Vertical Integration Helps Imperial Oil Weather A Difficult First Quarter

Summary

• Increased production was insufficient to offset profit declines caused by lower prices.
• While the upstream segment was hard hit, the firm's downstream division mitigated losses to an extent, showing the strength of Imperial's vertical integration.
• Non-cash impairment charges played a large role in the firm's negative earnings for the quarter.
• The firm maintains a strong liquidity position despite an approximately $300MM cash outflow.
• Business outlook is still negative, but Imperial has a strong chance of survival.

Author's Note: All figures discussed will be in CAD unless stated as otherwise.

Reduction in production levels, globally, has pushed oil prices off their previous lows. Many producers, however, would be unable to sustain their businesses at current prices. Energy demand is unlikely to rebound quickly as efforts to reopen businesses will be very slow. Many firms over-indebted and with high capital costs could face insolvency as refinancing credit could prove difficult. The risks facing the industry as a whole are significant, but the probability of survival for some is higher than others.

Imperial Oil's (NYSE:IMO) first-quarter results showed the strength of the firm's business model through a tumultuous environment. Its vertical integration mitigated losses stemming from the upstream division. Cash flow generated in the quarter proved sufficient to meet capital expenditures, damping the negative quarter's impact on the business' financial position. Being financially backed by one of the largest global oil producers, Imperial should prove capable of remaining a force within the oil sands region, but it is still wise for investors to remain cautious.

Analysis of First Quarter Results

Production volumes increased year over year through the first quarter, despite the reduction in energy demand. Net oil-equivalent production rose by 14% to 403 thousands of barrels per day from a year prior. The increase comes largely as a result of the firm's supplemental crushers coming fully online at its Kearl site. The capital project began in 2017 intending to reduce the impact of a bottleneck at the front end of the plant which had previously led to longer downtime.

Increased productivity at the Kearl site should create greater cost efficiency for the firm as operational costs can now be spread out against a larger volume of products, reducing the per-unit costs of the facility. However, any benefit to be had from the increased productivity was overshadowed by the steep decline in average commodity price realizations.

(Source: Imperial Oil Q1 2020 News Release)

As a result of unfavorable market conditions, the upstream division posted a significant loss as production and operating expenses remained essentially flat, while revenues fell by 26% to $2,374MM. The strength of Imperial was evident in the first quarter despite these weaknesses, as the business's downstream segment's revenue fell by only 9% to $5,379.

As discussed in a previous article, the strength of Imperial's vertical integration lays within the fact that the downstream business is less susceptible to commodity prices, instead profiting from the margin between crude oil inputs and the resulting petroleum products the business sells. While this approach limits the gain to be had on surges in oil prices, it provides downside protection.

Net income losses of $608MM in the upstream division were mitigated to a large extent as the downstream business posted a net gain of $402MM, which is up from Q1 2019 income by 56%. The positive impacts for the downstream business came as a result of higher margins accounting for approximately $190MM of the total income for the period.

A large portion of the total losses was a result of non-cash impairment charges. As with many firms in the industry, Imperial saw a write down in its inventory totaling $281MM, $229MM of which came from the upstream division. Non-cash expenses, while not of importance for short-term liquidity, hold relevance in the fact that, all else equal, they can impair a firm's leverage. This could require businesses to sell assets at disadvantageous prices to maintain target capital ratios.

In Imperial's case, the write-down was not significant to the firm's overall financial health due to the relatively small size of the expense. A cash inflow of just over $1 billion from accounts receivables and a simultaneous reduction in accounts payable of approximately the same amount helped the firm maintain its positive working capital position.

The exact nature of the adjustments in the current accounts is not made available in interim reports. It would be advantageous for the analyst to understand such changes to a greater extent, specifically in regards to accounts receivables and payables. The current economic environment creates a great deal of uncertainty surrounding the business's capability to fulfill credit obligations. It is then of concern to understand how just over 1.5 billion in current assets could be impacted. In section 5 of the notes to the quarterly financial results, the interim report states that "no material adjustment to credit allowances in the quarter was required."

(Source: Imperial Oil Interim Report)

Despite the hit to earnings, free cash flow was positive for the quarter as Imperial was able to generate $423MM in cash from operating activities compared to $310MM used for capital expenditures. The ability to cut CAPEX significantly on fairly short notice surely benefitted the firm in this respect, and the results for the first quarter put the business on pace to achieve within its target range of $1.1- $1.2 billion for the year.

One point of potential concern to highlight is the large disparity between the downstream segment's earnings and cash flow. As mentioned already, the division posted a significant gain of $402MM, this, however, is in stark comparison to the CFO generated of only $22MM.

The consolidated cash flow statement does not provide any clear indication in terms of large non-cash adjustments. It is possible that the significant reduction in accounts payable came largely from the downstream division, thus resulting in a reduction in cash received from the business. Without the calculations showing the adjustment from net income to CFO for each division, the analyst cannot identify with certainty the cause for such a disparity.

