Prospects for continued growth in production volumes—and strength in oil and gas prices—prompt S&P to rate the energy giant a strong buy
From Standard & Poor's Equity ResearchWe think energy giant ExxonMobil's (XOM; recent price, 85) size gives it advantageous economies of scale, and its strong earnings have enabled it to build a cash balance of $34 billion, exceeding its total debt of $17 billion (including our estimate of $7.3 billion for the present value of its operating leases), as of Dec. 31, 2007.
We estimate ExxonMobil's returns are the best in its peer group with a return on capital of 32% (as of Dec. 31, 2007), reflecting very high returns from its exploration and production operations—which, on the scale of its business (some $129 billion of capital employed) is remarkable. For the past 19 years, we estimate ExxonMobil's shares have outperformed the S&P 500 on a total return basis, yielding 15% annually, compared to 11% for the broader market.
While the company's exploration and production earnings benefited from a sharp increase in crude oil prices in 2007, these prices outran refined product prices and cut into its downstream margins. However, ExxonMobil has partially mitigated this negative impact through its substantial capacity to refine cost-advantaged crudes. As a result, its refining and marketing earnings declined from the first to the second half of 2007, but beat our expectations.
Over the past five years (2003-07), we estimate ExxonMobil's after-tax operating earnings expanded by about 19% per annum. While after-tax operating earnings rose 1.6% in 2007 to $40 billion, or $7.20 per share, we see full-year 2008 operating earnings rising 16% to $46.6 billion, or $8.55 per share, before moderating to a 1% increase in 2009 to $8.63 per share. We view this as pretty good compared to its "supermajor" peers, which our earnings projections indicate, on average, will rise only about 8% in 2008 before declining 5% in 2009.
ExxonMobil is expected to report 2008 first-quarter earnings in late April. We project first-quarter operating earnings will increase 24% to $11.5 billion, or $2.11 per share.
With our forecast for solid volume growth over the next five years and continued strong oil and gas price realizations, and based on our intrinsic and relative valuations, our recommendation for ExxonMobil shares is 5 STARS (strong buy).
Our fundamental outlook for the integrated oil subindustry is neutral, as S&P sees the upside potential from high oil prices offset by narrowed refining and marketing margins. While prices for the benchmark grade of crude oil, West Texas Intermediate (WTI), have topped $100 per barrel, we believe new oil supplies from both OPEC and non-OPEC producers and slowed global economic growth will ease oil prices later this year. Crude oil prices moved sharply higher in the 2008 first quarter, reflecting market speculation, geopolitical tensions, and continued strong global oil demand. Prices of refined petroleum products have failed to keep pace with the sharp rise in oil prices, and refining margins have narrowed. S&P projects 2008 U.S. refining margins will narrow almost 40% from 2007.
While the subprime mortgage crisis has reduced our forecast for U.S. gross domestic product growth, S&P and Global Insight believe a U.S. slowdown will have a limited impact on the global economy, with the bulk of the worldwide oil demand growth coming from emerging economies in countries that are not members of the Organisation for Economic Co-operation & Development (OECD). As of Feb. 25, we revised down our 2008 estimate of global oil demand growth by 0.3 million barrels per day (b/d), to 1 million b/d, about the same as last year. We also reduced our 2008 estimate of global oil supplies growth by 0.25 million b/d to 1.58 million b/d, reflecting lowered expectations for non-OPEC production growth due to continued project delays.
Using data from Global Insight, and reflecting strong global demand from non-OECD nations amid geopolitical concerns, and the inflow of monies into commodities—an inflation hedge as the Fed cuts interest rates and the U.S. dollar declines—on Mar. 6, S&P raised its 2008 WTI oil spot price forecast by $9.98, to $91.33 per barrel, and 2009's by $2, to $76.75. We now expect 2008 second-quarter WTI prices to average $96 per barrel, but soften to $85 by December.
On the U.S. natural gas front, as of Mar. 4, S&P and Global Insight expected Henry Hub bid week prices (a blend of spot and contract) to average $9.44 per million Btu during the 2008 second quarter, $8.87 in 2008, and $8.72 in 2009. Cold winter temperatures, and reduced U.S. liquefied natural gas imports due to increased international competition, have tightened the U.S. gas market, and U.S. natural gas in storage for the week ended Mar. 21 was 1.28 trillion cubic feet (Tcf) (2.7% above the five-year average, but 15.8% below last year).
