Should Exxon And Chevron Investors Fear A Trade War?

Summary

• The risks and probability of a trade war have greatly increased over the past month, and I feel investors should consider how their investments may be affected.
• Exxon and Chevron are financially strong companies that can handle any realistic turmoil that may occur due to trade disputes.
• In the short term if trade relations continue to deteriorate, it would likely adversely affect oil prices and hence their profitability.
• However, I believe oil markets would once against stabilize, and hence, long-term investors should not be too concerned, whilst still being prepared for the possibility of higher volatility.

Introduction

During the past month, there has been a great deal of news and debate surrounding the Trump administration's new trade tariffs and polices that are largely targeted towards China. These proved to be the catalyst required to finally return the volatility that was largely absent from last year's bull market.

Many investors, myself included, have been keenly following these announcements, concerned they may ultimately spiral into a full-blown global trade war with the United States and China at the center. Whilst I feel this outcome is still not inevitable, in my opinion it is wise for investors to consider how their investments would fare if such a situation eventuates. Even though the exact fallout is unknown, I believe it is possible to accurately estimate the general level of threat posed.

This article will not be discussing the trade policies themselves, but rather the effects that a trade war would likely have on ExxonMobil (NYSE:XOM) and Chevron (NYSE:CVX), and in doing so, address my headline question: should investors in these companies fear a trade war?

Image Source: CNN Money

Possible Effects

Economic Activity

I'll begin with the main and most obvious threat that most businesses face from a global trade war: lower global economic activity that possibly leads to a recession. A recent article published by Bloomberg highlights the drag a trade war would have on the world's economic activity (see below).

Image Source: Bloomberg article (previously linked)

I suspect most readers are already aware that lower economic activity equals lower demand for oil and its related products, which is obviously an issue for Exxon and Chevron. However, I feel it is important to remember that oil demand is currently forecast to continue growing over the foreseeable future. Therefore, if lower economic activity reduces future oil demand, it may only be reducing the growth in demand that otherwise would have occurred, not the actual level of demand.

Regardless of the exact effect on oil demand, a trade war would certainly have a negative impact on oil prices in the short term. Over the long term, the supply and demand imbalance would correct, and due to Exxon and Chevron's strong financial positions, they have ample flexibility to handle any realistic turbulence during this process.

Furthermore, whilst it cannot be guaranteed, I believe it is highly likely that OPEC and Russia would step in to cut production if prices were to fall too far (sub ~$40 a barrel), thus providing an extra safety net.

Higher Inflation and Interest Rates

If global trade tariffs continue increasing, they will likely cause cost-push inflation to increase, and thus cause interest rates to increase. The timing of this is particularly concerning, since interest rates are already on their way up again and the Federal Reserve has begun shrinking its massive balance sheet left over from quantitative easing. A sharp increase to interest rates would likely have far-reaching effects, not just on broad economic activity but also on the cost of capital.

A significant increase to the cost of capital is a large threat to zombie companies that do not generate enough cash to sustain their operations and are hence reliant on supportive capital markets offering cheap credit. By examining the financial ratios I've calculated below as well as their credit ratings, it is apparent that both Exxon and Chevron are in a very strong financial position. Therefore, both companies can definitely handle higher interest expenses and are not solely reliant on capital markets.

	ExxonMobil	Chevron
Gearing Ratio	16.76%	18.48%
Interest Coverage	32	31
Net Debt / EBITDA	1	1.17
Current Ratio	0.82	1.03
Credit Rating	AA+	AA-

Click to enlarge

Table Source and Calculations: My own work

Data Source: Exxon 2017 10-K report and Chevron 2017 10-K report

Higher Steel Prices

One of the key areas that the Trump administration has imposed tariffs on is steel and aluminium imports, which is of concern to Exxon and Chevron, since most of their operations are fairly steel-intensive. This obviously has little effect on their continuing operations, as these are already built, and thus, the main effect will be on future investment decisions.

Since steel is only one cost input and their future investment opportunities span many different countries, I believe this is a hurdle they will be able to overcome with minimal impact. These steel tariffs are more of a problem, but still manageable, for energy companies that only operate in the United States, such as Pioneer Natural Resources (PXD).

Chinese Retaliation

Since the two main countries in this trade dispute are the United States and China, I feel it is wise to consider how China could possibly retaliate against U.S.-based companies such as Exxon and Chevron. Thus far I have seen no formal indication that China plans to retaliate against either of these companies or the products they produce; however, this could change in the future if relations continue to worsen.

Thankfully for Exxon and Chevron, I believe that China has no effective means of retaliating against them. An example of a possible retaliation would be for the country to reduce or stop purchases of oil and LNG from U.S.-based companies. Whilst this may sound significant, in the long run I doubt it would have any meaningful effect on them, as it would ultimately just change the destination of their cargoes, since they are globally traded commodities.

Conclusion

A global trade war, if it does eventuate, would certainly pose a short-term threat to Exxon and Chevron. However, due to their strong financial position, I believe they are both capable of handling any realistic fallout and are unlikely to suffer any meaningful long-term setbacks.

To answer my headline question, it depends on your investment horizon. If you're only making a short-term investment, then yes, you should be concerned. However, if you're a long-term investor, then no, I do not believe you should be too concerned, but still be prepared for increased volatility. Since I'm a long-term investor and Exxon shares are currently trading near a 52-week low, I feel it is quite an attractive investment, and hence, this morning I doubled down on my investment at ~$75/share.

Analyst’s Disclosure: I am/we are long XOM.