Two years ago to the month the now infamous fall in oil prices began as OPEC declared a price war on, well, everybody.
Now as we see OPEC nearing capitulation and ready to agree to some reductions or at least talk about doing so endlessly without taking action, it is a great time to check in on Exxon Mobil (NYSE:XOM) and see how the company has fared. In this article we start talking about the peak earnings trap, which is always relevant and great learning for those thinking about investing in many publicly traded companies.
Then we dive into an example about why crashes in oil prices, such as we have recently endured, are actually great for oil majors. Is Exxon doing what they need to do to manage the cycle and what is up with the InterOil acquisition? All this and more!
Peak earnings trap
One of the key theories or tenets of investing that goes beyond the basic understanding of what moves stocks and the language of the market (EPS, buybacks, PEG ratio, etc.) is the concept of peak earnings.
I define peak earnings as the point at which a company seems to be the cheapest it has been in quite a while but in reality it is very expensive and a bad investment at that point.
This phrase and idea may have originated from the well regarded Peter Lynch. He gave the example of buying Ford (NYSE:F) just as the economy and auto sales peaked only to be in a world of hurt three years later when cars are being moved off the lot at bargain basement prices.
What causes this trap and how can we avoid it?
The peak earnings trap usually involves companies that are cyclical or highly levered to an underlying commodity. These would include oil companies, gold miners, most industrials, car makers, etc.
An example relevant to this article is that of an oil and gas exploration company, call it company A. When the price of oil hits all-time highs, they company produces record earnings and even if the price keeps up the company will trade at 10-20 times earnings. To the novice investor this may seem cheap and perfectly reasonable given the circumstances and record profits.
When oil trades down to $20 a barrel company A barely breaks even. The price comes down but any price compared to a few cents in EPS is going to produce a PE ratio in the 30-500 range. A company trading at $20 with a yearly EPS of .05 has a PE of 400x.
Novice investors might look at such a company and valuation and declare it "super overprice" or "outrageously expensive."
And it appears that on the surface they are correct, but let's explore why they are not and in fact come up with the exact opposite conclusion from the correct one.
PE Values Throughout the Cycle
XOM PE Ratio (TTM) data by YCharts
The above Exxon Mobil chart of the 10-year trailing PE starts to illuminate what we are talking about, although not as clearly as we like because Exxon can be a stubborn old dog and is less volatile than most oil stocks.
You can see the spikes in the PE ratio when earnings get hurt due to oil prices. The most recent spike is especially pronounced as the drop in oil prices from the highs in late 2014 have caused bankruptcies, operating losses, write offs, and all sorts of other chaos in the industry since.
But is now the best time to buy Exxon, despite the fact that this indicator shows it is crazy expensive? One could only come to that conclusion if they believed and for certain that oil prices would stay below $40-$50 a barrel for the next five years.
Since there is no way to know that, although fools can certainly predict such a thing with no one there to validate their initial claim, now could be a great opportunity.
Why is this important? Why should we care when it is a great time to buy oil companies, especially these gigantic, slow-moving super majors?
We care because it can be worth it. Exxon Mobil has returned over 12.71% per year over the past 30 years. This compares to 10.61% for the S&P 500 index.
The secret to this success is that the boom and bust cycles help patient, long-term investors who reinvested their dividends or acquired more shares with fresh capital. The nice part is that one does not need to time the exact bottom either if the downturns last a few years as this one has.
Starting yields of these firms skyrocket when their commodity drops and the PE ratio soars as well. Earning a outsized yield for any amount of time when prices are low can have an acceleration effect as more shares are acquired when prices are so low. When the cycle turns the investor now owns more shares than they otherwise would have, all else being equal.
This means they receive more dividends, a larger share of retained earnings, and their ownership position grows faster as the company reduces the share count through buybacks and their (larger) dividends are reinvested.
Acquisitions At the Bottom of the Cycle
The other secret to oil majors being great investments and the importance of understanding the cycle is the impact that acquisitions have. It is relatively simple to understand that you want to be buying assets at the bottom of cycle, not selling.
Yet how many stories and news items have you seen since 2014 about companies selling assets to pay dividends, pay down their debt, or merely stay afloat?
- Chesapeake Energy Sells Key Shale Assets, Investors Applaud
- Marathon Oil Corp. secured agreements to sell $950 million of assets in its latest move to raise cash to weather the worst crude market rout in a generation.
You may think the majors are guilty of this too and everyone has failed this cycle. But you would be wrong.
First let's take a look at what Exxon did back in 2010 when they bought XTO.
XTO gave them an instant presence in many of the hot shale plays that they had largely missed out on.
One could make the argument that in terms of the price of natural gas that the acquisition was ill timed. Natural gas prices have been up and down since then and are now below where they were in 2009-2010 when the acquisition was made.