Given this industry outlook, how have the earnings of energy companies fared? Earnings of energy companies in the S&P 500 index rose only 6% in 2007 vs. a 25% increase in 2006, and as of Mar. 20, S&P projected a 16% rise in 2008. That compares with a 6% decline in earnings in 2007 for the companies within the entire index, vs. a 15% rise in 2006, and S&P projects a 17% rise in 2008. So, we are looking for the earnings of energy companies to rise in line with the broader market in 2008. For the supermajor oils, we estimate earnings rose about 5% in 2007 and 16% in 2006, and we are looking for an 8% rise in 2008.
That said, there is a disconnect between the projected earnings rise for these companies and the performance of their shares, which have declined. The S&P Energy Sector (12.8% of the S&P 500 index) and the S&P Integrated Oil & Gas subindustry have performed in line with the S&P 500 Index so far this year—down 10.5% and 11.1%, respectively, through Mar. 20, compared with a 9.8% decline for the "500."
In late 1999, the Federal Trade Commission allowed Exxon and Mobil to reunite in one of the largest mergers in history. In 1911, the Supreme Court had ordered the breakup of John D. Rockefeller's Standard Oil Trust, resulting in a spin-off of 34 companies, two of which were Standard Oil of New Jersey (later Exxon) and Standard Oil of New York (later Mobil).
We believe the company's substantial business and geographic diversification helps to mitigate its exposure to business risk and margin volatility. In addition to being one of the largest oil and natural gas producers in the world (the company's upstream business accounted for 65% of 2007 segment earnings), ExxonMobil is also one of the world's largest refiners (24%) and producers of petrochemicals (11%). Its leverage to refining helps to shield the company from declining crude oil prices. Other operations include electric power generation, coal, and minerals. Through wholly owned ExxonMobil Canada Ltd. and its 69.6%-owned affiliate, Imperial Oil, ExxonMobil is the largest crude oil producer in Canada.
To fund increased drilling and development activity amid increased industry costs, the company has raised its 2008-12 capital budget to $25 billion to $30 billion, after spending about $21 billion in 2007.
We view ExxonMobil as one of the best managed companies within the energy sector. Key to its success is its global model of management, which was put in place when Exxon and Mobil reunited in 1999, as well as its standards of investment discipline, operational excellence, and leading technology that allows it to achieve sustainable competitive advantages and top market positions.
Exploration and Production
ExxonMobil maintains the largest portfolio of proved oil and gas reserves and production in North America, and is the largest net producer of oil and gas in Europe. The company is the largest deepwater acreage holder in the world, and estimates its deepwater production will significantly increase over the next few years from projects in the U.S. Gulf of Mexico, West Africa, and elsewhere, providing more than 20% of the company's production by 2010.
Proved oil and gas reserves declined 3.1% to 13.2 billion barrel oil equivalent (boe; 41% natural gas, 59% liquids), as of yearend 2007. In addition, proved Canadian oil-sands reserves decreased 3.3% to 694 million barrels, as of yearend 2007. Liquids production declined 2.4%, to 2.616 million b/d in 2007, and natural gas production available for sale rose 0.5%, to 9.384 billion cubic feet per day in 2007. Using data from John S. Herold, an energy consulting firm, we estimate the company's three-year (2004-06) reserve replacement at 130%, above the peer average; its three-year finding and development costs at $7 per boe, below the peer average; its proved acquisition costs at $0.56 per boe, below the peer average; and its reserve replacement costs at $6.07 per boe, below the peer average.
The company participated in seven major project startups in 2007; 12 are slated for 2008 and seven for 2009 and 2010. Beyond 2010, an additional 40 major projects are in various stages of project planning and execution. Using the company's 2007 Financial and Operating Review disclosure, we estimate ExxonMobil added about 251,000 boe/d of peak project production in 2007, and will add 412,000 boe/d in 2008; 429,000 boe/d in 2009-10; and 2,455,000 in 2011 and thereafter.
