Description

Exxon Mobil offers a very attractive risk/reward given its highly scarce and irreplaceable asset base comprised of among the lowest cost energy assets in the world, a world class chemicals business, and one of the most complex refining operations in the world. At just over 10x 2011 my $7 estimate and at a steep discount to net asset value, XOM shares offer a very good entry point.  These are the cheapest and arguably the highest quality oil barrels in the world.  At the end of the day, this is one of the world's best franchises, earning returns on equity north of 25% through the cycle with a long track record of excellent returns on capital, and of capital. Not least the stock is trading at its lowest price to book multiple in some 15 years implying returns will go down by a signficant amount despite some high return projects that the company has on now (Qatar) and coming on (Kearl Oil Sands).  While many are pointing to the dilutive nature of the XTO deal, I believe the market will look back at this acquistion as it does at XOM's last acquistion which was Mobil in over 10 years ago: i.e. a smart acquistion at close to the bottom of a tough cycle.

 Attractive Risk/Reward:

• XOM has dramatically under-performed since the market bottomed last March rising about 13% against the market's signficant rally.  This underperformance is in spite of the oil curve having moved up considerably in the past year.
• With XOM's earnings set to grow meaningfully due to higher year-over-year commodity prices and new projects online now and furhter coming over the next 2 years, I believe the stock presents quite attractive, yet defensive upside.
• All three of its major business should accelerate sequentially with ultimate mid-cycle earnings well north of $7/share.  To this point, I would say that over the cycle, chemicals and refining are 20-30% of the business and both seem to have troughed in late 2009.  I would pay special attention to the chemicals business which should surprise to the upside as it has already eclipsed prior cycle peaks.

 Valuation:

• Excluding the acquisition of XTO, XOM owns ~73bln billion barrels of potential oil-equivalent resources basically evenly split between liquids and gas.  Of the ~73 billion barrels, 22.9 billion are "proved reserves" and ~50 billion are potential resources.  Proved reserves are classified as such because they have a high probability of being realized.
  • As a rule of thumb, a barrel of proved reserves is generally worth between $12 and $18 per boe (barrel of oil equivalent).  Currently, the large cap E&P peers are trading at a median of $16/barrel of proved reserves.
  • If you multiply XOM's 23 billion barrels of proved reserves by $15/barrel you get about $345bln of value.  Clearly, the market is not ascribing as much value to XOM's as it is to other E&P's despite XOM's lower cost reserves and its massive resource potential. I assume this is due to production growth being flat to slightly negative for a while now and I will address this below.
  • I would argue that this is actually understating XOM's proved reserves because when measured on a profit/unit basis, it stands above most of its peers.
  • When I build a quick and dirty discounted cash flow on the company's 23bln barrels of proved reserves for which I use pretty conservative assumptions, I get about $300bln of value. I'm happy to provide more details should anyone want.
• So with XOM at $70, the market cap is ~$360bln. Taking my DCF value for the proved reserves of $300bln, here is what we are getting for $20bln:
  • ~50 billion barrels of resource potential
  • Among the best chemical businesses in the world
  • Among the best refiners in the world
  • And XTO...
• On an EPS basis, the stock is trading at ~10x 2011 estimates that seem too low but this is cleary a very difficult company to have confidence in a quarterly or yearly EPS estimate.  However, looking at the earnings and asset base, it is less difficult to estimate a normalized earnings number of $7+.  I believe that a company that provides inherent inflation protection, owns a portfolio of highly scarce asset that grows faster than global GDP on a per share basis, and earns returns on capital higher than 20% through the cycle should trade at much higher than 9 or 10x earnings.
  • I think it's worth noting that out of the 25 analysts who cover XOM, 14 have holds or sells.
  • For the typical energy investor, XOM has been a source of funds for years as investors have flocked to higher beta E&P names.

 Misperception:

