Read This Before Investing In Exxon

March 30, 2018

Read This Before Investing In Exxon

  • I’ll discuss the current earnings and XOM’s long term forecast. I’ll also discuss some factors that might jeopardize the forecast.
  • I’ll talk about why XOM is falling.
  • And I’ll conclude with a risk reward view on XOM.



Introduction

Exxon Mobil (NYSE: XOM) is down 11% year to date and I’ve seen many headlines discussing how the stock is extremely cheap and a bargain.

I’ll first discuss why the stock is dropping, analyze the company, and then give you my view on the risk and reward of investing in XOM. 

Why Is XOM Falling?

An 11% drop for a blue chip like XOM is a big deal.

Figure 1: XOM’s stock price year to date. Source: CNN Money.

The major drop on the above chart was due to missed earnings expectations and since then, the stock price drifted even lower which means that something serious is going on. Earnings disappointed when global production was down 3% and Q4 2017 earnings came in at $0.88 which missed expectations by $0.15. The revenue miss was $7.7 billion on $66 billion of actual revenue. Consequently, the cash flows disappointed and increased CAPEX spending is also something Wall Street doesn’t like.

Long Term Perspective

Let’s look at XOM from a long term investing perspective and go beyond the next few quarters that Wall Street usually focuses on.

Positives for XOM:

Oil Prices

In the last two years, oil prices have more than doubled. This is excellent news for any oil producer.

Figure 2: Oil prices in the last 5 years. Source: Bloomberg.



Further, XOM expects both demand for oil and gas to grow in the future where new investments are necessary to cover for the difference.

Figure 3: XOM’s view of oil demand in the future. Source: XOM.

And XOM’s expectations are what is priced into the price of the stock. More about the other side of the story in the negatives for XOM.

Higher Earnings

So, if oil prices increase or stay at current levels, XOM hopes to see huge earnings growth, even if oil prices drop to $40.

Figure 4: XOM’s earnings outlook. Source: XOM.

As current earnings are $4.62, the expected EPS by 2025 could be $6.23, $9.47, $10.8, or $15. Thus, at the current stock price, we could see a PE ratio of 12, 8, 7, or 5. The conclusion with XOM is simple, it all depends on oil prices and it’s also important to understand that the management will always be extremely optimistic, that is in their job description.

So if things stay as they are, XOM will do well with the usual ups and downs. However, if things change in this fast changing world, XOM might not be a great investment after all, especially at the current valuation of 16. Let’s take a look at the potential negatives.

Things Going Against XOM

Climate Change Lawsuit

New York City’s lawsuit where the city is suing petroleum majors for climate change effects. This might sound frivolous, but the case is that the big oil companies intentionally deceived the public by not showing their climate impact research in order to sell more fossil fuels. This isn’t priced into the stock, but might be something huge down the road. More about the case here. This looks crazy, but we all know politicians are crazy and if the people vote for such ideas it will be good for the environment but not good for XOM.

But, the biggest challenge and risk for oil is the EV trend.



Who Is Right? Automotive Producers Or Oil Companies?

Big oil only woke up to the threat of EVs in 2017 when OPEC quintupled its EV projections and the big oil companies also increased their projections. However, there is still a huge divergence between what oil companies say and what automotive producers say.

Figure 5: OPEC’s changed view on EV implementation. Source: Bloomberg.

The divergence in expectations is the key factor to watch when contemplating what will happen.

Figure 6: Divergence in expectations between groups of different interests. Source: Bloomberg, compiled by author.

My personal feeling is that all of the above assumptions will be completely wrong and that the world will be a much different place than it is now by 2040. My personal hope is that we burn no more fossil fuels that pollute the environment.

What’s the key factor in what will happen? A factor that doesn’t have anything to do with heart, but it still is the most important factor – cost. As soon as the cost of EVs are below the internal combustion engine, bye, bye oil. And that isn’t something I would bet my money against for a 4% dividend yield.

To quote Bloomberg New Energy Finance:

Source: Bloomberg.



The key is that estimations are usually always underestimating the real trends because we are trained to think in a linear way in a random world.

Figure 7: IEA estimates from 2006 have already been blown away. Source: Bloomberg New Energy Finance.

What Does This All Mean For Oil Prices & XOM’s Value?

Well, a 1.7 MBOED decline in demand in 2009 lowered oil prices from above $120 to $36. Consequently, the share revolution did the same again in 2014.

Figure 8: 10 year oil prices. Source: Macrotrends.

As demand for oil is expected to decline by 8 million barrels per day just due to electric vehicles, not even discussing improvements in engine efficiency, oil prices could be much lower.

My point is that you won’t see stable declines in oil prices. Supply gluts will provoke sharp declines and panics on stock markets which will increase the volatility in the markets and quickly change expectations. This will probably lead to the continuation of the same trend that has plagued XOM in the last 10 years and made it underperform the markets.

Figure 9: XOM’s stock price is down over the last decade. Source: Seeking Alpha.



Conclusion

What no one knows is the timing of all of this. However, as investors, we have to look at the risk reward of each investment. Given the risk and reward, XOM doesn’t really look like a sound investment at this point in time and I didn’t even mention higher interest rates coming and a possible recession in the next few years which would dampen demand for energy related products.

The point is that oil prices won’t fall anytime soon, but the key is in what lies ahead. If XOM plans to spend $30 billion in CAPEX per year up to 2025 only to find much less demand than expected, the value of the company could be zero.

I don’t know when EV costs will fall below the current ICE costs, but it is very likely it will happen in the near future. Just compare it to the cost of international calls 20 years ago and today; extremely expensive vs. free. When Steve Jobs introduced us to the iPhone, few estimated that it would be a disruptor for cameras, payment cards, watches, and GPS systems, but it has been. There is a probability that EVs have a similar impact.

The whole EV disruption story might sound like tapping in the dark, but that is the key to watch when investing in oil companies. Everything else is less important.