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.

Losing 4.3 billion barrels of reserves could be just what Exxon Mobil Corp. needed.

There's no denying that having almost one in five barrels of oil equivalent of your proved reserves slip off the books, as Exxon announced this week, isn't the company's finest hour. Coming just after Exxon took a $2 billion asset impairment, it looks like newly appointed secretary of state Rex Tillerson has left his successor as CEO some fixing to do.

Still, this is Exxon, and a big chunk of those lost reserves are still there in physical terms. It's just that, for example, the 3.5 billion barrels in the Kearl oil-sands operation in Canada no longer meet the SEC's criteria for being economic to produce anytime soon, chiefly because oil prices have collapsed (see this column from last year for more details on this).

Sandstorm
Trailing Canadian oil prices ended 2016 at $30, down 58 percent from two years ago
Source: Bloomberg
Note: Trailing 12-month averages.

So, as Exxon points out in its 10-K filing, higher prices could push those reserves back onto the books.

But even if the physical barrels are there, it's clear that reserves replacement, once a badge of honor for Exxon, has become a millstone. Here is how Exxon's reserves replacement fared cumulatively over the past decade, roughly coinciding with Tillerson's tenure as CEO:

Rise And Fall
Buying XTO Energy boosted Exxon's reserves replacement ratio but subsequent debooking sent it back down
Source: The company
Note: Cumulative reserves replacement over time. Reserves replacement equals net change in proved reserves divided by production.

The importance of acquisitions to keeping that ratio aloft becomes clearer once you strip them out (along with disposals):

Evaporating
Exxon's low organic reserves replacement in natural gas has been chronic, while progress in liquids was wiped out by the latest debooking.
Source: The company.
Note: Cumulative organic reserves replacement. Calculated as net additions to proved reserves from revisions, improved recovery, extensions and discoveries, divided by production.

Tillerson chased the next big thing with his deals for XTO Energy Inc., which was badly timed, and in Russia, which suffered some bad geopolitical luck.

Overall, Exxon's reserves and production were actually lower in 2016 than in 2007, despite a string of growth targets set each year during most of the past decade. Even with lower output, reserves now cover only 13.1 years of production, down from 14.2 years in 2007 and a high of 16.9 in 2014.

Meanwhile, return on average capital employed -- again, a metric Exxon long favored as a measure of discipline -- in the dominant upstream division has fallen from 41.7 percent in 2007 to just 0.1 percent last year. And Standard & Poor's cited specifically the challenge of replacing Exxon's huge production when it cut the company's triple-A credit rating last year.

It is time for a reset.

The root of the problem for Exxon, and the rest of Big Oil, is an obsession with bigness. Focusing on finding ever more barrels, in ever more challenging places, led companies to invest awesome sums in new projects at the height of the boom, precisely when industry and asset inflation gave each buck progressively less bang. Doug Terreson, who covers the majors for Evercore ISI, summed it up in a report last October:

Investors correctly point to the $380 [billion] rise in capital employed but only a $140 [billion] increase in market value during 2008-2014 even before oil prices declined (Brent @ $100). Because companies did not heed the imbalance between capital formation and competitively advantaged investment opportunities and mistakenly equated volume for value, capital became stranded in unproductive areas.

In other words, like a tech investor in the late 1990s or a house-flipper in 2007, the majors lost their heads.

One reason they did was an expectation that oil demand and prices would only go up and to the right. If a combination of Chinese thirst and OPEC restraint (or dysfunction) were going to ensure triple-digit oil forever, then even high-cost endeavors like oil sands met the investment threshold.

As is now painfully obvious, an unexpected shale boom and existential questions about long-term demand for oil have cast considerable doubt on that view. Here, for example, is how the average economics of new oil-sands projects compare with North America's shale basins:

For the majors as a whole, there has been a growing disconnect between promises of ever-increasing dividends and bloated costs and capital expenditure budgets that swallow up cash but don't deliver higher production or decent reserves replacement. About half of Exxon's projects slated for 2018 onward, as detailed in its financial and operating review for 2015, consist of oil sands and liquefied natural gas, neither of which look great absent a sustained increase in oil prices.

Exxon has scored some successes in exploration of late, notably in Guyana, and has been buying its way into the Permian shale basin. It has also toned down its growth projections. These are good steps.

Exxon needs more, though. While its traditional premium to its peers has faltered somewhat of late, the stock remains relatively expensive, especially in light of the slide in return on capital:

Still Exxpensive
Exxon's aura has dimmed but it still commands a premium of 55 percent over its peers
Source: Bloomberg
Note: Exxon's premium to market-cap weighted average price/book ratio for BP, Chevron, Royal Dutch Shell and Total.

Given much of that premium rests on Exxon's reliability, it shouldn't be taken for granted. After all, instead of owning Exxon, investors could instead own a basket of rivals such as Pioneer Natural Resources Co., Suncor Energy Inc., Valero Energy Corp. -- and maybe, within a year or so, even a bit of Big Big Oil, courtesy of Saudi Aramco's planned IPO.

So when Tillerson's successor Darren Woods takes the podium next week for his first Exxon analyst day as CEO, he should emphasize a decisive break with the past decade.

Committing to keeping capital expenditure flat for the next few years would be one element of this, at least after the 14 percent jump Exxon has already indicated for this year.

As ever, M&A is a tool Exxon can use (especially with that relatively highly valued stock as a potential currency). That doesn't mean mega-deals, especially now that the recovery in oil prices has lifted the price of most big, needle-moving E&P targets. But it could mean pulling back in certain traditional areas like oil sands, swapping or monetizing them to expand in assets with better economics or more flexible production, such as more shale.

Above all, this should form part of a broader message: that being big is no longer the biggest idea out there. Access to profitable production providing cash for distributions, rather than reserves and growth per se, is what counts -- even if it means being flexible on traditionally non-negotiable things like, say, formal ownership of reserves.

Exploring such options, at least, is warranted. Exxon's new chief shouldn't let a good setback go to waste.

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

  1. To clear up any confusion, Exxon de-booked 4.3 billion barrels of oil equivalent, according to Wednesday evening's press release. That is equivalent to 17.4 percent of its proved reserves at the end of 2015. The headline figure of 3.3 billion BOE is a "net reduction" in reserves, which also includes other revisions, extensions and discoveries and the purchase and sale of assets. Overall, factoring in production -- which also obviously takes away from reserves -- Exxon's reserves fell by 4.8 billion BOE, or 19.3 percent, in 2016.

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