In terms of net cash generation, the firm posted a net outflow of $330MM for the quarter; the amount was fully funded from cash holdings. The spending was largely attributable to shareholder compensation, as thus far management has been reluctant to reduce the dividend, currently, paying out $164MM per quarter. Added to this, the cumulative share buybacks resulted in an additional $274MM, almost entirely accounting for the net cash outflow.

Management had indicated in previous a news release that the business would be suspending its buybacks as of April 1. This creates a large area of cash savings for the business, but given the fact that the current crisis plaguing the industry did not begin until late in the quarter, it is uncertain if these additional savings will prove sufficient to maintain cash flow if prices remained subdued, although it can only help.

Business Outlook

If commodity prices remain subdued during the remainder of the second quarter, Imperial's cash flow may be significantly lower than that in the first. While prices may be rebounding to an extent, the fundamentals would suggest the demand for energy moving forward will be remarkably lower than that in the past.

Further disruptions brought about by dispute within OPEC+ could very well send markets again for a spin. Many countries within the group cannot survive with prices at such prices and may be tempted to leave the cartel. Countries such as Venezuela have been hard hit with economic catastrophe long before coronavirus was a topic of discussion. The country could leave the cartel if it believes it is to its advantage. With a significant portion of global oil reserves, Venezuela could easily flood oil markets and drive prices lower.

This possibility makes it necessary for firms to create cost efficiencies to ensure they can maintain with lower for longer oil prices. Management had indicated on the earnings call that its objective was to push all-in sustaining costs to the USD $20/bbl level and believes it is on a path to do so. Increased efficiency at the Kearl site could certainly help led the way in this effort. The target CAPEX spending range of $1.1-1.2 billion is approximately $100- $200MM above the minimum spending level to maintain operations. Management has indicated that, if necessary, they could cut current spending by these amounts.

Lack of Government Aid Could Create M&A Opportunities

The government aid allocated to the oil and gas industry thus far has been significantly less than estimates originally reported on. Those looking for a recap can find it in a previous article here under "Government Stimulus". Whether the funding is justified would depend largely on who is asked, as the divide over any matter that has environmental impacts has grown considerably over the years. What is evident, however, is that the proposed stimulus will not support those failing within the industry. The type and relative size of the aid are inadequate to cover the liquidity needs of producers.

This could lead to the insolvency of several firms within the region. If firms who are in danger of defaulting on their respected financial obligations begin looking for larger firms to buy them out, Imperial Oil could benefit from discounted asset purchases.

Not only does the firm's financial backing by Exxon (XOM) create stability, but it also gives the firm capacity to grow during times when many other businesses cannot afford to make acquisitions. This can be a very advantageous position for the firm as long-term prosperity could come from the ability to buy assets at depressed valuations.

Management was prompted on the subject during the recent earnings call and responded in kind.

Obviously, there are a lot of assets that, unfortunately, are distressed, given these economic conditions. So we always keep the aperture open, evaluating whether there are strategic opportunities for us to expand our portfolio or change our portfolio, and this time is no different. So we continue to refresh our analysis in that regard. I would say, though, that my experience in M&A is that at these extreme points in the cycle, it could be very difficult to transact because buyers and sellers' expectations become very different and view of what recovery might look like and the timing for that is often very different. So it's difficult to transact, but that doesn't discourage us from continuing to evaluate potential opportunities and see if there is something that makes good strategic sense for us. So that work continues.

(Source: Imperial Oil Earnings Call Transcripts)

Conclusion

The evidence for a "V-shaped" recovery that some have suggested is insufficient. Output is likely to be considerably lower for some time, as governments will be slow to remove lockdown measures. Even if these restrictions were removed rapidly, which is highly unlikely, consumer confidence and thus economic activity are likely to be damaged for the foreseeable future.

Imperial Oil's strong financial position backed by Exxon Mobil, in conjunction with its vertical integration has proven beneficial through the first quarter, but there is likely more pain to come. The firm's prospects of surviving and even growing through this crisis are good, but having capital at risk at this time may not be the wisest decision for investors. Only time will tell, but those who remain patient will likely protect against near-term losses.

In my previous article, I had indicated my intentions to delve deeper into a valuation analysis of Imperial. However, the current economic environment creates far too many uncertainties to value businesses, especially oil and gas, with any degree of accuracy. For those anticipating the insights, I apologize; the conclusion of any valuation at this time would only prove to create a sense of false hope, as predictions for cash flow are fraught with potential risks. The analyst is best during these times to remain diligent in their research, but more importantly, to remain honest with the potential gaps in understanding. For while curiosity killed the cat; hubris will kill the individual investor.

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Analyst’s 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.