Exxon is positioned to compete in a world with diminishing resources

by Allen Good (Morningstar Analyst)

Imperial Oil IMO has confirmed reports that its Kearl oil sands mine (a joint venture with ExxonMobil XOM) may be delayed until January 2013 on account of weather. While we had high hopes that the project would achieve first oil in December, we knew the biggest risk was weather. Taking into account the wind chill, the average hourly temperature in the Fort McMurray region was:

• 28 F (-2 C) in October
• 3 F (-16 C) in November
• -12 F (-25 C) in December (Dec. 1-10)

More telling than the average temperature has been the minimum (coldest) hourly temperature:

• -0.4 F (-18 C) in October;
• -40 F (-40 C) in November;
• -31 F (-35 C) in December (Dec. 1-10)

When we consider the extreme cold in October and into December, we are not surprised by the delay. For Imperial, we were forecasting production from Kearl of 4.4 thousand barrels per day for the fourth quarter but are now assuming no production during the quarter. The expected impact is a CAD 0.03 per share reduction in cash flow with no change to our 2013 production estimates or fair value estimate.

For ExxonMobil, the impact will probably be negligible, given the already anticipated late startup. However, without any Kearl volumes, Exxon is likely to find it more difficult to meet its full-year production target. There is no change in our fair value estimate.

ExxonMobil sets itself apart from the other majors as a superior capital allocator and operator. Through a relentless pursuit of efficiency, technology, development, and operational improvement, it consistently delivers higher returns on capital relative to peers. However, we think ongoing low U.S. natural gas prices are likely to prove a drag on returns, which could fall behind those of more oil-exposed peers. 

Longer term, we think Exxon will probably retain its top spot, but delivering returns on par with historical levels could be more difficult as it faces the ongoing challenge of reserve replacement. With a majority of the world's remaining resources in government hands, opportunities for the company to expand its large production base are limited. However, we believe Exxon's experience and expertise, particularly with large projects, should allow it to successfully compete for resources.

While we believe Exxon has an advantage in the current environment, that does not necessarily mean production and reserve gains will come easily or cheaply. Exxon's need for projects of a certain size in order to contribute meaningfully to its production profile and justify investment leaves it with an diminishing set of opportunities. In addition, investing exclusively in large projects exposes the company to a variety of risks including overinvestment risk, execution risk, and budgetary risk. Future projects will also probably rely on resources with higher extraction costs because of their lower quality (bitumen), location (deeper water) or stimulation requirement (fracturing).

Greater competition is also becoming an issue. Many available large projects will be done in partnership with national oil companies. To gain access, Exxon must not only demonstrate its value but may also have to agree to production-sharing agreements that are not as advantageous as in the past. More often, management is faced with a tough decision: Take less favorable terms on more projects, or focus on projects where its expertise is highly valued. A good example of the latter case is Exxon's recent deal with Rosneft to explore for oil in the Russian Arctic. If Exxon is able to exploit similar opportunities where it can add oil reserves with attractive terms thanks to its value proposition, then it can probably continue to deliver superior returns on capital.

Faced with these challenges, Exxon is turning to relative political safe havens to drive growth like the United States and Canada. In the U.S., growth will largely come from resources added with the acquisition of XTO. While the acquisition largely consisted of natural gas reserves and production, it also held acreage in tight oil plays to which Exxon has subsequently added, namely in the Bakken and Duvernay. It is now also shifting its drilling activities to these more liquid-rich plays in light of low prices. Exxon has cut its rig count to 50 from 70 last year and is using two thirds of those rigs in liquid-rich plays as opposed to less than half previously. That said, we still expect returns to suffer as low prices depress profits and shale gas invested capital sits idle.

Exxon also has promising offshore discoveries in the Gulf of Mexico that should be developed in the coming years. In Canada, Exxon's reserves are primarily oil sands, both mining and in situ. Its largest project, Kearl, will come on line in late 2012. While Kearl initially will add about 100 thousand barrels a day of oil production, oil sands mining projects typically fall on the upper end of the cost curve. We think Kearl is better positioned than other projects because it does not require an upgrader, but it still is indicative of the move to higher-cost resources by Exxon in the face of increased resource nationalism.

Another way Exxon is tackling its growth/reserve replacement issues is by investing in projects like oil sands and LNG that produce at plateau production levels for longer than traditional projects, some up to decades, and reduce its overall decline rates. Also, relatively little reinvestment is required after the large initial up-front capital, resulting in significant free cash flow generation after startup. We estimate nearly 40% of Exxon's production will come from these types of projects by 2016. However, most are large projects, especially the LNG developments, and thus hold the aforementioned risks.

Despite growing investment in the U.S., Exxon is not stepping off the international stage or away from political risk. Asia and Africa continue to be the company's largest producing regions and we expect them to continue as such, with numerous projects scheduled to come on line over the next five years in Nigeria, Angola, and Kazakhstan. Exxon also has the potential for shale resources in Europe and South America that would allow it to leverage its acquired unconventional technology and bolster its value proposition and competitive advantage in the global competition for resources.

