It's barely February, and there's no denying that 2020 has been a hard year for energy investors. Year to date, the energy sector, one of the 11 sectors in the S&P 500, has fallen 10% compared to the S&P 500's 3% gain. For long-term ExxonMobil (XOM +0.95%) shareholders, the pain has been even worse, as Exxon closed below $60 a share on Feb. 11 to mark a fresh 9-year low.
It is in tough times like these that ExxonMobil shareholders, and those interested in the company, need to determine if Exxon remains a sound investment.
Commodity prices
Before going further, remember that energy stocks are cyclical and respond to changes in commodity prices such as oil and natural gas as well as the byproducts of oil, such as the most common plastic in the world, polyethylene, which is used in plastic wrap, plastic bottles, grocery bags, and much more.
Commodity prices are one of the biggest risks for investing in ExxonMobil, and that risk has been amplified by recent movements. Natural gas prices have hit a 3.5-year low. West Texas Intermediate (WTI) crude oil, the commonly quoted benchmark along with Brent, recently fell below $50 a barrel, a 13-month low.
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For an integrated oil and gas company such as ExxonMobil, the silver lining to low oil and gas prices has historically been downstream in that refining operations become cheaper due to lower input costs. Yet Exxon's chemical and refining margins are near the bottom of their 10-year ranges, which, when compared to 4Q 2018, contributed a negative $1.62 billion difference for refining and a negative $670 million difference for chemicals. Lower gas prices represented a negative $680 million difference. In fact, Exxon's results would have been much worse had it not been for nearly $3.7 billion of income from a Norwegian asset sale that contributed over half of Exxon's upstream income for the quarter.
Commodity prices are particularly impactful for Exxon. The company prides itself on innovating to be the best oil and gas company in the world, whereas competitors such as Royal Dutch Shell (RDS.A +0.00%) (RDS.B +0.00%) see a future in renewables and, according to Bloomberg, led supermajors in clean energy investments last year.
Unfortunately, there's little hope in the short term that commodity prices will turn toward the upside. As a result, companies large and small have set their sights on the Permian Basin where they think lower break-even costs per barrel can be obtained by fracking the region's vast reserves. The Permian has been the go-to growth answer for Exxon and Chevron (NYSE: CVX), but that growth is dependent on large acreage holdings and heavy investment. Exxon's goal to produce over 1 million barrels of oil equivalent per day (boed) by 2024 and return 10% at $35 oil is a big bet on the profitability of the Permian.
Allocating assets to the Permian by diverting from legacy assets, as Exxon demonstrated by selling assets in Norway in 4Q 2019, helps fund infrastructure builds necessary for Exxon's expansion of upstream and downstream segments. That being said, falling oil prices can cripple the bottom line to the point where investment may seem too cavalier. Many of the 5-year growth initiatives set by big oil management teams are dependent on steady oil prices around $55-$65 per barrel, as it had been for most of 2019. Simple math tells us that if a company's average breakeven price across assets is, let's say $45 per barrel, and oil was $60, then profit margin would decrease by two-thirds in a $50 per barrel environment. That leaves little profit to spare, especially when a good amount goes toward current and future dividend obligations. ExxonMobil has grown its dividend for 36 consecutive years. In sum, $50 oil is a big problem for Exxon because it reduces profits which hinders funding which limits the ability to scale effectively. Without scale, there will likely be even lower margins for Exxon.
Another headwind to short-term commodity prices is China's lower demand for oil in response to the coronavirus. "Just a few weeks after the outbreak of the virus, daily Chinese oil demand is already down 20 percent because of dwindling air travel, road transportation and manufacturing," said a recent New York Times article. "Since China consumes 13 of every 100 barrels of oil the world produces, every oil company is being hit to some extent," the article continued.
Oil demand has fallen mostly from the transportation industry, with airports on lockdown and international commerce running at diminished rates. Forecasts for 2020 were originally optimistic, predicting another year of record global consumption largely fed by U.S. production. That outlook looks increasingly unlikely.
Relevance of oil and gas
Even with the rise of renewables, oil and gas still play a vital role in the energy mix of today. Going forward, though, things could change.
The general consensus among research firms such as McKinsey & Co., Wood Mackenzie, and IHS Markit is that natural gas in particular will continue to play a vital role in the power generation and industrial sectors, although residential and commercial use declines significantly. The EIA's 2020 Energy Outlook, released in late January, predicts that renewables will be the "fastest-growing source of electricity generation through 2050." McKinsey expects 3% U.S. natural gas growth per year between 2020 to 2025, 1% to 1.4% from 2025 to 2035, and 0% between 2035 to 2040, with almost all growth into 2040 occurring from LNG exports to China, India, and emerging markets. Around 1 billion of the world's population continues to live without electricity, and every natural gas power plant or LNG import that's delivered instead of coal is a win for the environment. In this way, natural gas can make a difference.
The switch from coal to natural gas is sweeping the United States thanks to the 45% reduction in CO2 emissions achieved when switching from coal to natural gas combustion. Developing countries are also building infrastructure around natural gas. As far as oil, it dominates the transportation sector in the form of distillates like diesel and jet fuel. Plastics are used in everything from household products to clothing. Simply put, the world still runs on oil and gas, its greatest benefit being as an alternative to coal. Renewables should increasingly play a pivotal role in the energy mix, but they can work together with fossil fuels.
In need of a change
Forecasts and the long-term relevance aside, big oil has cornered itself into an undeniably bleak predicament. Several headwinds, some of which, are self-inflicted, have converged to produce bleak and borderline terrible financial results. It's a blow to the majors and downright existential for smaller companies. In Q3 2019, the number of North American Exploration and Production (E&P) cumulative bankruptcy filings since 2015 topped 200 according to Houston-based corporate law firm, Haynes and Boone.
For what it can control, the oil and gas industry may need to consider decreasing production to stabilize prices. This would also cut spending in the short-term. In terms of buyers, the main market is in developing countries, many of which still lack the infrastructure necessary to import and deliver natural gas. The fact of the matter is that although US production is on the rise, OPEC's spare capacity is at a 10-year high, and that doesn't include the millions of barrels of oil lost in places like Venezuela, Iran, Nigeria, and more. Simply put, the oil and gas industry got too good at producing oil and gas, and no one knew when or how to tone it down.
The diversified portfolios of the majors will partially insulate them from this potential downturn, but there's no doubt that the ripple effects of high supply will permeate throughout the industry.
The verdict
XOM Debt To Capital (Quarterly) data by YCharts.
ExxonMobil takes center stage as a company whose troubles are far from over. Although the near term looks rough, Exxon still plays a crucial role in global industry. The company's balance sheet has improved, sporting the second-lowest debt-to-capital ratio among supermajors. It now yields 5.7%, the most in over 10 years. Still, ExxonMobil is hard to justify as a true value stock in this environment. Its competitors, most notably Shell and Chevron, are also attractive at these prices, and in my opinion, they have an edge against Exxon over the long term. Shell, in particular, has a huge gas portfolio, which could be a safer commodity than oil over the next few decades.
Exxon isn't a pretty stock right now. Its recent woes are justified by lackluster earnings and a slew of headwinds. At this price, though, it wouldn't be the worst idea to try the classic Foolish principle of buying in thirds. It's a good strategy for when a stock comes down in price, but you're hesitant to jump in all at once.
