Segment Apart From Peers'
Exxon's downstream segment earns excess returns thanks to its low-cost position due to economies of scale and unique assets, as well as integration among operating segments. Exxon's low-cost position is evidenced in the excess returns the segment has delivered over the cycle. Even in 2009, when the global refining and chemical markets buckled in the wake of the global recession, Exxon's downstream segment earned its cost of capital when others did not.

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The strength of the segment's returns also differentiates it from peers and explains in part Exxon's dominance in returns on capital. Over the past decade, Exxon's downstream segment averaged 24% returns on average capital employed compared with the upstream segment's 34%. Meanwhile, peers have averaged only 11% for downstream and 24% for upstream. The gap is even more striking when Exxon is just compared with Shell (RDS.A), its closest peer with respect to the size of its refining and chemical operations. Shell's average downstream returns over the past 10 years were 10%.

Low-Cost Position Is Thanks to Economies of Scale and Unique Assets
Our evaluation of Exxon's downstream cost position is less formulaic than the upstream, but still rooted in a low-cost position that stems from its economies of scale and access to unique assets. The economies of scale derive from Exxon's global footprint. Exxon is the world's largest refiner with interest in 32 refineries worldwide with net distillation capacity of 5.4 million barrels a day. It is also the sixth-largest chemical manufacturer in the world with annual sales volume of more than 24 metric tons. The economies of scale also are present on the facility level, as Exxon's average refinery is larger than most peers, especially that of its closest peer, Shell.

Although Exxon's size advantage delivers economies of scale on the global corporate level as well as facility level, we think its unique assets are a greater advantage and really set it apart from peers. Specifically, the integration between Exxon's refineries and chemical manufacturing sites is an advantage that no one can replicate. We estimate 12 of Exxon's refineries totaling 3.4 mmbbl/d, or 63% of its capacity, are part of an integrated refining and chemical complex. An additional 415 mb/d of refining capacity has some associated lubricant production. This amount of integration far exceeds that of Shell, which has five facilities totaling 1.4 mmbbl/d of capacity, or 43% integrated with chemical production.

Exxon realizes numerous benefits that bolster its low-cost advantage from having its refineries and chemical facilities on the same site, such as reduced overhead and administrative costs from shared site management and an ability to leverage common utilities and infrastructure to reduce energy costs. The most valuable benefit from this integration, however, is the feedstock flexibility and product optimization. At these sites, Exxon can process feedstock into the highest-value product based on current market conditions. It can also realize greater value or alternatively lower feedstock costs by sharing feedstock and byproducts between refining and chemical facilities.

Exxon outperforms peers despite a similar business model designed to capture the rents involved in hydrocarbon production and processing irrespective of commodity prices. Exxon does it best by keeping costs low in both the upstream and downstream segments and maximizing integration opportunities to create value. As a result, it delivers peer-leading margins despite having facilities that are otherwise comparable to peers'.

Maintaining the Integration Advantage
We think Exxon's advantages will continue to result in peer-leading and excess returns. First, the integration between refining and chemical facilities will continue to be a strength. Prices of feedstock and products will continue to vary over time and Exxon's ability to maximize the value of each--and capture rents in multiple price environments--will be an advantage. Second, Exxon will continue to benefit from economies of scale, given its assets size and global footprint.

Most important, however, is that we think Exxon is well positioned to take advantage of the emerging feedstock advantage in North America. We estimate North American refiners will have access to cost-advantaged light and heavy crude over the next five years, placing them lower on the global cost curve. With 2.5 mmbbl/d of refining capacity in North America (46% of total) and the majority of that in the Mid-Continent (600 mb/d) and Gulf Coast (1.5 mmb/d) where the crude advantage is greatest, Exxon should benefit. Additionally, 1.5 mmb/d of Exxon's refining capacity is part of an integrated complex with chemical manufacturing, allowing Exxon to further capitalize on low natural gas and natural gas liquid prices.

Meanwhile, Exxon has relatively little European refining exposure at 1.6 mmb/d, where market conditions are likely to be weakest. At 31% of its total, that is less than all its peers except Chevron, which sold all of its European refining assets. Also, Exxon's average refinery size in Europe is 182 mb/d compared with an average 134 mb/d for peers, and 60% of its capacity is integrated with chemicals. As such, despite the market pressure on marginal refineries, Exxon should continue to be well positioned as it benefits from economies of scale and integration.

Exxon's Excess Returns
Exxon's low cost of capital plays a part in its wide moat rating. Although not the lowest of its peer group, it still provides a low hurdle rate to earn excess returns. Combined with higher returns on capital, Exxon generates greater excess returns. This wide spread between returns on invested capital and the weighted average cost of capital, or the size of the excess returns relative to peers', gives us confidence in Exxon's ability to generate excess returns for 20 years, earning it a wide moat. The magnitude of peers' excess returns is less, providing less of a margin of safety and earning them only narrow moats.