On August 31, ExxonMobil (NYSE:XOM) will exit the Dow Jones Industrial Average (DJIA) in favor of software giant Salesforce.com. The removal marks a transition from the old economy to the new economy, but it also leaves Chevron (NYSE:CVX) as the only remaining oil stock in the index.
Here's why that removal could be a red flag for Exxon investors, and a buying opportunity for shares of Chevron.
A better reflection of the American economy?
Despite its flaws, the rich history of the DJIA and its tethering to certain exchange-traded funds makes it relevant, even today. For Exxon, removal from the Dow is a sign that oil and gas remain out of favor on Wall Street.
Based on S&P 500 Global's comments on its reasons for the index changes, it would seem that its opinion is that Chevron better reflects the American economy than Exxon. The idea was to reduce redundancies in the index by keeping just one oil stock because the energy sector represents a smaller percentage of the stock market than it used to. Today, the sector comprises less than 5% of the S&P 500 and less than 3% of U.S. large cap stocks, down from 6.5% at the end of 2015.
S&P 500 Global's selection of Chevron over Exxon is just the latest blow in a series of disappointing years for America's largest oil company. Over the past decade, Exxon has barely kept pace with the overall energy sector, whereas Chevron has outperformed it significantly.
Chevron's outperformance, particularly over the past five years, is due in part to its spending reductions. Chevron was outspending Exxon and suffering negative free cash flow (FCF) for years as it invested in assets that were not yet operational. But now, Chevron is able to generate more FCF than Exxon while spending less money and operating with less debt on its balance sheet. Exxon has reduced its estimated $33 billion in 2020 capital expenditures by 30% down to just $23 billion, but Chevron plans to only spend $14 billion, down 40% from its original estimate of $20 billion.
Chevron is simply a leaner oil and gas company right now. Its focus is on short cycle investment in the Permian Basin, which is easier to ramp up or scale down based on market conditions.
On the other hand, Exxon has major long term investments in Guyana, Papa New Guinea LNG, and potentially in the "pre-salt" offshore blocks off the coast of Brazil, to name a few.
Given the years of planning and procurement needed for these investments to pay off, Exxon has essentially committed itself to higher spending. It can't afford to simply turn off the tap without taking on massive sunk costs. This commitment is why Exxon estimated capital expenditures to be a whopping $30 billion to $35 billion per year over the next five years.
The industry leader
There are several reasons why Chevron is now the primary representation of oil and gas in the DJIA. Aside from its performance being superior to Exxon's, Chevron has demonstrated industry-leading financial discipline. Even with the addition of more debt to weather the impacts of COVID-19 on the oil and gas sector, Chevron's balance sheet remains less leveraged than those of its competitors.
In addition to its performance and financial discipline, Chevron has shown better profitability than Exxon in both its upstream and downstream businesses.
Most recently, Chevron displayed some impressive patience when it walked away from an expensive acquisition in 2019. Chevron's patience paid off, and it was able to take advantage of the current market downturn by scoring a discount on Noble Energy in July.
The better oil company
Whether you're interested in Exxon or not, its removal from the DJIA is a historic event that marks the next step for an economy that may be less influenced by oil and gas. Chevron staying in the index instead of Exxon doesn't necessarily alter the investment thesis for either company. Instead, it more so symbolizes investor sentiment that favors financial strength and capital discipline (Chevron) over big spending and more debt from a higher leveraged capital structure (Exxon).
Exxon's commitment to long term projects means it's unlikely to reduce capital expenditures any time soon. And with Exxon set to distribute over $5 billion more in dividends each year than Chevron, it's hard to see a scenario where Exxon can afford to reduce debt.
Given Chevron's financial discipline, outperformance, and savvy negotiating skills, the decision to remove Exxon from the DJIA looks to be the right call. Even with a slightly lower dividend yield, Chevron is the better stock to own right now.