If you're looking for one of those investments where you can park your money for a really long time, Big Oil is a pretty good place to start. It is very likely the demand for oil and gas will remain very strong for decades; the size and scale of these companies give them almost unprecedented economic moats; and they all produce decent dividends that can grow wealth over time.
However, not all Big Oil companies are created equal, and the whims of the market can make a great company a lousy investment. So, let's take a look at Big Oil in five different ways -- margins, free cash flow generation, production, shareholder returns, and valuation -- and determine which one is the best investment today.
Who are the candidates?
When talking about Big Oil, there are pretty much five companies that always come up: ExxonMobil (NYSE:XOM), Chevron (NYSE:CVX), Royal Dutch Shell (NYSE:RDS-A) (NYSE:RDS-B), BP (NYSE:BP), and Total (NYSE:TOT). All five of them have production in excess of 2 million barrels of oil equivalent per day, each has a market capitalization in excess of $100 billion, and they all have assets related to the entire value chain of oil, from finding and producing all the way down to the retail stations, where you can fill up at the pump.
There is actually one other company that also meets these criteria: PetroChina. However, let's leave this one off for now, because it's actually the publicly traded arm of the larger state-run China National Petroleum. So much of the company's activities are dictated by government policies, and sometimes that is in conflict with the interests of shareholders.
|Company||Gross Margin (Current)||Gross Margin (10-Yr. Avg.)||EBITDA Margin (Current)||EBITDA Margin (10-Yr. Avg.)||Net Income Margin (Current)||Net Income Margin (10-Yr. Avg.)|
Evaluating these companies based on their margins is pretty self explanatory, and not a whole lot different from any other industry. The are a couple things that really jump out when looking at these numbers. First, ExxonMobil, Chevron, and Total have much better margins across the board than Shell and BP today and on average over the past 10 years. The reason for this is that both ExxonMobil and Total have generated superior margins on the exploration and production -- or the upstream -- part of the business, while Chevron has a much more limited exposure to lower-margin refining and chemicals -- the downstream -- segments than the others in this group.
The other thing to note, here, is that just about every company involved has seen a slight decline in every margin. This is likely influenced by two primary factors: 1) oil prices have remained rather flat for close to three years now...
...and 2) more and more of the production from these companies is coming from more expensive sources. As this chart from Chevron shows, oil sources such as deepwater exploration and oil sands production can have breakeven prices as high as $100 per barrel. With more and more oil production from these companies coming from these sources, margins are going to be smaller unless oil prices start to swing upwards again.
Based on margins, it looks like Chevon is the winner; not only does it have the best EBITDA and net income margins of them all, but it is the only one that has been able to beat its 10-year historical averages over the past several quarters:
- Royal Dutch Shell
Free cash flow
|Company||Levered Free Cash Flow (Current)||Levered Free Cash Flow (10-Yr. Avg.)|
|Royal Dutch Shell||2%||2%|
More than anything over the past couple of years, Big Oil has struggled to generate free cash flow. A large factor that has influenced these numbers over the past several years has been big spending on big projects, and to make matters worse, the budgets of those projects have blown by their original estimates. Two examples of these massive projects today are the Kashagan oil project -- partially owned by ExxonMobil, Shell, and Total -- and the Gorgon LNG facility -- owned by Chevron, ExxonMobil, and Shell. These two projects alone have over $100 billion in capital spending tied up in them, and both have gone wildly over budget -- Gorgon's costs are 40% higher than originally estimated, and Kashagan's are more than double and still climbing.
Mega-projects like this have hurt free cash flow because it seems like almost every available dollar from these companies has been poured back into the business through capital spending. In fact, the numbers above don't even tell the whole tale here, because several of them have propped up free cash flow with asset sales. If we look purely at operational cash flow and capital expenditures, it paints an even grimmer picture.
|Operational Cash Flow as % of Capital Expenditures (Less Than 100% Means More Cash Spent)|
|Company||Last 12 Months||FY 2013||FY 2012||FY 2011|
The only company that seems to come out looking really positive here is ExxonMobil. While it has seen its free cash generated from continuing operations decline over the past few years, it hasn't been hit nearly as hard as the others. However, seeing BP improve its cash flow so significantly in the past 12 months compared to 2013 is worth noting. Just about every company in the space has mentioned on recent conference calls and investor presentations that 2012 through 2014 were the peak years for capital expenditures as the bulk of the spending on many megaprojects took place in that period. This is probably a metric worth revisiting in a year or so when we start to see if those 2015-2016 capital budgets truly are lower than what management has been saying.
