After slumping last year, most oil stocks have come back strongly in 2016. The SPDR S&P Oil & Gas Exploration & Production ETF (NYSEARCA:XOP), the benchmark fund for hydrocarbon producers, has gained 17% this year. But Exxon Mobil (NYSE:XOM), the world's largest publicly traded energy company in terms of production and market cap, has underperformed this year, with shares gaining by just 6.8%.
The above-mentioned rally among oil stocks have been driven in large part by the strength in oil prices which have climbed more than 20% this year. The increase has been driven in large part by declining supplies from some major non-OPEC producers, particularly the US, and increase in demand.
Recently, Schlumberger (NYSE:SLB), the world's leading oilfield services company, said in a presentation that crude oil output from some major producers, such as the US, Venezuela, Nigeria, Canada and China, has been going downhill. That's leading the decline in global crude output which, according to International Energy Agency, fell by 0.3 million barrels per day in August from the same months last year to 96.9 million bpd. Meanwhile, global oil demand is still growing by 1.3 million bpd.
Exposure to oil prices
The improvement in oil market's supply-demand fundamentals could continue to push oil prices higher. That will change the fortunes of all oil producers. However, independent exploration and production companies like ConocoPhillips (NYSE:COP) and Pioneer Natural Resources (NYSE:PXD) could turn out to be bigger beneficiaries of high oil price environment than Exxon Mobil, considering that the former have greater direct exposure to oil prices than the latter.
In the second quarter, for instance, ConocoPhillips earned total revenues of $5.57 billion and reported a net loss of $985 million (adjusted), almost all of which was associated with the sale of hydrocarbons. Exxon Mobil, on the other hand, generated a profit of $2.3 billion (ex. corp. charges) in the same period, but just $294 million or 12.6% of that profit came from the oil and gas business. The rest, $2.04 billion or 87.4%, was related to refining and chemical businesses.
These non-oil-and-gas-production businesses limit Exxon Mobil's direct exposure to commodity prices, which works out well when oil prices are falling. The downstream or refining business, in particular, acts as a natural hedge in the downturn. The unit uses oil as a raw material and therefore performs better when the commodity's price is declining. But when oil prices rise, the same refining business can prove to be a drag on the performance of the entire company.
It's not surprising therefore that with increasing oil prices, the shares of independent exploration and production companies are outperforming Exxon Mobil. If oil strengthens further, the independent exploration and production companies will continue to do well. There is, however, a flip side to this.
Although oil prices have gained substantially this year, the commodity's future outlook continues to look uncertain. On the supply side, the global market received positive news when OPEC members agreed to cap output. The cartel has decided to reduce its volumes to the range of 32.5 to 33.0 million bpd from 33.24 million bpd currently. Iranian Oil Minister Bijan Zanganeh has said that OPEC will reduce production by almost around 700,000 bpd. The group will discuss details related to production from each member state during its formal meeting in November.
The news has already propped up oil prices and energy stocks. This is certainly a significant decision from OPEC which not only shows that the cartel is reinstating the production ceiling, but also that arch rivals Saudi Arabia and Iran are willing to work together to rebalance the oil market. But it remains to be seen whether the decision was largely symbolic or it actually can have an impact on global crude supplies.
Remember, some key OPEC members, such as Saudi Arabia, Kuwait, the UAE and Iraq, continue to produce near-record quantities of crude. Iran has been ramping up output quickly to reach pre-sanctions level of production of 4 million bpd. Last month, the country produced 3.6 million barrels of oil per day. Russia, the largest crude producer outside of the cartel which isn't involved in the latest decision, is pumping near 25-year high level of crude. On top of this, we have Nigeria and Libya where oil production has been hampered by disruptions but could resume in the near future. Due to these reasons, the actual decline in output from OPEC could be much smaller than Zanganeh's forecast.
Meanwhile, the above-mentioned drop in global crude supplies seen in August was driven in large part by drop in production from non-OPEC members, particularly the US. But here, drilling activity has been gradually climbing. The US oil rig count has largely climbed since the start of the summer. The latest data from Baker Hughes (BHI) showed that US drillers added two additional rigs in the past week, bringing the total count to 418 units. The increase in drilling activity could slow down the pace of declining US oil production. This, coupled with persistently high output from key OPEC members and Russia, could push global supplies higher.
Meanwhile, although oil demand has been climbing, there is still risk to the downside. Note that due to the sluggish global macroeconomic growth, oil's demand isn't growing as fast as previously thought. The IEA has trimmed its demand growth forecast for 2016 by 0.1 million bpd and expects another drop to 1.2 million bpd by next year. The UK's decision to leave EU and growing geopolitical tensions in the Middle East and the Indian Subcontinent has further clouded future outlook. Therefore, although oil demand is still growing, there is a downside risk. Lower-than-expected decline in global oil supplies or weak demand could drag oil prices in the future. That may have a bigger impact on independents than Exxon Mobil.
The strength in crude oil prices has increased the appeal of independent oil and gas producers. But for an uncertain environment, in which oil prices continue to face downside risk, Exxon Mobil should remain one of core holdings for energy investors. The company is truly a vertically integrated major, with an enviable portfolio of refining and chemical businesses that provide crucial support to its bottom-line in the downturn.
Exxon Mobil's downstream refining is so large that it is at par with some of the world's leading refiners. Its Baytown refinery in Texas is its single largest refining asset. With a throughput capacity of 584,000 barrels of crude oil per day, this facility ranks as the second largest refinery in the US and one of the biggest in the world. Similarly, on a stand-alone basis, Exxon Mobil Chemical, which is engaged in the production of petrochemical and polymer products, is one of the world's leading petrochemical companies. Thanks in large part to these businesses, Exxon Mobil is one of the rare oil and gas producers that has remained profitable throughout the slump.
In addition to this, Exxon Mobil also benefits from having one of the best balance sheets in the industry. The company has an under-levered balance sheet, with a net debt ratio of just 18%. According to data from a recent report emailed to me from Oppenheimer, the leverage metric is lower than the average ratio of 22% of vertically integrated majors and 33% of large-cap independents. Exxon Mobil also carries the best credit rating from the primary rating agencies as compared to other publicly traded energy companies. That's also a testament to its strong financial health.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
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.
Additional disclosure: I own shares of funds that may hold a long position in XOM, COP, SLB, BHI