While full-year 2007 oil and gas production declined 1.3%, we believe these major new field developments will permit ExxonMobil to realize about 2% per annum volume growth over the next five years—to more than 4.5 million b/d by 2012. Over 75% of this new production is from long-lived platforms, which we believe should add considerable stability to ExxonMobil's future earnings and cash flows. With global oil demand expected to increase on average about 1.3% through 2010, and 0.8% from 2010 to 2030, we believe ExxonMobil's projected volume growth is strong.
We project exploration and production earnings will rise 35% in 2008, to $35.4 billion, before declining 8.5% in 2009, to $32.8 billion on projected lower oil price realizations.
Refining and Marketing
ExxonMobil is the world's largest refiner, and the third-largest in the U.S. At the end of 2007, the company had an ownership interest in 38 refineries worldwide, with 6.3 million b/d of atmospheric distillation capacity (U.S., 31%; Europe, 28%; Asia Pacific, 16%; Japan, 12%; Canada, 8%; and Latin America/other, 5%). The company estimates its refineries are 60% larger than the industry average, and they are among the largest in each geographic region. Its refineries are highly integrated, with about 80% of refining capacity integrated with either chemical or lubricants operations.
We estimate ExxonMobil's refineries collectively hold more than 2.6 million b/d of conversion capacity (ability to refine lower-cost, heavy sour crude oil), among the largest in the world. As such, we believe the company benefits from significant feedstock discounts.
Fourth-quarter refining and marketing earnings rose 16%, to $2.27 billion, above our expectations reflecting the use of cost-advantaged crude oil feedstocks and gains on asset sales. We expect earnings from refining and marketing will decline about 27% in 2008, to $7 billion, and about 9% in 2009, to $6.4 billion.
The company is a major manufacturer and marketer of basic petrochemicals, including olefins, aromatics, polyethylene, and polypropylene plastics, and a wide variety of specialty products.
Chemical earnings declined 10% in the fourth quarter, to $1.1 billion, reflecting narrowed margins and lower LIFO inventory effects, partly offset by higher sales volumes. With margins pressured by high feedstock costs, we expect chemicals earnings will decline about 2.5% in 2008, to $4.4 billion, and remain near those levels in 2009.
While oil prices have soared to more than $100 per barrel, the shares of the supermajor oils have declined by about 14% so far this year, which suggests to us the value of these firms has yet to be realized in the market. Comparatively, ExxonMobil's shares have outperformed its peer group and the market—declining only 9% year-to-date.
While we estimate ExxonMobil trades at a slight premium to its supermajor peer group on a price-earnings basis, on a relative basis, using expected enterprise value to EBITDA multiples, it currently trades at a discount to its U.S. supermajor peers. We believe the company should trade at least in line with, or at a decent premium to, all of its peers given its high degree of earnings and dividend growth and stability. Further, with a large number of long-lived development projects coming on stream, we expect its decline curve will moderate, which should lead to higher market multiples.
Our 12-month target price of $104 per share is derived by blending our discounted cash flow (DCF) and relative valuations. The result represents an expected enterprise value of 6.8 times our 2008 EBITDA estimate, in line with Exxon Mobil's U.S. supermajor peers Chevron (CVX) and ConocoPhillips (COP).
We believe ExxonMobil's corporate governance practices are sound, and above average for companies within the S&P 500 and the S&P Energy Sector. Its board of directors is currently composed of 13 members, and is controlled by a supermajority of independent outsiders (independent outsiders comprise greater than 75% of the board). In addition, the Board Affairs, Compensation, Audit, Public Issues, and Contributions committees are comprised of only independent directors. The full board is elected annually: No former CEO of the company serves on the board, the company has governance guidelines that have been disclosed, the performance of the board is regularly reviewed, and a mandatory retirement age of 72 years is in place for its directors.
However, shareholders do not have cumulative voting rights in director elections, the positions of chairman and CEO are combined, the board is authorized to increase or decrease the size of the board without shareholder approval, the company does not conduct performance reviews of individual directors, and there is no disclosure of a policy that limits the number of other boards that directors may serve on.
Risks to our recommendation and target price include geopolitical risk associated with the company's international operations and interests, changes in economic and industry conditions, difficulty in replacing its production with new reserves (which are increasingly dependent on its Asia-Pacific and Middle Eastern geographic segment), an inability to achieve upstream production growth and cost targets, and operational risk from its large development projects.