Even though all of these companies have assets in all facets of the oil and gas industry, a vast majority of their earnings are generated from the exploration and production side of the company. Sure, things like refineries can generate high rates of returns after several years of operations thanks to depreciation, but all of these companies need upstream production to be successful in order to remain profitable.
Production growth is a little trickier to evaluate because there are so many variables, and we have to rely a little on what management thinks or plans to bring online in the future. However, there are few things to look for. First, how much does management plan to grow production over the next couple years? Second, is it oil, natural gas, NGLs, or perhaps natural gas with prices indexed to oil? And third, what is the shelf life of that production? Certain projects have short lifespans (shale wells), while others can generate positive cash returns for decades (oil sands and LNG). Keeping this in mind, here is a quick description of each company's plan.
Here's the best way to think about BP's expansion plan: It's not the size that matters, but how it performs at making a return. The Macondo well blowout in 2010 forced management to take a hard look at what it was doing. As a result, it has sold off a ton of assets to cover expenses for the spill, but a slight added benefit is that it has also used it to trim low-return assets. To keep this high-return mentality, the company has gone away from actual production targets and has instead focused on simply bringing on projects that will increase sustainable free cash flow.
To do this, BP has developed a very conservative capital spending plan: If a new project can't be profitable at $80 per barrel oil, the company doesn't even bother looking at it anymore. Most of the projects listed from BP are all offshore, and it also receives a large portion of production through its equity investment in the Russian oil company Rosneft, but the real big project to keep an eye on is the Shah Deniz gas project in the Caspian Sea. This project is looking to deliver close to 2.5 billion cubic feet of natural gas per day via pipeline to Europe. This is one of the company's biggest-ticket items, and it could have a lot of political ramifications because, you know, natural gas supplies that don't come from Russia, and the Ukraine thing... etc.
Chevron has a lot of irons in the fire today, and it anticipates that all of them will result in production of about 3.1 million barrels per day of oil equivalent by 2017, or about 500,000 barrels per day more than current production. As recently as six months ago, the company anticipated that number to be 3.3 million barrels per day, but stagnant oil prices over the past couple of years -- with no clear indication that they will increase significantly over the next few years -- have led management to cut that outlook.
Chevon is putting a lot of eggs in one basket when it comes to growth: LNG exports. Between two projects -- Gorgon LNG and Wheatstone LNG, both off the coast of Australia -- Chevron has over $45 billion invested in new LNG facilities to serve the Asia Pacific region. These projects, and the potential for a third project in Western Canada, would turn Chevron from the Big Oil company with the smallest exposure to LNG to one of the largest. This could be very beneficial, because LNG facilities can be long-term cash-generation machines for many decades, provided Chevron can bring them online within a reasonable budget.
Here's the crazy part about ExxonMobil. The amount of production it needs to bring on annually just to replace the decline from other places is greater than what many independent companies produce in a year. Not only that, but the company also wants to grow its production by a "modest" 300,000 barrels per day to 4.3 million per day by 2017, which is actually a cut from the 4.8 million barrel per day target it was hoping to achieve in its previous production outlook.
ExxonMobil's plans are centered in three main areas: LNG, oil sands, and Arctic exploration. In the next few years, it hopes to make major expansions at its Keal Oil sand project that will produce close to 350,000 barrels per day. Further down the road, though, it will have massive amounts of capital tied up in Russian Arctic exploration. In a deal it signed with Rosneft a couple years ago, it will begin an exploration and development plan there that could cost as much as half a trillion dollars. That's a lot of potential, but lots of things need to go right for it to happen.
Shell is very much in the same boat as BP right now. Management has been a little unsatisfied with its results as of late, so it has abandoned its plans to grow production to 4 million barrels per day, because the company thought many of the projects were simply production for production's sake and would not generate sufficient returns. With its decision to curb production targets and focus more on high-return projects, it has also decided to unload several billion in assets that aren't performing up to management's standards.
Because there is so much asset-shuffling going on at Shell right now, it's hard to see clearly where production will be in the next few years and beyond, but most of the work it is going forward with should help to enhance cash generation.
Total is actually the most intriguing case of them all right now. Like BP and Shell, it plans on unloading several billion in assets -- about $15-$20 billion worth. At the same time, though, it still has plans to grow production by a whopping 750,000 barrels per day of oil equivalent by 2017, to right around 3 million barrels per day. This is the biggest expansion plan in Big Oil both on a pure size and percentage increase from existing production basis.
