Should Investors Reconsider Owning These 2 Oil Giants?

Major, integrated oil companies are not the kind of investment one owns for rapid growth. Rather, the investment thesis behind such companies stems mainly from three points: dividend income, dividend growth, and security. These come through a rock-solid balance sheet and massive diversification.

In the past I've written about two oil majors.One, ExxonMobil (NYSE: XOM  ) exemplifies the kind of "equity bond" mentality that Warren Buffett advises -- in fact, Berkshire Hathaway owns about 1% of ExxonMobil. It's a slow but steady winner, with a 44-year dividend compound annual growth rate, or CAGR, of 7.54% and a Volvo-safe balance sheet. Exxon is one of only three companies with AAA credit ratings from Standard & Poor's -- something not even the U.S. Treasury can claim. 

On a very different note is Petrobras (NYSE: PBR  ) , the largest oil company in Brazil. In my last article, I argued that despite the company's recent (and very long) string of political scandals, with allegations of money laundering and mismanagement -- a $5 billion planned refinery ballooned in cost to $20 billion, creating the most expensive refinery in human history -- it might offer a "dirty value" opportunity.

My investment thesis was that this was a play on Brazil's massive offshore oil deposits and that the management of its offshore divisions was actually proving itself competent. If the politicians who pack its board could get out of the way long enough for the offshore division to execute on its growth plans, Petrobras might be an opportunity for strong capital gains. 

Since those articles were written, certain events have unfolded that I wish to cover, in order to better help long-term investors decide whether ExxonMobil and Petrobras deserve places in their portfolios.

ExxonMobil: what's changed?
In its latest earnings release the company reported mixed results:

  • Net income down 4%.
  • Earnings per share down 1% (due to $3 billion in share buybacks).
  • Capital expenditure (capex) down 28%
  • Daily production down 5.6%.
  • Dividend raised 11%.
As I shared in my last article, management was guiding for a 12.9% decrease in capex by 2015, with a goal of increasing oil production by 4% and gas by 1%. The latest results are promising (capex cuts in just one quarter were twice what was expected over two years), but the declining production might indicate a problem with the company's 120+ ongoing production expansion projects.  
 
However, when it comes to long-term investing, a key principle is that a single quarter's results do not an investment thesis break. One of Exxon's strongest attributes as a long-term oil play is that for 20 consecutive years it has found more oil than it produced. Its current 25.2 billion barrels of reserves cover production for 14 years. However, another key principle is that valuation matters, and here is where potential investors in Exxon might want to pause before hitting the "buy" button.
 
Since February Exxon has rallied strongly (13% is a lot for a megacap). At that time the company was trading with a P/E of under 12, with a 21 year-historical P/E of 15. Today it's at a P/E of 13.6 versus a historical P/E of 14, indicating that a lot of the lowest-hanging capital gains have been picked. With a yield of 2.7% versus an industry average of 3.2%, Exxon is trading at a premium, but given its annuity-like safety and continued strong dividend growth, a strong case can be made that the stock deserves it.
 
Petrobras: turnaround not working
Since my original article I've done additional research and come to the conclusion that Petrobras is simply a "value trap." I cannot recommend it, even as a speculative play on Brazil's pre-salt offshore oil fields. What changed my mind? A few key facts:
  • EBITDA margin in 2003: 28.5%, last year 11.27%.
  • Return on assets in 2003: 15.3%, currently 2.42%.
  • Return on equity in 2003: 49.59%, today 5.38%.
  • Total debt $136.2 billion, denominated in U.S. dollars (the company gets paid in Brazilian Reals, exposing it to currency risk).
The latest quarter's results (and February's oil production data) put the final nail in the coffin. In February oil production dropped to 2.32 million barrels per day (down from 2011's peak of 2.6 million barrels/day). In addition, first-quarter earnings were down 30% year-over-year and adjusted EBITDA declined by 12%. Net income in the first quarter was 51% lower than it was in the first quarter of 2011 (the company's best quarter ever). 
 
The company says its five year, $237 billion investment program will increase production by 110%. However, in the last three years the company has taken on $53 billion in debt with nothing but disastrous results to show for it. 

Foolish bottom line
ExxonMobil is the kind of safe, "hold forever" dividend-growth stock that investors can rely on to do well whenever they buy on dips. Given the recent run-up, the case for buying now is weaker but still there due to a slight historical discount and the security of the dividend. On the flip side, Petrobras is a value trap with a track record that indicates investors should not trust its management with their hard-earned money.

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