Valuation

We are maintaining our fair value estimate of $91 per share after lowering our long-term natural gas price assumption from $6.50 per thousand cubic feet to $5.40. The lower natural gas prices reduces our fair value by $5, all else equal. However, the reduction is largely offset by the rise in short-term oil prices since our last update. Our long-term forecasts and assumptions incorporate a more challenging operating environment as well as a decline in returns on capital relative to historical performance over our forecast period.

Our fair value estimate is approximately 4.9 times our 2013 EBITDA estimate of $86 billion. In our discounted cash flow model, our benchmark oil and gas prices are based on Nymex futures contracts for 2012-14. For natural gas, we use $2.87/mcf in 2012, $4.08 in 2013, and $4.08 in 2014. Our long-term natural gas price assumptions for 2015 and 2016 are $5.40. For oil, we use Brent prices of $112 per barrel in 2012, $108 in 2013, and $104 in 2014. Our long-term oil price assumptions for 2015 and 2016 are $99 and $102, respectively. We assume a cost of equity of 8%.

We forecast a compound annual growth rate for production of 1.1% during our forecast period. Growth should be more robust in outer years after falling approximately 3% in 2012. We expect Exxon to actually increase oil volumes (1.8%) at a greater rate than natural gas (0.4%) over our forecast period thanks to large project startups over the next three years. Our forecast is slightly below management's forecast to compensate for the potential negative effects of higher oil prices related to production-sharing contracts as well as the risk associated with larger projects. Full realization of management's guidance could offer upside to our valuation, while extensive delays or reduced U.S. natural gas production due to lower prices could result in downside risk.

Refining margins have staged a recovery in the past year. However, we model slight margin weakness over the next couple of years with an improvement in the later years of our forecast. While ExxonMobil should benefit from highly complex facilities and access to growth markets, it has only limited exposure to wide U.S. domestic sweet crude discounts. However, that should change in the future as additional pipeline capacity brings domestic and Canadian crude to the Gulf Coast, improving ExxonMobil's access to discount feedstock. Meanwhile, we anticipate chemical earnings to remain tied to economic activity.

Risk

For a company with global operations, geopolitical risk is always an issue. Past events in Russia, Nigeria, and Venezuela underscore the risk associated with doing business in those countries. These risks will only become greater as Exxon expands its global production portfolio through partnerships with NOCs. By investing in large, capital-intensive projects, Exxon also runs the risk that commodity prices will decrease dramatically, making those projects no longer economical. Deterioration of refining fundamentals in the U.S. and Europe may continue to damage profitability long after an economic recovery.

Management & Stewardship

Rex Tillerson became chairman and CEO in 2006. Previously, he served as president. He has spent his career with Exxon, beginning in 1975 as a production engineer. The recent acquisition of XTO Energy raised concerns that he may be straying from the returns-focused strategy that has made ExxonMobil great and instead investing in growth for the sake of growth. ExxonMobil's subsequent performance has lent weight to this argument as gas volumes have grown while prices have fallen, resulting in declining returns. However, while the acquisition has proven to be ill-timed given the drop in natural gas prices, we think ultimately it can deliver returns that meet ExxonMobil's requirements as prices rise and it leverages XTO's knowledge to exploit unconventional plays globally.

ExxonMobil's record of generating shareholder returns deserves an exemplary stewardship rating, in our opinion. Despite the XTO acquisition, we think Tillerson is likely to continue a disciplined capital allocation strategy, given his previous statements, and deliver the high returns that his predecessor did. Recent efforts to exploit more lucrative Kurdistan reserves at the risk of losing pre-existing, but likely lower-returning, Iraqi contracts provides us some evidence to his focus on returns. As a result, we are inclined to maintain the exemplary rating. 

Returns to shareholders also remain a focus, with share repurchases the primary tool used to return excess cash. However, Tillerson recently acknowledged ExxonMobil's relatively low yield and indicated higher payouts could be in the future.

Overview

Financial Health: 

As one of the few remaining firms with an AAA credit rating, ExxonMobil's financial health is beyond reproach. Cash flow from operations remains sufficient to finance capital expenditures while increasing dividend payments and buying back stock. More important, the large cash position and access to cheap debt give the company resources to make opportune acquisitions.

Profile: 

Exxon is an integrated oil and gas company that explores for, produces, and refines oil around the world. In 2011, it produced 2.4 million barrels of oil and 12.1 billion cubic feet of natural gas a day. At year-end 2011, reserves stood at 17.7 billion barrels of oil equivalent (plus 7.3 billion for equity companies), 47% of which are oil. The company is the world's largest refiner and one of the world's largest manufacturers of commodity and specialty chemicals.