IEEFA update: ExxonMobil’s drill, drill, drill strategy earns a “D-“
ExxonMobil’s poor first-quarter earnings report revealed diminished profits, weak revenues, unproven cost reduction strategies, meager asset sales and the need to borrow US$3 billion to make ends meet. The company continued its drill, drill, drill strategy and paid an increase in dividends, even as a gang of ugly financial facts slaughtered its business model.
Its weak Q1 performance produced $8.4 billion in cash flow from operations and almost no asset sales. Out of this cash flow, the company spent $6.9 billion on capital expenditures (capex) and $3.5 billion on dividends. In short, its cash flow from operations did not cover capex and dividends. The company netted $2.3 billion earnings (including proceeds from the debt), down 77% from last quarter.
IT WAS A TOUGH FIRST QUARTER.
Markets took notice. After reaching a mid-week high of $83.38 per share, its stock sank to $77.32 less than a week out from the announcement, a 7.3% drop. The stock has run above S&P 500 performance year to date, but it is flat from last year at this time. Long-term investors know the stock has declined 20% over the last five years.
Crashing margins in its downstream business (refinery and chemical) contributed significantly to the company’s poor quarterly financial performance. The market for some of its key product lines took a hit, driven by oversupply. Instability in Canadian markets proved both ironic and troublesome as mandated production cuts improved oil prices but also reduced refinery margins. There were significant losses in its downstream operation, where the quarterly loss was $256 million, compared to a $2.7 billion profit last quarter. Chemical profits were $518 million, down from last quarter’s $737 million.
Refinery and petrochemical profits, though typically a smaller percentage of ExxonMobil’s earnings than upstream (exploration and production), have historically been more stable. This pressure on profits from its downstream business could be a one-quarter aberration. A potentially more troubling explanation could be that the volatility facing the rest of the industry may now be affecting downstream performance.
The company is betting heavily on fracking in the Permian Basin
The drill, drill, drill strategy continues – more barrels, less profits. The company is doubling down on exploration and production (E&P), having announced it would spend $30 billion in capex in 2019. And the Permian Basin remains a key focus of ExxonMobil’s U.S. exploration investments, where the company is betting heavily on fracking. But, so far, this strategy has not succeeded. The company’s upstream profits in the U.S. this quarter accounted for 4% of worldwide earnings and 37% of its capex. Over the last five quarters, U.S. upstream accounted for 8% of worldwide earnings and 30% of worldwide capex. To put this into focus, E&P in the U.S. consumes roughly one-third of the company’s total investment capital, but, as a percentage of ExxonMobil’s worldwide returns, produces only single-digit profits.
EXXONMOBIL’S CANADIAN SUSIDIARY, IMPERIAL OIL, HAD AN EQUALLY DISMAL QUARTER. Profits declined by 49% and the company announced capex reductions for the rest of 2019. The capex reductions come less than 90 days after the company rebooked 3.2 billion barrels of oil sands reserves, presumably because of improved market conditions.
Oil and gas prices were down during the quarter, but the drop was nowhere near the losses ExxonMobil experienced. ExxonMobil’s price realizations for oil remained in the high $50’s, a relatively safe zone, according to recent company reports. Investors have been peppered over the last year by ExxonMobil and Imperial Oil’s claims of dramatic cost reductions. Both companies are asserting their ability to withstand a prolonged period of low prices. Imperial’s performance this quarter, however, did not demonstrate any fruit from these cost-cutting measures.
The improvements in upstream prices, however, had a greater downside impact on Imperial’s bottom line. The Alberta government ordered a production cut of oil sands — over Imperial Oil’s objection. The production cut improved upstream prices for Imperial’s oil production, but resulted in higher costs for its refinery operations. This reduced refinery margins at a time when the company was particularly dependent on strong returns from its downstream to offset the weak upstream profits.
THE WEAK EARNINGS REPORT RESURFACED SOME OLD DISCLOSURE ISSUES, AND RAISED A FEW NEW ONES.
- The company de-booked 3.5 billion barrels of Canadian oil sands two years ago and re-booked 3.2 billion barrels in February 2019. Two months later, Imperial Oil has announced falling profits and cuts to its capex program. The depiction of a robust market implied by the rebooking requires greater clarity and explanation.
- After numerous earnings shortfalls, industry analysts have pressed the company’s CEO to participate in earnings calls. (The company has a long-standing tradition of keeping its CEOs off these calls.) ExxonMobil’s current CEO, Darren Woods, acceded to this demand during the Q4 2018 earnings call, the first time in 15 years that an ExxonMobil CEO had participated in such a call. However, Woods was nowhere to be found on the Q1 2019 earnings call, leaving it to others to deliver the tough news.
- In a rare statement by a stock analyst, Doug Leggate of Bank of America observed that a recent company filing to the Securities and Exchange Commission (SEC) that contained downward profit estimate revisions was unaccompanied by a press release. In essence, the bad news was hidden, or at best, downplayed. By contrast, the company provides press releases when filing 8-K ‘current event’ reports.
THE REPORTING MECHANISMS USED BY THE COMPANY ARE NOT KEEPING PACE WITH BASIC MARKET CHANGES. The result is increased opacity at a time when transparency is required. It is no longer enough to provide broad accounting categories to explain company performance. For example, the run-up in capex in the Permian Basin and the claims of extraordinary profitability clash with numbers that show ExxonMobil’s U.S. upstream earnings were less than 4% of its worldwide upstream earnings. If Permian Basin assets are now, and will continue to be, the go-to workhorse, then its accounting and performance needs to be reported separately from other U.S. segments. Within the Basin, performance needs to be spelled out in greater detail. Failing profitability is raising questions about well completions, life cycles and cost of production.
ExxonMobil’s thesis is that overall demand for fossil fuel products will remain strong and permanent.
The company also combines reporting on its Argentine and Canadian investments. Investments in Canada are distinctly troubled despite the company’s puzzling decision to rebook 3.2 billion barrels of oil sands. And Argentina is apparently of interest to the company at a time when the investment environment is increasingly risky and the company is stepping back from making long-term commitments.
ExxonMobil’s business model assumes that the company benefits from internal synergies. The company’s investment thesis is that overall demand for fossil fuel products will remain strong and permanent. Under this theory, integration will allow ExxonMobil to benefit even when parts of the industry falter. And profits, often pumped up by asset sales, can remain consistent and dividends can be increased.
This quarter’s results demonstrate that the theory has a sour spot. Oil and gas prices dropped modestly, from relatively stable but low levels. Upstream profits got hammered. Downstream and chemical sectors could not weather technological changes, governmental policy shifts and highly nuanced impacts on company price realizations. Even lower oil and gas price inputs for the downstream business were not enough to lift earnings.
ExxonMobil’s response to this dismal financial performance is to announce new drilling, new refinery capacity, high technology efficiency innovations and new oil and gas-related product lines. To a hammer, everything looks like a nail.
Authors
Tom Sanzillo ([email protected]) is IEEFA’s director of finance.
Kathy Hipple ([email protected]) is an IEEFA investment analyst.
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