The energy industry is in the doldrums, and there’s no way to sugarcoat it. On top of that it has to deal with a negative environmental image. Put simply, ExxonMobil (NYSE: XOM), the one energy company I own, and its peers are getting hit from every direction. I think Exxon can survive these tough times, but that doesn’t mean investors should ignore the facts. Here’s a quick reality check and why I think Exxon can get to the other side of this tough stretch in one piece.
A tough time for Big Oil
Looking at the very big picture, global warming is definitely taking center stage today. Those with an ESG focus might prefer to see Exxon and its peers go out of business, which many environmentalists would cheer as well. That isn’t in the cards today, since carbon-based fuels remain vital and entrenched energy sources, but the bias against energy stocks is a headwind they have to face on Wall Street.
Image source: Getty Images.
Digging in a little deeper, toward the end of 2019 Exxon CEO Darren Woods pointed out just how widespread the problem is in the energy space. On the upstream side of the equation (energy drilling), the prices of oil and natural gas both remain toward the low end of their 10-year ranges. These are commodities, so Exxon can’t do anything about prices. And since drilling is Exxon’s largest business, weak pricing is tough.
Normally, low oil and natural gas prices would be offset by the company’s downstream operations (chemicals and refining). The logic is simple: Oil and gas are key inputs on this side of the business, so cheap prices should be a net benefit to these operations. Only margins in Exxon’s chemicals and refining businesses are near the bottom of their 10-year ranges, too. So what would usually be a positive in a tough oil price environment is today also a negative.
Adding to the bad news is that Exxon’s production has been falling for a few years. To fix that, Exxon is spending heavily on exploration (upgrades to its downstream operations are also part of the spending), with as much as $35 billion a year earmarked for capital investment through 2025. Weak financial results due to troubling market conditions, however, mean that Exxon is going to need to lean heavily on its balance sheet to get through the next few years. Investors are not pleased.
At this point, there’s not a lot going that’s likely to change this scenario for the better. For example, energy prices are likely to linger at around current levels because of the supply-and-demand dynamics in the market. On the supply side, U.S. energy production has exploded in recent years, upending the historical equilibrium in the space. Fracking tends to ramp up quickly when prices rise, keeping a lid on the price of oil.
Natural gas, meanwhile, ends up being a byproduct of increasing shale oil drilling. So even if natural gas-specific drilling efforts are curtailed (reducing supply), gas production is likely to remain relatively high and continue to be a headwind to this fuel. Exxon’s efforts to increase its own production are good for the company in many ways, but they will help hamper energy prices.
How Exxon can be a survivor
That said, it is positive (perhaps a mixed blessing) to see that Exxon appears to have turned a corner productionwise, with key metrics here turning higher throughout most of 2019. The bigger benefit, however, is that Exxon is working to improve its portfolio of assets so it has more profitable operations — replacing expensive-to-produce oil with less expensive new production.
And, as its capital investment activities turn into operating production assets, its return on capital employed (effectively a measure of how well it uses shareholder capital) should start to pick up. Falling ROCE has been yet another headwind hampering Exxon’s shares. Essentially, Exxon is trying to control the things it can in a tough pricing environment so it can come out the other side of this oil downturn a stronger company.
However, equally important in this environment is that the oil major is working off of a strong foundation. Specifically, Exxon’s financial debt-to-equity ratio is roughly 0.15, giving it a rock-solid balance sheet. It could double its debt load and still be within the same range as most of its peers. In addition, it is selling lesser-quality assets to help offset the spending. That improves its portfolio and helps reduce its need to issue debt. Yes, leverage is going to increase over the next few years, but Exxon’s balance sheet can handle it, and management is doing what it can to soften the blow.
Reality bites, but not too much
Exxon’s 5% yield is near 20-year highs. Its price to tangible net worth is near 30-year lows. The oil giant appears to be on sale, which should interest dividend-focused investors and those with a value bent. That, however, is the good news. The bad news is that Exxon is in the Wall Street doghouse for very good reasons, and there’s not a whole lot on the horizon today that appears likely to change that.
I’m willing to hold through this storm, reinvesting my dividends, in the belief that the supply/demand imbalances in the energy space will correct themselves over time. And when that happens, based on what Exxon is doing today, it will be well positioned to prosper. However, I would be fooling myself if I believed that all was well here. This oil giant is still muddling through a rough patch, and that will remain true for the foreseeable future unless something material changes in the energy sector. My bet is that it can handle the strain.
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