The short-term outlook for oil and natural gas prices is very difficult to predict due to increased production in North America and the lack of global growth, particularly in developing markets. Over the long-term however, as the global population grows, increasing the demand for energy, and the supply of large and cheap resources dwindles, it is difficult to imagine prices not rising considerably. Exxon Mobil Corp. (XOM) is the largest independently owned integrated oil company, and has long produced the highest returns on capital employed. Exxon's considerable size will make it very difficult for the company to continually be able to replace its production, but the structural competitive advantages that the company possesses in the areas of refining, chemical production and financial strength should allow the company to produce returns well in excess of its cost of capital into the distant future assuming generally rising energy prices.
Exxon projects that total global energy demand will increase by 30% by the year 2040. Improvements in energy efficiency and slower growth in the developed markets will slightly offset the rapid increase in energy demand that will occur in the emerging markets. Oil is projected to continue to be the leading energy resource with natural gas utilization scheduled to increase due to its abundant supply, and its gentler climate footprint in comparison to coal. There has been an increasing trend of national oil companies (NOC's) controlling domestic energy resources making it difficult for independent companies to gain access to resources on as attractive of terms as were possible in the past. Companies that can bring unique technological acumen to complicated projects have an advantage in this type of environment, and no company is better positioned than Exxon Mobil in this regard. Exxon has huge operations across the globe where it is partnered with national oil companies, with the goal of adding its abundant technical skill to extract difficult to access resources, and also to increase productivity. Notable examples of these types of relationships are Exxon's partnerships in both Russia, with Rosneft, and Iraq with the government there. Exxon invested $4.8 billion in research and development between 2007 and 2011 to develop best-in-class technologies, and the company has always aggressively targeted the most talented engineers and geologists. Exxon is one of only a handful of companies in the world that are still rated AAA, and boasts the strongest balance sheet in the energy sector putting it in an advantageous position as far as financial resources goes.
Exxon Mobil separates itself from its competition on the quality of its integrated downstream and chemical operations. The company has refineries and chemical facilities throughout the world that work hand to hand with one another, in addition to the upstream assets. This gives Exxon access to the lowest cost feedstocks, reduces transportation costs, and allows the company to produce some of the highest margins in the industry.
Exxon produces both basic and high value-added chemicals such as Mobil 1 motor oil. Exxon's stock would likely increase in value if the company were to spin off the refining and chemical assets, which would likely fetch premium valuations due to their quality, but the benefits of maintaining an integrated operating structure has kept management from taking advantage of this opportunity thus far. Peers such as ConocoPhillips (COP) have brought considerable value to shareholders through spinning-off assets and at some point I would expect Exxon to follow suit, but I'll certainly admit that this could be in the very distant future. I believe Exxon's deeply integrated structure is more efficient than its competitors operations are and were, therefore I don't believe spinning-off those assets is necessarily in the best long-term interests of shareholders, but I do believe it would provide a short-term catalyst. Impressively in 2011, Exxon's $41 billion of net income after taxes came with a return on capital employed of 24.2%. Exxon consistently posts the best return on capital employed metrics in the industry and I believe should continue to do so moving forward.
The tables above show the consistently strong profitability of both the downstream and chemical divisions of Exxon.
Exxon became quite natural gas heavy with its disastrous acquisition of XTO when gas prices were more than double current prices. While there is no doubt XTO provided a strong management team and engineering capabilities, along with attractive assets, the price paid did impair Exxon's returns on capital. Over the last five years most production growth has been skewed towards natural gas and LNG's. Exxon has some very strong oil producing growth opportunities in the Canadian Oil Sands, Russia and the Gulf of Mexico, but due to the declining production on legacy assets production growth is not likely to be very strong. My biggest concern with Exxon is that the company will feel pressured to constantly replace reserves at inopportune times, as opposed to focusing on maximizing shareholder returns however that may be.
Exxon's management devotes considerable resources to both dividends and share buybacks, as can be seen in the table below.
The table above highlights Exxon's massive share buyback and dividend initiatives. Shares outstanding are down 32% since 2002. The company's tremendous operating cash flow puts tremendous pressure on management in the areas of capital allocation. Over the next 5 years Exxon will likely generate between $250-$400 billion of operating cash flows depending on energy prices, and how that money is spent will have a huge impact on shareholder returns. Exxon wasn't the only company that overpaid for natural gas assets during the last decade, but additional poorly-timed acquisitions could certainly hurt shareholders. I would have liked to have seen the company take on some additional long-term debt when the stock traded around $70 a share to take advantage of record low borrowing costs by buying back stock.
Through the first 3 quarters of 2012, Exxon has generated $7.50 of earnings per share. Lower natural gas prices have really hurt the company, and like other oil producers Exxon is diverting assets towards liquid-rich resource plays. Exxon's global diversification allows the company to benefit from higher Brent Crude prices, and to not have quite as cyclical of downstream operations as North American only operators might have. With a portfolio as large as Exxon's, there will always be delays and problems, and the delay of the massive Kearl oil sands mine due to incredibly cold weather will only have a temporarily negative impact on the company.
As of the 3rd quarter of 2012, Exxon's pristine balance sheet boasted $13 billion in cash against just $9 billion in long-term debt. Exxon should be able to fund all of its CAPEX, dividends and buybacks out of its operating cash flows. If the stock were to sell-off materially I'd like to see management be even more aggressive on the stock buyback front. I believe that there are a number of attractive large E&P companies that could be bought much more cheaply than the same amount of production could be procured through the drill-bit. Apache Corporation (APA) would be a great fit for Exxon due to its liquid-rich resources and its considerable growth prospects, combined with a highly discounted valuation. Although Exxon is already heavy into natural gas, I believe the company could use its financial wherewithal to acquire financially distressed Chesapeake Energy (CHK) on the cheap. At a recent price of $91.73, Exxon trades at about 10.3 times forward earnings and offers a 2.38% dividend yield. That is not as attractive of an opportunity as Apache, Devon Energy (DVN) or British Petroleum (BP) in my opinion. I believe investors that are long Exxon should look to switch into those names but if the stock were to drop to the low $80s, I believe that the stock should be acquired through a dollar-cost-averaging program as a terrific bet on long-term energy price appreciation, and best-in-class returns on capital employed.