Energy

Liam Denning is a Bloomberg Gadfly columnist covering energy, mining and commodities. He previously was the editor of the Wall Street Journal's "Heard on the Street" column. Before that, he wrote for the Financial Times' Lex column. He has also worked as an investment banker and consultant.

Three out of four ain't bad. But in dealing with the downturn, Big Oil is still drawing heavily on its reserves of oil and gas, credit -- and reputation.

The "three" are Exxon Mobil, BP and Total, which all beat earnings forecasts this week. The odd one out, by a long way, was Chevron.

Over the Top
Adjusted earnings versus consensus forecasts, 1Q 2016
Source: Bloomberg

All four were saved, more or less, by their downstream businesses. At Exxon, more than 60 percent of its earnings -- pre-corporate expenses -- came from its chemicals business, making it more like a Dow Chemical than an oil business this quarter.

Which is all great, except that earnings don't really matter right now.

What matters is cash. And everyone at the top of the oil game is still hurting on that score. Big Oil still isn't covering its capital expenditure bills with cash flow, and all four here are borrowing heavily to fund the dividends on which they have staked their reputations. Herculean efforts are yielding some improvement, but the gap is far from being closed: Combined free cash flow for the trailing four quarters, after capex and dividends, stands at negative $39 billion.

Exxon, which reported results on Friday, is by no means the worst of the bunch. Compatriot Chevron, which announced the same day, burned through nearly $2 for every $1 that Exxon did, including dividends.

But Exxon hit an important milestone this week, and hit it quite hard: It lost its triple-A credit rating for the first time since the Great Depression.

This isn't a problem in terms of Exxon's ability to fund itself. Double-AA plus is still excellent; and as you can see, it'll be a while before anyone takes away Exxon's credit card:

Still Good For It
The downgrade caused the spread on Exxon's 10-year bond maturing in 2026 to jump this week, but it remains well below where it started trading in February
Source: Bloomberg

The bigger issue is something less tangible but arguably more important: reputation.

Exxon doesn't really do theatrical. But in a display of practiced insouciance, it announced a dividend increase the day after Standard & Poor's made its cut. And Friday's earnings release made no mention of S&P's effrontery. On the subsequent call, Exxon's head of investor relations said the rating cut made no difference to the company's strategy -- he even kicked off with a nonchalant "As you may be aware..." And, as usual, the call was peppered with references to Exxon's long history of dealing with cycles and its financial strength and flexibility.

And yet, with chief executive Rex Tillerson due to retire within a year, it feels like something has to give. Having taken the reins from the much-lauded Lee Raymond, Tillerson will hand over a weaker company to his successor. On his watch, Exxon:

  • Lost its triple-A rating.
  • Didn't replace its reserves in 2015 for the first time in more than two decades.
  • Paid $35 billion for shale-gas producer XTO Energy just before U.S. natural gas prices collapsed.
  • Finalized a partnership with Rosneft in Russia that has been pole-axed by sanctions.
  • Hasn't really grown its oil and gas production.

Tillerson shouldn't be blamed for the bad luck of a once-in-a-generation oil downturn or a war in Ukraine. That doesn't mean they won't factor into his legacy, though. And decisions like buying XTO certainly will.

This is a problem for shareholders. Exxon's appeal as a stock, especially now, rests on its reliability, not its leverage to the oil price. So far this year, its stock is lagging behind its smaller E&P rivals and is barely beating Chevron, even though the latter is struggling even more.

Small Fly
E&P stocks have outperformed Exxon so far this year. Since oil hit its low-point in February, E&P stocks are up by nearly 50% versus just 11% for Exxon
Source: Bloomberg

While Exxon continues to tout its strength, the message becomes less compelling as the dings to its reputation mount, leaving the case for holding its stock more of a head-scratcher.

For example, Exxon repeated on Friday that it has 90 billion-odd barrels of oil equivalent of potential development opportunities. This is an impressive number.

Yet when set against a dearth of final investment decisions on new projects and a pretty flat medium-term production outlook, the awe fades somewhat. In cutting Exxon's credit rating, S&P specifically cited worries about the company's ability to replace its reserves as debt continues to climb.

Taking the Strain
Exxon's net debt as a percentage of capitalization
Source: Bloomberg, the company
Note: Capitalization equals net debt plus shareholder equity.

Without production growth, it is hard to square Exxon's rising leverage with its commitment to raising dividends -- let alone restarting buybacks -- in the years to come, barring a rebound in oil prices.

While talk of acquisitions was noticeably absent from Friday's call, a deal to bolster reserves using the company's still-highly rated stock offers one way of dealing with Exxon's dilemma. The problem there is that Exxon didn't think E&P companies had realistic price expectations a few months ago, and these won't have become any more realistic amid the recent rally. On that basis, Exxon could actually use another lurch down in oil prices to help shake some choice acquisition targets loose -- and offer the chance for some partial exoneration as the Tillerson era draws to a close.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

To contact the author of this story:
Liam Denning in San Francisco at ldenning1@bloomberg.net

To contact the editor responsible for this story:
Mark Gongloff at mgongloff1@bloomberg.net