Last week, Berkshire Hathaway (NYSE:BRK-B) disclosed a 0.9% stake in ExxonMobil (NYSE:XOM), the world's largest oil and gas company. However, this isn't the first time that soft drinks-to-financials conglomerate has invested in an integrated oil company. When Berkshire increased its stake in ConocoPhillips (NYSE:COP) to 5.7% in 2008, the energy company was still functioning as an integrated oil and gas major.
However, in April 2012, ConocoPhillips spun off its refining segment as a separate stand-alone entity -- Phillips 66 (NYSE: PSX) -- a move that has paid off handsomely for investors. This spinoff subsequently unlocked the hidden value for both the independently run upstream and downstream majors.
Is something similar suspected at Exxon?
The question that Fools need to ask is: What exactly did Buffett have in mind when he acquired a stake in ExxonMobil last week? Is something similar expected at Exxon? Let's explore.
This is how ConocoPhillips has performed since Buffett acquired a stake in early 2006:
And this is how Phillips 66 has performed since it was spun off as an independent refiner:
As an integrated oil company, the exploration and production, refining, and transportation and marketing divisions are housed together as a single entity. In many ways, the integrated structure was one of the most efficient ways to be in the business of producing and selling oil and gas. In fact, this structure dates to the 1870s, when John D. Rockefeller's Standard Oil started consolidating his refining business by buying up pipelines for oil transportation. Eventually by 1890, Standard Oil extended its business into exploration and production. In the words of eminent oil historian Daniel Yergin, "Rockefeller created the vertically integrated petroleum company."
For more than a century, the integrated structure of oil and gas companies has been arguably among the most profitable undertakings in any industry. It's no surprise that the hugely successful Standard Oil had to be broken up in 1911 because of an increasingly monopolistic hold within the industry. The seven successor companies -- having evolved under various mergers and acquisitions -- have been highly profitable, too. Among them are ExxonMobil, Chevron (NYSE: CVX), Conoco (before its merger with Phillips to form ConocoPhillips), and the American arm of BP (NYSE: BP). In short, the integrated structure served the oil and gas business extremely well.
Why was this structure successful?
One of the biggest reasons corporations preferred the integrated structure was the efficiency it brought about. Since its discovery in the 1850s, oil had been subject to various demand and supply shocks that saw various bubbles being formed at different periods of time. The integrated structure, on the other hand, brought about the much-required stability into the business because of which corporations didn't really have to depend on third parties to buy or sell oil. Instead, they could extract the black gold from their own properties, transport it via pipelines in which they held majority stakes, refine it into various products in their own refineries, and market them under their own brands.
Initially, entire operations took place within the United States. However, as these corporations started building deeper cash reserves, operations began to expand around the globe, especially exploration and production. Huge legacy assets ensured easy access to large reserves of oil that served these companies for decades.
However, in the past 10 years, global energy demand took a sharp turn north as emerging countries started developing at a dramatic pace unseen till then. Naturally, oil prices shot up. Eventually, it became clear that easy oil production can no longer sustain the ever-increasing global demand for oil and gas.
Reserves once considered uneconomical to produce started becoming serious business prospects. Higher crude oil prices afforded expensive -- but game-changing -- technology to be employed in order to extract resources once considered difficult and unviable. In short, the exploration and production business became even more highly specialized in the past five years.
The word is "unconventional"
The discovery of shale oil and tight oil reserves in the U.S., as well as ultra-deep sea reserves around the globe, saw the limelight shifting to unconventional production of oil and natural gas. Independent oil producers such as EOG Resources (NYSE: EOG) and Kodiak Oil and Gas (UNKNOWN:KOG.DL) were early movers in the "unconventional" scene, as they amassed properties cheaply in the Eagle Ford and Bakken shale plays. Even ConocoPhillips moved fast by acquiring shale oil-rich properties.
Unfortunately, integrated companies weren't so nimble. Their overdependence on legacy assets around the globe turned out to be more burdensome in the long run. Gradually, they needed to pump in more money to ensure stable production levels from these fields. They were slow in making a transition and staying abreast with the changing industry trends.
As complexity in operations increased and cost of production soared, companies realized that one way to keep a check on expenses and increase operational efficiency was by focusing solely on core competencies. As a result, smaller independent producers such as EOG Resources and Kodiak were more flexible in making quick turnarounds in their production profiles than the 800-pound gorillas of the industry.
Will Exxon divest its refining arm?
The big question now is: Will ExxonMobil divest its refining arm? The company has underperformed the broader markets for the last few years. Despite an increase in production from last year, earnings slipped thanks to disastrous refining margins, thus bringing into question the integrated model. Growth has been an issue. Here how Exxon's total returns compare with the S&P 500 for the past five years:
Traditionally, Exxon has been a good allocator of capital with impressive returns, which is probably what caught Buffett's attention in the first place. However, growth looks limited at this point unless a spinoff is on the cards. I can't see why the markets have been otherwise undervaluing an excellent company.
Getting gassy and exploring new frontiers
Through its acquisition of XTO Energy in 2009, Exxon has natural gas making up 49% of its total reserves. While natural gas may not garner a lot of attention from the market in the short run, global demand for this commodity is huge in the long run. Exxon is also involved in ultra-deepwater exploration activities. But it remains to be seen how profitable they are.
Despite an impressive lineup of projects, the execution of the major ones seems unmistakable slow. Fellow Fool Tyler Crowe points out that the $30 billion Kashagan project is seven years late and 300% over budget. The $4.1 billion Kearl Oil Sands project is a year late and 61% over budget, while the Papua New Guinea LNG project is 21% over budget.
The signs are ominous. ExxonMobil could break up. Or it may choose to stay the same. But definitely a spinoff of some sort will unlock the hidden value in both the upstream and downstream divisions. Warren Buffett has already seen one such divestiture while holding ConocoPhillips. The question is: Is he sensing something similar to take place at Exxon? The time seems ripe. The integrated model seems to be dying. Long live the integrated model.