Exxon Mobil (NYSE:XOM) certainly creates mixed feelings for us. On one hand, the company is a behemoth in what is a neglected and undervalued sector in our opinion. On the other hand, we don't want to buy it just for the reason everyone else is piling on into it - the large dividend yield. The company reported Q1-2020 earnings and we thought it tipped its hand rather notably on the key reason we think the dividend is unsustainable. We break down the results and give you our take.
The results
XOM's Q1-2020 reads like a badly scripted horror show with GAAP loss of $610 million thanks to large write-downs.
Results included a $2.9 billion charge from identified items, or $0.67 per share assuming dilution, reflecting non-cash inventory valuation impacts from lower commodity prices and asset impairments.
Source: XOM Q1-2020 press release
XOM broke down changes from Q4-2019, most notable of which was the Norway divestment.
Source: XOM Q1-2020 presentation
While the GAAP loss might be due write-downs, even outside those we would note that XOM remains extremely commodity price sensitive.
Source: XOM Q1-2020 presentation
70% of the entire delta versus Q4-2019 was produced via price changes in the underlying commodities. Total adjusted earnings were down so much despite refining margins actually moving up versus last quarter and volumes moving higher (slide above).
Source: XOM Q1-2020 presentation
In fact, even XOM's mix of liquids to gas production moved favorably for the company this quarter.
Oil‑equivalent production was 4 million barrels per day, up 2 percent from the first quarter of 2019, with a 7 percent increase in liquids partly offset by a 5 percent decrease in gas. Excluding entitlement effects and divestments, oil‑equivalent production was up 5 percent from the prior year, with Upstream liquids production up 9 percent on growth in the Permian and Guyana.
Source: XOM Q1-2020 press release
All in all, this was a very tough quarter for the company. With energy companies, GAAP earnings though mean less than the underlying cash flows and so that is where we focused our attention.
Cash flow
For the purposes of our understanding of cash flow, we ignore changes in working capital as that can be very volatile from quarter to quarter.
Source: XOM Q1-2020 presentation
Taking that out of the equation, we see that XOM produced $7.4 billion in adjusted operating cash flow in this quarter compared to $10.6 billion the previous. XOM spent $10.2 billion in dividends and capital expenditures in Q1-2020 quarter, handily outpacing the adjusted operating cash flow. In other words, adjusted operating cash flow was just 72.5% of capex plus dividends. As horrible as that run rate sounds, we stress that this is just the tip of the iceberg for the next few quarters. One key reason is that West Texas Intermediate averaged about $46.70 in Q1-2020 as shown by the 66-day average in the chart below.
Source: Stockcharts
WTI has averaged $19.00 so far in Q2-2020 and spot prices have blown up even more significantly.
Source: Oil Price
Even after XOM's operating cost reduction, we expect Q2-2020 to have an unprecedented negative adjusted operating cash flow before capex and dividends. Taking this out further with even a modest V-shape recovery, where oil averages $35 in Q3 and $40 in Q4 of 2020, we can see the cash outflow drain the company coffers.
Source: Author estimates and calculations
The key problem here is the the rate of change in debt alongside the inability to actually create a payback cycle. In Q4-2019, XOM boasted of its financial capacity. We show below our extrapolations of where XOM will be by year-end 2020 if our projections are in the ballpark.
Source: XOM Q4-2019 presentation, with Author estimate of YE-2020 numbers
The tell
XOM recently said that it is cutting 2020 capital spending to $23 billion which is a 30% reduction below previously announced guidance of $33 billion for 2020. For us the key tell of why this is getting to the point of a dividend cut was the volume guidance revision. XOM's $10 billion capex cut has already chopped off 125,000 barrels per day from 2021.
Source: XOM Q1-2020 presentation
Note this is for 2021 and XOM is assuming there won't be any economic shut-ins, but just based on the capex cut, volumes will fall 3%. At this point, we think that XOM is till modeling a high capex for 2021, but in all likelihood, volumes will be revised even lower as 2021 capex is cut. This gets back to our key theme here that XOM needs $25 odd billion a year in capex to keep production flat. We are seeing that here as 2020 capex will get near $23 billion and 2021 production will dance with the 0% growth line. Thus, to sustainably pay a dividend and maintain production, XOM needs an annual $40 billion in adjusted operating cash flow. That translates into a $10 billion a quarter adjusted operating cash flow.
Source: Author estimates
When was the last time that XOM surpassed that? Well, in back half of 2018 where crude oil prices averaged $60, natural gas averaged $3.30 and XOM had strong refining margins, it was able to average $10.9 in quarterly adjusted operating cash flow. With today's refining margins and natural gas prices, XOM needs oil over $80/barrel to produce the same results. The volume story has once again revealed that XOM needs to spend big to keep its aging asset base producing decent volumes.
Conclusions
One strong positive aspect about XOM is its ability to recycle its older assets and divest them for good proceeds. That, however, is a big headwind in this price environment as nobody wants to be a buyer. Devon Energy (DVN) recently bent over backwards to complete a sale that the seller was developing cold feet on. XOM is going to find that nobody has an appetite to buy these assets today at what are good prices for the company. This removes the last possible fallback for trying to muddle through this low price environment.
Investors who are using the global financial crisis as a playbook for XOM maintaining the dividend are not seeing this correctly. XOM went into GFC with a net $22 billion in cash and a $20 billion capex run rate to keep production flat. They also got an average oil price of $90/barrel in 2008 and $53/barrel in 2009. Natural Gas prices averaged $10/MCF in 2008 and $4.50/MCF in 2009. At end of 2020, they will be in $65 billion of debt and require $25 billion a year to sustain production. They will be looking at realized prices at half of 2009 levels for both commodities. This is not remotely the same thing and XOM will cut its dividends within 1-3 quarters.
The cut, though, is not to be feared as it likely will create a capitulation for a long term move higher. We still think, though, that XOM will provide compelling value to investors on a relative basis and outperform the broader indices over the next decade by a wide margin.
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Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints.
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