International energy giant ExxonMobil (NYSE:XOM) has plans to spend up to $35 billion a year through 2025 on a massive capital investment program. The goal is to reverse a multiyear decline in its production. The only problem is that oil and natural gas prices are low right now, so finding the cash for this spending will be difficult and, increasingly, includes asset sales. Here's what Exxon can do to fund its investment plans and why investors shouldn't be too worried about the moves it's making.
A rough spot
The third quarter was a tough one for oil companies in general, and Exxon didn't avoid the pain. Its third-quarter earnings were down roughly 50% year over year. The upstream operation (oil and natural gas drilling) was the hardest hit, representing roughly two-thirds of the overall decline. The main culprit was "lower liquids and gas realizations," which is a fancy way of saying that the prices of these commodities fell. Unfortunately, downstream operations (chemicals and refining) weren't an offset, with earnings at both falling year over year as well. The main cause here was weaker margins. Simply put, it was a rough quarter.
There was a positive hidden in the bad news: Exxon's production increased about 3% year over year in the third quarter. That shows that its capital spending plans are bearing fruit. This progress, however, wasn't enough to overcome the impact of volatile energy prices. Oil and gas prices are, for better or worse, the biggest driving force at Exxon.
This highlights the big problem this energy giant is facing today. It is investing heavily to increase production at a time when oil prices are relatively low. How Exxon will come up with the cash to keep spending is an increasing concern on Wall Street. The answer isn't easy.
Finding the cash
The first issue that needs to be addressed is that Exxon doesn't really have much of a choice when it comes to investing in production growth. For several years, its production was in decline, which is a trend that can't be allowed to linger for too long. At the very least it needs to work to keep production roughly flat. An oil company that continually produces less and less oil isn't on a sustainable path.
The second issue is how to pay for its investment plans, which are huge. The most obvious choice is to simply take on additional debt. Exxon has the balance sheet strength to do this, with a financial debt-to-equity ratio of roughly 0.15 times. Most of its closet peers have ratios that are at least twice that level. Simplistically speaking, Exxon could double its roughly $26 billion in debt and still be toward the lower end of its peers leverage-wise.
Before you say that $26 billion doesn't even cover one year of the company's spending plans at a run rate of $35 billion, Exxon doesn't need to fund all of its spending with debt. It is using cash flow to pay for as much of its capital program as it can. For example, in the third quarter the oil giant generated roughly $9 billion in cash flow. Around $3.7 billion of cash went toward shareholder distributions, with another $6 billion being spent on capital projects. Those numbers still don't square, since cash going out the door exceeded cash coming in -- so Exxon also sold $1.9 billion in debt and $500 million worth of assets, which more than filled the void (its cash balance actually increased sequentially).
Assuming that it needs to sell around $2 billion worth of debt each quarter to keep the math simple, that's roughly $8 billion a year in additional debt. Exxon's current investment program lasts through 2025, so it has about five years of spending left. That means about $40 billion worth of debt to get through 2025. These are very rough estimates intended to make a larger point; there's clearly a lot more going on here. Still, that would more than double the current debt Exxon has. However, even that would still leave financial debt-to-equity ratios around the levels of its more heavily leveraged peers.
Only Exxon isn't looking to use leverage to fund all of its investment plans; it also intends to sell assets. The original goal was to sell around $15 billion of assets. If you use that offset the debt needs in the simple model just outlined, you bring debt issuance down to $25 billion. That's roughly doubling the company's current debt load, which would leave Exxon toward the low end of peers on the metric.
More recently, though, Exxon has reportedly upped its asset sale goal to $25 billion. This would mean even less need for debt and was likely driven by investor concerns over the company's increasing leverage. Exxon's conservative financial profile is one of its stock's key selling points, so taking on materially more debt is a tough sell on Wall Street. But here's the big question: Is this decision a sign of trouble?
Clearly, Exxon is stating that it needs more cash to help offset the hit from its spending plans. That's not a great situation to be in, largely driven by the fact that oil prices are relatively weak today. However, you need to step back and look at what is going on from a big-picture perspective. As management has explained before, Exxon isn't selling assets willy nilly. Every single sale is being compared to other opportunities in its portfolio, including the ones in which it is investing today but that aren't yet producing.
Exxon's take is that what it is selling, or plans to sell, isn't as valuable as what it's being compared against -- the oil company is upgrading its portfolio as it is selling. Backing that up is Exxon's continuing to find new oil in its biggest development projects, increasing the size of these opportunities. So selling older fields isn't really as big a deal as it may at first seem. And as these assets come on line -- combined with investments the company is making in its downstream operations -- more cash should be available to put toward the company's massive spending plans. Yes, it is tough right now, but Exxon looks like it is still heading in a good direction.
It wouldn't be accurate to say that Exxon is riding high today; there's clearly a mix of good and bad news. Right now the bad news is weighing heavily on its financial results and investor perceptions. But from a big-picture perspective, Exxon remains in decent financial shape and shouldn't have any problems supporting its spending plans.
While the increase in asset sales could be viewed as a sign of financial strain, it's more likely a mix of assuaging investors and a reflection of the strength of its investment pipeline. Investors shouldn't read too deeply into the issue, since production from some of Exxon's big projects is expected to start adding more materially to results in 2020. Production in Guyana, for example, only started in December 2019, and production from its onshore U.S. fields is still ramping up. Assuming that leads to more robust production growth, Exxon remains on a solid path.