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.

Here is what usually happens when a company announces that some of those friendly types from the SEC have shown up asking questions:

A Painful Case
Valeant fell 18 percent on February 29, after it disclosed an SEC probe
Source: Bloomberg

And here is what happens when that company is Exxon Mobil:

Worried? Me?
Exxon's stock slipped just 1.5 percent after an SEC investigation surfaced
Source: Bloomberg

The SEC is apparently somewhat mystified that Exxon has, unlike its peers, avoided the indignity of taking a write-down on the value of its oil and gas reserves despite the slump in prices.

An added twist is that the SEC is also reportedly interested in how Exxon factors potential carbon regulations into how it values its reserves, dovetailing neatly with several state investigations into whether the oil major covered up knowledge about the impact of climate change.

Valuing oil and gas reserves, like anything, depends on a lot of assumptions: future energy prices, how much is produced (and how quickly and for how long), operating costs, and discount rates to name a few. Exxon says it values its fields conservatively, so that when cyclical downturns inevitably happen, it doesn't have to mark them to below where they are carried on the books, thereby necessitating a write-down.

There is likely much truth to that. One probable reason Exxon has struggled with replacing reserves is that it was slow to accept that oil prices had moved structurally higher in the past decade. A more exuberant view would arguably have prompted it to move faster on acquisitions and drilling.

Even the likeliest catalyst for a write-down -- the purchase of shale-gas producer XTO Energy in 2010 -- looks less likely when you consider only $39 million, or 0.08 percent of the total assets, was accounted for as goodwill.

As for factoring in potential carbon pricing, Exxon says it does, though it doesn't disclose the price(s) used. In any case, that is one assumption where the range of valuation outcomes is as wide as the political polarity it seeks to model.

So the market's apparent insouciance about the probe is understandable -- only if it is taken in isolation, though.

Exxon's record of low costs, high returns on capital, steady dividend growth and billions upon billions of share buybacks have earned it something close to papal infallibility in many investors' eyes. The clearest expression of that is a steady premium to its peers:

Big Oil's Big Gap
Exxon's premium to its peers on price-to-book has averaged 77 percent over the past decade
Source: Bloomberg
Note: Premium to average price-to-book multiple of Chevron, Royal Dutch Shell, BP and Total.

As you can see, that reputation seems intact despite some notable dings this year, including:

  • Exxon disclosing it didn't replace its reserves in 2015 for the first time in more than 20 years;
  • Exxon losing its triple-A credit rating for the first time since the Great Depression;
  • Exxon missing the consensus second-quarter earnings estimate by 36 percent, the biggest miss in at least a decade, according to data compiled by Bloomberg;
  • And now the SEC showing up.

In considering the SEC investigation, many shareholders will likely dismiss it as mere political malarkey. Ask them about that XTO acquisition, and while they might concede Exxon announced it when U.S. natural gas prices were roughly double today's level, they'll usually follow that by saying those gas reserves will generate cash for decades to come. As for reserves replacement, the credit rating and earnings, those are just cyclical.

That level of loyalty is a great strength, of course (ironically enough, it is also a vital support for a company without Exxon's track record but which potentially threatens its long-term well-being: Tesla).

It can also breed myopia, though. Exxon, while world class, isn't infallible. Apart from the strains apparent this year, it has clearly made some strategic missteps and suffered some setbacks in the past decade or so, not least in its U.S. gas business and in its bet on Russia (the Crimean annexation clearly wasn't Exxon's fault or even foreseeable, but it's a big setback nonetheless).

And the sudden ramp-up in the company's capital spending after 2007 -- it peaked at roughly double that year's level by 2012 -- was oddly pro-cyclical for Exxon, leading to a sharp decline in its cherished return-on-capital metric.

The added risk now concerns that climate-change issue. Even if the legal probes come to naught, Exxon's guiding philosophy of simply plowing through the oil cycle with its eyes fixed firmly decades ahead could become a liability if technological and regulatory change portend radical upheaval during those decades.

The Big Oil model centers on big projects that take vast upfront investment and don't pay out for years. And Saudi Arabia's decision to IPO Saudi Aramco, revealed earlier this year, was a sign that at least one bigger rival to Exxon is getting nervous about the future for oil.

It doesn't take demand to go to zero to seriously damage cash flows, dividends and valuation -- just a shift in supply and demand that makes your company's projects less economical than you thought they were (just ask Big Coal). 

It was telling that Exxon's board lost a vote at the company's annual general meeting this year; a relatively minor one, but one centered on whether it was planning adequately for future disruption in the global energy market. This was, of course, like the credit-rating cut or the weak reserves replacement: just another hiccup to deal with. There's a good chance Exxon will also tough out this tangle with the SEC.

Even so, investors comforted by the thought of just how hard it is to sink a supertanker should remember it's also pretty hard to turn one of those things.

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

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

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