But this acquistion was about more than short term natural gas prices. Rex Tillerson, the CEO of Exxon Mobil, gave you the real reason right in Wall Street Journal article after the acquisition was announced:
"Exxon said it doesn't expect significant cost savings from trimming overlap. ""This is not a near-term decision, this about the next 10, 20, 30 years."" Mr Tillerson said." (Source)
Go back to that 10/20/30 year chart above. Ask yourself, how does a company generate such outperformance over such a long timeframe?
Sure, anyone can outperform quarter to quarter or even for a year or two by juicing the numbers with lower tax rates and other financial mischief, but 30 years?
Quoting from Joshua Kennon, a private investor and entrepreneur, in his essay on oil majors:
"Twenty or thirty years from now, the price of these commodities will in all likelihood be considerably higher in nominal terms, the acquisition costs long paid in full. The stockholders of big oil will be collecting much larger dividend checks per share than they are now, perhaps not realizing that the nexus of those funds date back to this period." (Source)
What have the other majors not named Exxon Mobil been up to you ask?
Well you made have heard about Royal Dutch Shell's (NYSE:RDS.A) (NYSE:RDS.B) $52 billion acquisition of BG Group in 2015. This is similar in many ways to Exxon's acquisition of XTO in that it is a clear sign from RDS management that they believe the future will be more about natural gas than oil and they want to be an integral part of it.
Did RDS time it well? The Guardian cites recent events before the acquisition took place:
"...Shell will be taking on a portfolio of potentially riskier assets. BG shares had fallen by nearly a third in the last year prior to today's announcement, as the company's exposure to a series of troubled projects in Brazil and costs associated with the launch of a new liquefied natural gas (NYSEMKT:LNG) project in Australia weighed on the shares." (Source)
Joshua Kennon gets straight to the heart of why oil majors are such successful investments even though their industry is prone to wild swings in end prices is capital intensive.
"By thinking in decades instead of quarters, oil majors are able to profit from commodity downturns. In fact I would go as far to say that the commodity cycle is crucial to why these companies have been such great investments in the past and will continue to be. Without the uncertainty and great deals the cycle causes, the returns would be much subdued. " (Source)
The cycle helps oil majors and shrewd investors achieve outsized returns. The trick is that if either the investor screws up and buys at the wrong time or the company makes no acquisitions at the bottom of the cycle or too many acquisitions at the top, everything can go awry. The saving grace for the investor is that with enough time and patience they can make up for an ill-timed purchase, as we saw from the 30-year return chart above.
With that in mind, lets move on to Exxon Mobil's latest acquisition of InterOil.
Interoil holds potentially valuable licenses in Papa New Guinea for natural gas. Much like the XTO acquisition a few years back, this acquisition is heavily focused on natural gas and shifts the oil major further away from crude just as Royal Dutch Shell has.
The structure of the deal is mostly in newly issued Exxon stock with a contingent payment based on how much natural gas is truly on InterOil's properties. I like the structure of the deal considering that Interoil is a company with a history of operating losses and no revenue. It is a explorer, not a producer.
One my expect Exxon Mobil to issue some dirt cheap debt or use their cash on hand for such an acquisition, but I have to imagine that the share method looks more appealing once one examines how Exxon's debt level has exploded since oil prices came crashing down.
Exxon Mobil's balance sheet remains strong although they did lose their AAA rating from S&P so it is not as strong as it once was.
My one question is: Were there no actual producers Exxon could have bought? While oil has stabilized between $40-50 with the hope of an OPEC miracle on the horizon, surely there are some companies out there still looking for a way out of the dark tunnel?
Exxon could be holding back their debt-issuing capabilities for just such a move, but since I haven't heart any whispers of such a move since July when this transaction was announced.
For another quick take on Interoil, M&A Daily writer and Seeking Alpha linchpin Chris DeMuth had a entertaining instablog back in 2013 about how all InterOil produces are press releases and more shares outstanding while their employees goof off thousands of miles away.
More recently he said this might be a huge blunder and one of the worst acquisitions ever. Whether the suits in Texas can whip the employees into shape and find enough gas to recoup their 2.2 billion remains to be seen. Look forward to minimal press releases and exploration results buried past page 100 in quarterly filings if it doesn't.
Hopefully this article has given you a sense about how oil majors have been so successful in the past and help you frame your opinion about which ones are doing the right things during this cycle to dominate on the other end.
An investment at Exxon Mobil at current levels depends upon your outlook for oil prices, whether or not you believe OPEC has any effectiveness in today's oil world, and whether or not you are comfortable with Exxon's exploding debt load and their only acquisition this cycle being a highly risky explorer rather than, say, a Permian Basin fracker.
Disclosure: I am/we are long RDS.B, XOM, CVX.
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.