Exxon Mobil Needs To Stop Buying Back Shares And Buy Penn West Energy Instead

Feb.13.12 | About: Penn West (PWE)

I'm a big fan of share buybacks. Share buybacks are a great way to return capital to shareholders on a tax friendly basis.

I am not, however, a fan of the giant investment in Exxon Mobil (NYSE:XOM) shares made by Exxon Mobil over the past few years.

Look at how much cash Exxon Mobil has allocated to share buybacks in the past few years:

2006 - $29.5 billion

2007 - $31.8 billion

2008 - $35.7 billion

2009 - $19.7 billion

2010 - $13.0 billion

2011 - $16.6 billion

That is an incredible $146.3 billion spent on Exxon Mobil shares.

I'm not a shareholder of Exxon, but what would annoy me is that the most money spent on share repurchases occurs in years when the share price is high. Then, when the share price drops along with a drop in commodity prices, the share repurchases are greatly scaled back.

The Exxon Mobil share repurchase program is not being done in an opportunistic manner in a way that seeks to enhance shareholder value. It is more a buyback that is being undertaken simply because Exxon Mobil has the cash.

You don't see Warren Buffett buying back shares of Berkshire Hathaway (NYSE:BRK.A) simply because he has the cash. Buffett deploys his cash in a manner designed to best increase value per share for Berkshire shareholders. If there is nothing attractive to spend the cash on, Buffett lets the cash build up and waits for better opportunities down the road.

So to Exxon Mobil management, I say stop it. Start thinking like Buffett.

Your cash is a precious weapon, use it more intelligently. At the very least let the cash build up when commodity prices and Exxon's share price are high. You know at some point in this volatile business oil and gas prices will decline. When that happens a big war chest of cash ready to buy Exxon shares at lower prices will be available.

Or better yet, create that cash war chest so that it will be available to buy other oil and gas companies.

Because let's face it, Exxon is one of the world's largest companies. It is owned by thousands of institutions and its share price seldom becomes seriously dislocated from intrinsic value.

In my opinion, Exxon shouldn't be spending all that cash on moderately undervalued Exxon shares. It should be a much more aggressive acquirer of other companies which have share prices which often do get far below intrinsic value. Making an acquisition at 60% of intrinsic value is more accretive to shareholders than buying back Exxon stock at 90% of intrinsic value.

I've got one specific idea that would have been a much better use for the $16.6 billion Exxon has spent so far this year buying back its own pretty much fairly valued stock:

Penn West Energy (NYSE:PWE)

There is an unconventional revolution going on in the oil industry folks.

That horizontal drilling and multi-stage fracturing have changed the domestic oil production game is not news to those of us who follow the industry. But for whatever reason, the stock market seems to think that these technologies are still unproven.

Penn West is going to be the Canadian company that benefits most from these new technologies.

Penn West looks reasonably valued using booked reserves and existing production:

Enterprise Value - Roughly $12 billion

Dollar per barrel of 2P Reserves - $12 billion / 661 million boe = $18.15

Dollar per flowing barrel - $12 billion / 174,000 = $69,000 per flowing barrel

Those are all very sensible metrics. But they don't look forward. Because when you look forward you see that Penn West is a company with its best days ahead of it.

What those metrics don't tell you is that all but five percent of the reserves are booked based on conventional production methods and not horizontal drilling and production. And Penn West is just now in the process of moving from a sleepy no growth conventional producer to horizontal producer with years of growth ahead of it.

Penn West isn't benefiting from this horizontal revolution because they saw it coming and went out and astutely acquired the land. They are benefiting because they have held the largest land position in the Western Canadian Sedimentary basin for years and other companies have now unlocked more of the oil in place for them.

Penn West has identified 10,000 (and growing) drilling locations in the Cardium, Swan Hills, Viking, Spearfish, Peace River, Colorado and Cordova areas of Western Canada. These unconventional wells are not in the current reserve figures. As these unconventional wells get drilled additional reserves are going to be booked and production will increase.

Penn West has the most leverage to large scale oil development using horizontal drilling in Western Canada. There is nothing baked into the Penn West stock price for what is going to be radical change to how this company operates.

The key thing to know about Penn West is that it controls 6 million acres, most of it in the Western Canadian Sedimentary Basin. These acres were originally developed using conventional development methods years ago.

When Penn West's conventional properties were drilled conventionally, Canadian regulations limited drilling to one well per section which means 80 acre spacing between wells. Compare this to the Permian Basin in Texas which has been developed using 5 acre spacing. There is a lot of recoverable oil yet to be pulled out of the ground on this already developed acreage.

As Penn West takes the horizontal drill bit to its underexplored acreage there is going to be years of growth in reserves and production ahead.

If I were an Exxon Mobil shareholder I'd far prefer the next $16 billion of capital be deployed buying Penn West Energy instead of Exxon Mobil stock.

Disclosure: I am long PWE.