In mid-October, shares of Exxon Mobil (XOM) were sitting at 2013 lows, down about 3% on the year while the S&P was nearing all-time highs. Since then, XOM has soared to 52 week highs, rallying more than 10% as investor sentiment rapidly turns. First, Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) disclosed a $4 billion stake in the company, and whenever Buffett turns positive on a company, you can be certain there will be a near term pop. Since then, investors and analysts have been following Buffett's lead with Goldman Sachs upgrading shares to a buy this morning, which sent shares up another 3% to an all-time high (more details here). However, after this quick run up, I think some of the enthusiasm might be over-extended.
Goldman Sachs cites two bullish catalysts, both of which I believe are not all that positive. First, for five years, Exxon has struggled to generate any type of production growth whatsoever. Exxon has not actually grown production organically since 2006. After years of stagnant and declining production, it jumped 1.5% last quarter, which has sent analysts into a bullish frenzy. In fact, Goldman is now looking for a 5% increase in production and 2.4% on a barrel of oil equivalent (BOE) basis. I really struggle to see a catalyst for production growth to accelerate so rapidly.
I believe investors should be cautious about extrapolating one quarter of positive growth forward after seven years of problems, especially because Exxon is under-exposed to U.S. onshore oil drilling where much of the potential upside is. It is worth noting that Exxon has been spending a lot of money that past five years exploring for oil without generating any additional growth:
- 2009: $22.5 billion
- 2010: $26.9 billion
- 2011: $31.0 billion
- 2012: $34.3 billion
- 2013 (9 months): $25.2 billion
- 2013 (projected fully year): $34-$34.4 billion
Exxon has been spending significant amounts of capital trying to grow production with minimal success. To generate the type of growth Goldman is looking for, I believe Exxon will need to maintain elevated levels of cap-ex, which amount to more than 7% of revenue. When Exxon was at $88, I could see value in buying shares on the hope that Exxon was about to reverse a long-run decline in production, but at $98, the risk/reward of their failure to do so is extremely unfavorable. I continue to believe 1-2% production growth is a far more realistic target, especially as depressed natural gas prices make expanded drilling less economical. Investors looking for 2.4% BOE production growth are a bit overly optimistic, and that rate of growth is already priced into the stock.
The next case Goldman makes is valuation, and they are correct to cite that Exxon is trading at a sizable discount to itself and the market. Shares have a P/E multiple of 11.6x or 76% of the market's compared to their historic 15.6x or 95% of the market over the past 20 years. However, I don't think Exxon merits the valuation it used to. From 1995-2008, commodities were in a super-cycle with oil prices soaring, which led to rapid revenue growth. I don't expect oil prices to appreciate at the same rate going forward as they have in the past. In fact with better energy efficiency and major finds in the U.S., there is significant downward pressure on oil prices. Without the tailwind of ever-increasing gas prices, Exxon's profit growth is slower, which means it should trade at a discount to itself.
At the same time, Exxon is trading at a premium to its peers with Chevron (CVX) trading at 10x earnings while ConocoPhillips (COP) is 10.5x, and both companies will grow production faster than Exxon next year with a better geographic breakdown of assets. Exxon's historical metrics are flawed because of the energy bubble, and the stock is actually relatively expensive, especially as Chevron is cutting its cap-ex budget, which should significantly boost free cash flow in the coming three years.
I think Goldman is late on its recommendation to buy Exxon as the move has already happened. Bulls are all too happy to use one solid quarter to project accelerating production growth next year while ignoring the company's longer run issues and growing cap-ex budget that has generated decreasing returns. At the same time, Exxon is trading at a premium to its peers with an over-exposure to natural gas thanks to the XTO Energy purchase. If investors want exposure to energy, CVX and COP are far better choices in 2014 than Exxon as they have superior growth prospects at lower multiples.