• Sell-siders and many E&P management teams clearly obsess over production growth and many do it at the cost of shareholders as they issue debt and/or equity to acquire acreage and to dig oil or gas out of the ground.  In fact, most E&Ps seem to spend all their cash flow and whatever the capital markets will provide to grow production.  I don't believe this is shareholder friendly in the long run.  Production growth is important but only if it's at acceptable returns. It's like a homebuilder buying land at any price for the sake of reporting "land growth" or a retailer driving same store sales with negative operating margins...XOM, on the other hand, approaches its capital allocation decisions purely from a returns decision and has proven that is has a very strong appetite to return capital to shareholders when it is best to do so.   They actually have returned a tremendous amount of capital to shareholders over time resulting in per share growth and value created that easily beats any E&P I have looked at.  I can't help but think about all the M&A they likely passed up for their own shares.
• With XOM, importantly, analysts are right that XOM has produced around 4 MMBOE/d for the last decade since the Mobil acquisition; however, the Company has also repurchased 32% of its shares outstanding since 1998 (a -3.8% CAGR), so on a per share basis, XOM actually stacks up to the competition well with mid-single digit production growth per share.
• Some stats:
• Through mid 2010, the comapny returned over $90bln of capital in the last 3 years in dividends and buybacks. Over the last 5 years the number is over $170bln! Most of this has been through share buybacks that just accelerated again to $5bln for the 4th quarter alone.
• The comapny has returned over 50% of operating cash flow very year since 2005 with 4 years over 70%.
• ROE has been norht of 30% every year except for 2009 when it was 17.4%. 
• Based on its pristine AAA balance sheet and current Upstream/E&P project outlook, and focus on returns, I anticipate that the coming years will see similar per-share value creation.
• Not least, I do believe that Q409 marked an inflection point in production growth and the next 5 years will be far better than the previous 5.  Importantly, XOM has now brought on some massive LNG projects in Qatar that it has spent that past 5-8 years working on.  From a few calls I've done, these projects are coming on at higher commodity prices than were modeled for when the contracts were signed and the incremental returns on these projects from here should be very high.  These are highly capital intensive projects but the capital is front end loaded with very little capital needed once the projects go live with operating costs at about 1-3% of the upfront capex. So we are entering the sweet spot where the new facilities start generating returns with very low capital intensity going forward.

Capital Structure/Capital Allocation

• I believe the market with look back at the XTO acquisition favorably within 2-3 years.

Catalysts:

• In the past few months, XOM has brought online some large LNG projects that up until now have been uses of a lot of capital expenditures.  The interesting thing about LNG projects is that after the initial capital is spent, the operating costs are very low (~1-3% of total capital spent) and so the cash flow expands pretty dramatically after the project is brought on.  Not least, the projects just brought on were signed up 6-7 years ago before the big run in commodity prices and so XOM's returns are likely far higher than they thought they'd be or than they negotiated for.  The projects coming online will likely help production growth accelerate and returns of capital expand for these reasons. Specifically, net income per barrel has recently turned and I believe it will accelerate going forward putting to bed fears that returns here are set to go lower.
• Cyclical/Sequential pick up in XOM's chemical and refining businesses. (I spent relatively little time in this writeup on these businesses given they are less than 20-30% of earnings over the cycle but the cost structure and returns profile of these businesses are significantly higher than most in their respective industries.)

 Valuation: Another way to frame valuation is that they earned over $1 in Q408 and Q109 which were clealry among the toughest quarters in a long time. Annualizing that number to $4 and adding XTO earnings get you to 15-16x trough earnings for a world class business.

Some comments on XTO acquisition:

• In December XOM announced its intention to buy XTO with stock and $10bln of debt for $41bln-its first deal in over 10 years.  The market has frowned upon this deal saying that XTO will dilute the XOM returns (by as much as 400bps) and therefore XOM should lose its premium to other big oil companies.
• I look at it differently.
  • The spread of oil/gas ratio is well above norms with the gas market currently oversupplied. In a sense, XOM maybe playing for the eventual mean reversion of this spread while locking in significant North American gas resource at a decent price (~$3/mcf on a proved reserve basis).
  • XOM is buying a very good natural gas asset at what will likely be the cycle trough. It fills a whole in its portfolio of assets (North American gas) with a best-in-class management team, expertise that it can leverage, and bets on its previously stated long term vision that natural gas will demonstrate good growth in demand over the next 20 years. To this XOM adds a bullet-proof balance sheet and scale, which are competitive advantages in a US natural gas industry that is levered and beholden to hedges and drilling to "hold" acreage.
  • If, in fact, the ultimate recoveries of the new shale resources are not as high as all the management teams currently tout, this may prove to be a very good investment for XOM as it would be able to use its balance sheet to curtail production in the short-term for the sake of higher prices down the road.
  • The implied value of XOM's resource based on what they paid for XTO is much higher than the market is paying today.  XOM paid just under $18/boe of proved resource and just under $5.50/boe of total resource.  With the North American gas industry drilling what may be uneconomic wells due to hedges and to hold leases of land they own, XOM may be taking a longer term view on what this land is worth and with its balance sheet, it can easily pull back on production and wait for a better time to drill. 
  • Over the long run, the merits of this deal will depend on how much XOM can lower XTO costs, how beneficial a balance sheet of XOM will be to XTO's asset base, what the ultimate recoveries of shale gas are, and what really is the marginal cost of US natural gas.
  • In the short run, it is likely dilutive to earnings, but accretive to cash flow and volumes.

Catalyst