What makes this plan so promising isn't the total amount coming online, it's the expected returns from that production. More than 500,000 of that new production is expected to come from LNG and from Canadian oil sands, both long-term, cash-generating forms of production. Also, Total's management estimates that the average cash margin on all of this new production will be about $50 per barrel of oil equivalent -- that's huge. If this is truly the case, then Total could see margins, free cash flow, and overall returns grow immensely over the next couple of years.
I think that of the companies here, Total is the clear winner, with Chevron and ExxonMobil battling it out for next in line. BP and Shell could end up being very productive from their plans, but the future is still a little uncertain since we're not sure of further asset sell-offs.
Generating a return for shareholders
All of these things are nice, but more important than anything else is that these elements lead to value for us as investors. First we will look at return on equity. The simple way to evaluate return on equity is by looking at net income alone, but those numbers can be misleading sometimes, especially if one company is juicing on debt. Just to make sure, let's look at return on equity based on what is known as a DuPont model -- a method developed by the company DuPont in the 1920s that breaks down return on equity into its various components. This graphic gives a quick description of each of these components.
When you multiply these factors together, you get a return on equity, so here is what each company looks like based on this model.
Thanks to strong margins and a high asset turnover rate from its high sales but low-margin downstream business, Exxon looks to be the strongest performer of all the companies in the group, with Chevron and Total in a distant second.
Another way we can look at it is to examine a company's return on invested capital, which is generally a sign of management's effectiveness at allocating capital.
With the exception of BP, every company in the space has seen its returns decline over the past several years -- BP's returns have been helped immensely by large asset sales. Diminishing returns on invested capital are mostly a result of each company's free cash woes.
Also, like free cash flow, this may be a metric worth looking at again down the road, because it is skewed by all of those megaprojects on the books not yet generating cash. Chevron estimates 40% of its invested capital is in pre-producing assets, and many others have high percentages of not-yet-producing assets on the books. Once those assets come online, they should significantly boost returns.
Just about everything covered so far has related to performance, but what about price? Some of the differences between these companies have been rather close, and one of them trading on the cheap could be enough to put it over the top. Before we look at the numbers, though, keep in mind that Big Oil companies almost always trade at a pretty significant discount to the overall S&P 500. The historical average for the Robert Shiller adjusted P/E ratio for the S&P index is 16.55, while the 10-year average for each of these companies is below 12. Here's a look at the numbers.
|Current Trading Multiples|
|Company||Total Enterprise Value/Revenue||Total Enterprise Value/EBITDA||Price/Earnings||Price/ Tangible Book|
So yeah, all of these companies look cheap when compared to the broader market today, but compared to each other there isn't a real convincing winner. Also when compared to their 10 year historical averages, the only thing that seems to stand out is that they are all trading below their historical tangible book values.
|Historical Trading Multiples (10 year average)|
|Company||Total Enterprise Value/Revenue||Total Enterprise Value/EBITDA||Price/Earnings||Price/Tangible Book|
This may also be in part from all of those pre-producing assets on the books, but not yet producing a return. There is really no clear winner, here, so let's call valuation a wash.
What a Fool believes
There is an old phrase among financial advisors and hedge fund managers: "No one ever got fired for buying IBM." It's the idea that you can always play it safe and buy big, well-established companies with almost insurmountable competitive advantages regardless of the price. To some, buying Big Oil is like buying IBM -- it's safe, and you won't get in trouble if you buy it at any time.
I slightly disagree with this. Sure, all of these companies are pretty solid, but even a solid company like ExxonMobil bought at a high premium will result in disappointing returns over the long run. With this in mind, there isn't a single company in this group screaming for you to buy it.
If forced to make a choice today, I would go with ExxonMobil. It has strong margins, the best returns, a strong quiver of potential projects, and it's what I guess you would call fairly valued. Although, I am going to keep a very close eye on what Chevron and Total are doing over the next couple of years, they too have strong margins, and their suite of projects could significantly enhance earnings and returns if they can keep their budgets in line.
In all honesty, though, I think better buying opportunities could present themselves further down the road. All it takes is a surge of media attention on a theme like "oil prices are doomed" for some short-term thinkers to overreact and send share prices down. When they do, I will be ready with some cash I have set aside for those very moments.