Why The Oil Companies Are Cheap

| About: Exxon Mobil (XOM)

Most investors should have noticed that the oil companies have been consistently much cheaper than the stocks of the other sectors, i.e., they have traded at a much lower P/E (price to earnings) ratio for years. To be sure, Exxon Mobil (NYSE:XOM) and Chevron (NYSE:CVX) have traded at an average P/E ratio of about 11 and 10, respectively, in the last 5 years whereas the S&P has traded at an average about 50% higher. In this article, I will refer to the two American giants but the concept applies to all the upstream oil companies, such as BP (NYSE:BP), Total (NYSE:TOT), Royal Dutch Shell (NYSE:RDS.A), Statoil (NYSE:STO) and Conoco Phillips (NYSE:COP).

The cheap valuation of Exxon and Chevron is even more surprising if one considers the exceptionally generous distributions of the two companies. Exxon returns about 6%-8% per year to its shareholders via dividends (3%) and share repurchases (3%-5%), while Chevron distributes about 5.5% to its shareholders (3.5% dividends and 2% share repurchases).

Therefore, I bet that the admirers of the two oil giants are really amazed by their cheap stock price and believe that the market is offering them a unique opportunity. In reality, there are some cases in which the market really offers tremendous bargains but these usually do not last for long. On the other hand, the cheap valuation of the oil companies has been the norm for more than a decade and hence there should be a good reason for this.

A possible reason could be the inherent risk of a Macondo-type accident, which could cause great losses to an oil company. For instance, BP has lost almost $100 B of its pre-crisis (2007) market cap due to the accident, while the other oil majors have retrieved or exceeded their pre-crisis levels. Therefore, the risk of a major accident, which is more likely now that the oil companies drill in great depths in the ocean, could partially explain the low valuation. However, this cannot fully explain the cheap stock prices because the companies of the other sectors face significant risks too. For instance, although retailers are not afraid of explosions, they always run the risk of the emergence of a new major competitor.

I believe that the main reason for the cheap valuation of the oil companies is the escalating difficulty in replenishing their oil reserves by drilling in increasingly hard areas. To be sure, the capital expenses of Exxon and Chevron have skyrocketed in the last 4 years; Exxon's capital expenses have doubled and Chevron's have increased by 50% whereas their oil production has remained essentially constant. Of course, the results from their recent investments will be realized in the near future but they will still need to invest enormous amounts in order to offset the natural decline of their current oil fields.

The legendary investor Warren Buffett uses what he calls "owner's earnings" in order to evaluate the real earning capacity of a company. Owner's earnings are the reported earnings plus the depreciation (which is only a paper loss, it is not a cash outflow) minus the capital expenses required to maintain constant sales (not the capital expenses used for growth). Unfortunately, the oil production of most oil companies (including Exxon and Chevron) has remained almost constant in the last few years. Therefore, it is reasonable to assume that almost all capital expenses are used just to maintain the output (not for growth). The results of Buffett's formula for the two oil majors are shown in the 2 tables:

XOM 2008 2009 2010 2011 2012
Net income ($B) 46,867 19,658 31,398 42,206 47,681
Depreciation ($B) 12,379 11,917 14,760 15,583 15,888
Capex ($B) 19,318 22,491 32,226 36,766 39,799
Owner's earnings ($B) 39,928 9,084 13,932 21,023 23,770
% decrease in earnings 15% 54% 56% 50% 50%
Click to enlarge
CVX 2008 2009 2010 2011 2012
Net income ($B) 24,031 10,563 19,136 27,008 26,336
Depreciation ($B) 9,528 12,110 13,063 12,911 13,413
Capex ($B) 22,775 22,737 21,755 29,066 34,229
Owner's earnings ($B) 10,784 -64 10,444 10,853 5,520
% decrease in earnings 55% 101% 45% 60% 79%
Click to enlarge

The above results are quite disappointing. On average, the "real" net income of Exxon decreases by 45%, while the net income of Chevron decreases by 68%, compared to the reported net income. Therefore, if one applies Buffett's formula on the two companies, one finds out that their stocks actually trade at a high real P/E multiple of about 22 (Exxon) and 30 (Chevron).

Of course it should be mentioned that both companies carry a very low amount of net debt, which can be fully paid off with one year's earnings (Chevron) or 2 years' earnings (Exxon). This means that the companies have ample room to keep borrowing without incurring much interest burden and actually this is what they have been doing in the last few years, in which the sum of their capital expenses and their increasingly generous distributions have markedly exceeded their earnings. Therefore, the reality for the oil stocks lies somewhere between the low nominal P/E and the high "Buffett's" P/E.

Conclusively, it is very hard to determine the correct stock valuation for the oil companies. Of course, the two oil majors have an extraordinary performance record and are led by great managers. Moreover, both companies are very friendly to their shareholders, with consistently generous distributions that are far above the average. However, as the easy oil has already been pumped, their task of replenishing their oil reserves has become increasingly challenging. Therefore, the investors should remain cautious and should never forget that the market always has a good reason for its prolonged norms, such as the cheap valuation of the oil stocks for more than a decade.

Disclosure: I am long CVX, BP. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.