ExxonMobil (XOM 1.15%) recently unveiled that it plans to record a historic writedown of up to $20 billion during the fourth quarter. The oil giant is making this move because it plans to throw in the towel on drilling for oil and natural gas in several regions due to low prices. With those areas offering unappealing investment returns, Exxon had no choice but to write down the value of the associated assets.
The company's rip-the-bandage-off approach could spur others in the oil patch to do the same. Three oil stocks that our energy contributors believe might be next in line for a massive writedown are Chevron (CVX 1.33%), Occidental Petroleum (OXY 0.12%), and Diamondback Energy (FANG 0.77%).
The obvious comparison
Reuben Gregg Brewer (Chevron): If you are looking at Exxon, you are almost certainly also examining U.S. peer Chevron. The two companies are in vastly different positions today. For starters, Chevron took an impairment charge of roughly $5 billion in the second quarter. So it has already looked at its portfolio and taken the hit that Exxon is just now announcing. But there's information in the size difference, as well. Exxon has long avoided write-offs, which effectively inflated the number. There's no reason to think that Chevron, which has been more proactive over time, needs to play catch up.
Meanwhile, Chevron is just in a better position all around. For example, its capital spending needs were lower coming into 2020 because it was benefiting from past investments. Exxon, by contrast, needs to invest vast sums today to maintain its production. Which helps explain why Exxon's long-term debt load has increased by roughly 50% since the start of the year while Chevron's has only jumped by 30%. Debt-to-equity at Chevron sits at the low end of the industry at roughly 0.26 times versus Exxon's much higher 0.4 times or so. Exxon's write-off will make that number look worse, since it will reduce shareholder equity.
At the end of the day, Exxon's write-off doesn't forewarn of trouble at Chevron. In fact, Chevron continues to operate from a position of relative strength, including the ability to ink an opportunistic acquisition. For conservative investors, Chevron and its 5.9% yield is really the more attractive choice between these two U.S. energy giants right now.
Another massive writedown seems likely
Matt DiLallo (Occidental Petroleum): U.S. oil giant Occidental Petroleum has already recorded several impairment charges this year due to the impact low oil prices are having on the value of its oil and gas assets. In the first quarter, the company booked $1.4 billion of goodwill impairment charges and equity investment losses due to its investment in MLP Western Midstream (WES -1.42%), which it acquired along with Anadarko Petroleum Last year. The company also took $580 million of impairment and related charges on its domestic and international oil and gas properties in that quarter.
Occidental followed that up with a massive $6.6 billion writedown during the second quarter, including $5.2 billion for continuing oil and gas operations and another $1.4 billion for discontinued operations. Finally, it took another $2.4 billion writedown of its Western Midstream investment in the third quarter and $700 million of losses associated with the sale of its onshore assets in Colombia and its mineral and surface acreage in Wyoming, Colorado, and Utah. Add it all up, and the company has written off $10 billion of assets this year.
Unfortunately, that might not be the end of the red ink. The company paid a gargantuan $55 billion for Anadarko in 2019, a whopping $5 billion above Chevron's rival bid. That price tag was at a significant premium when oil prices were around $60 a barrel. Today, crude is closer to $40, suggesting that Anadarko's assets aren't worth anywhere near what Occidental paid for them. That's evident in the disconnect between the company's total assets and its enterprise value:
This gap implies that the market sees the potential for Occidental to record additional writedowns of as much as $25 billion.
Drilling on thin ice
Daniel Foelber (Diamondback Energy): It's been a tough year on oil and gas prices, so it's no surprise that many oil producing assets are worth less than they were at the beginning of the year. A writedown, or impairment, is an accounting adjustment to asset values. A $5 change in the price of oil can be the difference between scraping by and losing money. And severe price changes can mean assets are worth a fraction of their previous value. The same logic goes toward the upside, where higher prices can make cheap assets valuable.
In the first quarter of 2020, The U.S. Energy Information Administration (EIA) tracked 40 publicly traded U.S. oil producers. The companies wrote down a collective $48 billion worth of assets, the highest quarterly adjustment since the third quarter of 2015. Writedowns can result in financial insolvency and potentially could lead some oil companies to bankruptcy.
In its second quarter, Diamondback Energy recorded a staggering $2.54 billion impairment charge related to lower commodity prices. It's worth noting that this doesn't mean the company had to pay $2.54 billion, it means that the value of its assets, and ultimately its company, is worth $2.54 billion less because it isn't as profitable when prices are lower.
Asset values are one thing, but what about the company's day-to-day performance? How much cash is it generating? Free cash flow can be a better indication of operational performance than net income. But unfortunately for Diamondback, it's been generating a lot of negative FCF for the past five years. In fact, only recently has it turned FCF positive.
Management noted that it expects "to generate significant free cash flow in the second half of 2020 and in 2021 at current forward commodity prices." Capital expenditures are decreasing as well as the company wraps up some big infrastructure projects. This should allow Diamondback to generate the same or higher production while spending less money.
This is a vulnerable time for Diamondback. The company has sustained a high level of spending for years with little cash to show for it. If commodity prices continue to recover, it looks well positioned to return to profitability and generate positive FCF. If they don't, then it wouldn't be surprising to see more writedowns from Diamondback in the coming years. Either way, the risks outweigh the reward and investors are better off steering clear of buying Diamondback Energy stock at this time.