Analysts Are Wrong About Exxon

| About: Exxon Mobil (XOM)

Exxon Mobil (NYSE:XOM), the largest oil company in the world by market capitalization, reported earnings below expectations because of stagnant demand for oil in the world as well as falling prices for natural gas in the U.S. Net income for the second quarter was $15.9 billion (EPS of $3.41 per share) compared to $10.7 billion (EPS of $2.18 per share) in the corresponding quarter of the previous year. But, almost half these profits came from one time items and, if these are excluded, the EPS drops to $1.80 per share, which is $.15 per share lower than the consensus estimates. Exxon fell short of estimates for the second consecutive quarter in the backdrop of declining production, which, at the equivalent of 4.15 million barrels per day for the quarter, was the lowest levels in the last two years. The company is trying to arrest the decline with $37 billion in capital expenditure for this fiscal. Sales were up 1.5% to $127.4 billion.

Brent oil crude futures, which are the benchmark for much of the global oil, averaged just over $108 a barrel, which is a 7% decline from the same quarter of the previous year. Natural gas futures for the quarter fell by 46% to hit the lowest quarterly average since 1999. Oil demand in the US and Canada, which account for more than 30% of global demand, stayed flat at the same level as the previous year. Natural gas is the most widely used fuel for furnaces in the U.S. Natural gas is also the second largest source of electricity in the U.S. But recent innovations in drilling and fracking shale rock formations enabled U.S. and Canadian producers to flood the market with natural gas, causing prices to crash to the lowest levels in the last 10 years. Exxon itself spent $35 billion in 2010 on the acquisition of XTO Energy to enable it to overtake Chesapeake Energy (NYSE:CHK) as the largest natural gas producer in the U.S. Prices have dropped nearly 33% since then. I believe natural gas will be a drag on Exxon for some time to come.

Exxon increased natural gas production by 1.4% despite the glut, and the U.S. now accounts for almost one third of global gas production. Profits from U.S. oil and gas wells dropped more than 50% to $670 million, while oil and gas income outside the U.S. rose by over 8% to $7.68 billion. The company sold part of its Japanese business to TonenGeneral Sekiyu KK, and the total one-time gains for the quarter were $7.5 billion. Many of these factors also caused competitor Royal Dutch Shell (NYSE:RDS.A) to announce a 13% fall in quarterly profits to $5.7 billion against the consensus estimate of $6.3 billion.

There is no doubt that the Exxon's second quarter numbers were disappointing, but a closer look reveals that upstream earnings fell by around 8% because of the nearly 9% decline in production. Despite the declining production, Exxon seems to have done a reasonable job in producing profitability from this production and, along with Petrobras (NYSE:PBR), Chevron (NYSE:CVX), and Hess (NYSE:HES), is one of the most profitable upstream producers at the moment. Upstream performance in the U.S. was tolerable, but the company's international performance was much better. Refining was disappointing because of the earnings decline of around 13%, and well below expectations. Compared to companies like Suncor (NYSE:SU), there is definitely room for improvement in the case of Exxon, bearing in mind that this is a volatile business with large quarterly variations.

Exxon currently faces the same problems as many other energy companies. It faces declining returns on new exploration, a high rate of depletion, and increasing difficulty in finding new sources of oil to boost its reserves. One way of offsetting its declining production is to make a major oil acquisition, but unless there is some foreseeable growth in global energy demand, the acquisition would only compound the current problems. Equally, the current gas situation in the U.S. makes many gas producers look cheap but, once again, unless there are significant new sources of demand, the cheapness alone does not justify such an acquisition.

Exxon has seen some positive developments in the second quarter. The company has raised its dividend for 29 consecutive years. Exxon currently yields 2.7%. This provides the consistency of dividends that many income investors seek, and the sheer size and financial strength of the company means that the dividend is sustainable in the long-term. It has a balanced portfolio of businesses which enables it to cater to any kind of global product demand. The company is a veritable cash machine with operating cash flows of over $57 billion and free cash flow of over $22 billion. Exxon is also a disciplined investor with substantial capital expenditure, while leaving enough cash for a generous dividend.

UBS has downgraded Exxon from "buy" to "neutral", primarily because of the decline in production and the fact that asset disposals accounted for a large part of second quarter profits. Yet, if you look at it dispassionately, it really does not make sense for the company to ramp up production at this point of time. Instead, it makes sense to cut back on gas production in order to reduce losses, while holding oil production at current levels until demand begins to revive. In the long-term, given that there is no alternative, oil and gas will continue to be major sources of energy, and demand is bound to increases again at some point of time.

Contrary to many analysts, I recommend buying Exxon at this time. Exxon is a solid and stable investment with a sturdy dividend yield which should please dividend investors for the long-term. Exxon is also a good choice as a "buy and hold" investment if you are a patient and conservative value investor. I urge investors to hold onto any existing investment and collect the dividend yield while waiting for capital appreciation.

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

About this article:

Author payment: $35 + $0.01/page view. Authors of PRO articles receive a minimum guaranteed payment of $150-500. Become a contributor »
Tagged: , , , Major Integrated Oil & Gas, Alternative Investing
Problem with this article? Please tell us. Disagree with this article? .