Exxon Mobil And The Jam Today/Jam Tomorrow Dilemma

Jul.30.12 | About: Exxon Mobil (XOM)

Exxon Mobil (XOM) knows a good thing when they see it - a pristine balance sheet, nearly 20 billion barrels of reserves, and the largest refining system in the world produces almost bond-like cash flow that makes Exxon Mobil a favored place to park cash and capture decent dividends. If management really has anything to worry about, it may be as to whether it's worth risking the wrath of Wall Street to build an even better long-term asset base.

Lots Of Noise, But Basically Underperformance For Q2

Exxon Mobil's second quarter numbers weren't the cleanest that an investor could hope for, but that's become something of a trend lately. In any case, it was reasonably clear that clean earnings missed expectations, with pretty much all of the miss coming from the downstream operations.

Exxon's E&P (upstream) earnings fell about 8% (adjusted) on a sequential basis, weighed down by a nearly 9% sequential decline in production. While oil production was basically flat (and just above half of production), gas dropped sharply due in part to issues in Qatar. This quarter also marks the fourth straight year-on-year decline in quarterly production (down about 6% this time).

While production volumes did Exxon no favors, the company did a laudable job of wringing profitability out of that production and is up there with Petrobras (PBR), Chevron (CVX), and Hess (HES) as the most profitable upstream producers right now. It's worth noting too that Exxon's U.S. upstream business performance was more on the order of "okay", while the international operations were quite solid.

Refining was far less impressive, as adjusted earnings declined about 13% and missed expectations by a wide margin. Favorable crack spreads helped mitigate the underperformance in the U.S. refining operations; both US and OUS disappointed, but the OUS operations looked to be about two-thirds of the miss. Relative to Suncor (SU) et al, Exxon's performance in refining was not impressive, but performance in this business can be volatile on a quarterly basis.

Long-Tailed Assets And Reasonable Capex Needs Are Good Things

Although Exxon Mobil's acquisition of XTO was probably the wrong deal at that time, it's hard to fault Exxon's overall asset base. Relative to Chevron and ConocoPhillips (COP), Exxon's required capex intensity seems lower and yet the assets that the company is developing should have relatively long productive lives.

If there's a downside, it's that the near/intermediate-term production profile for oil isn't as strong as it as for a company like Chevron or Hess. Some of this is due simply to the assets that the company holds; relative to Chevron or Conoco (or even Royal Dutch Shell (RDS.A)), Exxon doesn't have a lot of liquid-rich shale acreage ready to exploit. Some of this may also be due to management's long-term view - the company has stayed firm in its conviction regarding solid long-term global demand for natural gas.

Buy For Today Or Invest For Tomorrow?

Exxon faces the same long-term problem that most other energy companies face - a declining return curve on new exploration investments due to increasing service intensity, faster depletion, and so on. Nevertheless, the company is still earning a very good return on its capital and I wonder if the company's balance sheet is under-levered at present.

I don't think it makes all that much sense for Exxon to chase an oil-heavy deal unless they find an offer they can't refuse. On the other hand, while buying one of the high-quality North American gas-heavy plays that currently trade relatively cheaply may make a lot of sense for the long term (particularly if LNG terminal construction gets moving), I don't think analysts or investors would cheer the news in the short term and the company could lose some of the higher multiple it currently enjoys (relative to the sector). Consequently, returning more cash to shareholders may be the preferred option - even if it's not necessarily what long-term shareholders ought to want.

The Bottom Line

I have no problem with Exxon getting a slight valuation premium, though I'd probably be just as happy owning Chevron today or a more speculative name like Apache (APA) and Statoil (STO) - and let me be clear, I mean speculative only relative to the rock-steady reputation that Exxon currently enjoys.

With fair value in the mid-$90s assuming no major long-term global economic malaise, Exxon Mobil looks like an okay energy company prospect today. I have no problem with those who see this as a veritable "buy and forget" holding, but I would observe that there are a lot of solid names for the buying today if investors are willing to cast a wider net.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.