XOM’s Q3 results saw revenue drop by more than 35% and earnings fall nearly 50% compared to 3Q14, driven by weak upstream results (upstream earnings fell 79%). However, strength in XOM’s downstream businesses resulted in earnings actually rising 1% compared to last quarter. While headline figures remain ugly, we are optimistic that XOM’s fundamentals are nearing a bottom and are happy to keep the stock in our Conservative Retirees dividend portfolio.
With most of its earnings dependent on the price of oil, there is only so much XOM can do to manage its business throughout the current downturn. The company grew its production by 2.3% in Q3 compared to the year-ago quarter, and XOM appears to be doing a nice job executing on its strategy to improve its mix towards higher-margin barrels. From a cost perspective, XOM has reduced capital and cash operating costs by $8 billion YTD (3.8% of sales) and should make additional progress in future quarters.
Unfortunately, none of these actions are significant enough to overcome the major challenges caused by oil prices, which remain down over 50% from early 2014 and hover near a 6-year low. From a demand perspective, growth has generally remained sluggish or weak in the U.S., China, and Japan, although Europe has shown some signs of stabilization. Longer-term, emerging economies will need to build out infrastructure and their populations will consume more oil-based products, but these trends don’t help the outlook over the next few years.
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Regardless, supply has been and continues to be the biggest issue weighing on the price of oil. The onslaught in oil markets started over a year ago as the Organization of Petroleum Exporting Countries (OPEC) executed its plan to protect member countries’ share of the oil market by out-producing higher-cost rivals led by U.S. shale drillers.
According to the U.S. Energy Information Administration, OPEC member countries produce about 40% of the world’s crude oil. Equally important to global prices, OPEC’s oil exports represent about 60% of the total oil traded internationally. Despite the significant supply pressure from OPEC, North American production continued increasing last year before starting to slow in the first half of 2015. According to a report by OPEC earlier this year, the increase in non-OPEC supply last year was more than twice that of global oil demand growth. However, OPEC expects this relationship to flip this year before widening in 2016 so that world oil demand growth exceeds the change in non-OPEC supply.
The rebalancing process is playing out and, barring a global recession, makes it seem likely that the price of oil has limited downside risk from here, especially with most upstream oil players reporting capital spending cuts of 20-40%. Further support is added when we take a look at the pressures being felt by most of OPEC’s member countries.
According to Bloomberg, Saudi Arabia’s government relies on oil for at least 80% of its revenue and faces its biggest budget deficit in nearly 30 years (20% of GDP, according to an estimate by the International Monetary Fund). The country sold bonds for the first time in 2007 and is contemplating further project delays to help its budget. The other wealthiest Middle Eastern oil producers, such as Kuwait and the United Arab Emirates, are also tapping their foreign currency reserves for the first time in about 20 years to bridge the gap in revenue.
It goes without saying that weaker member countries such as Venezuela are on the brink of possible economic collapse. These nations lack the big sovereign wealth funds and super cheap oil and continue pressing OPEC to alter its current strategy. As seen below, courtesy of Bloomberg, only Kuwait earns enough to cover government spending at the current oil price. For Saudi Arabia, the oil price is $45 per barrel too low to balance its budget.
Russia’s involvement in Syria, which is positioned within reach of most major oil supplies, adds another twist to the story. With Russia’s government collecting nearly half of its revenue from taxes on its oil and gas industry, Putin’s ultimate motive in the Middle East could be to help push oil prices up.
OPEC’s ministers are expected to meet on December 4th to review output policy and update the organization’s long-term strategy. While the outcome is uncertain, there will likely be many different opinions between the members given the pain each country is incurring. Altogether, geopolitical issues could foreseeably put a floor under oil prices.
While your crystal ball is as good as ours when it comes to forecasting anything macro-related, including oil, we can take a better look at the safety of XOM’s dividend.
We continue to view XOM’s dividend as the highest quality of any of the oil majors. Today, that means XOM is the best house in a bad neighborhood. Through the first three quarters of 2015, XOM’s dividend has consumed 68% of the company’s “as reported” net income but 122% of its free cash flow, including asset sales. Looking at earnings estimates for next year, XOM’s EPS payout ratio would be approximately 75% if current forecasts are correct.
As seen below, the company has not been generating enough free cash flow to fund its dividend or share repurchases. The company’s Q3 free cash flow (including asset sales) fell $1.1 billion short of covering the dividend and was $1.6 billion short including share repurchases. If XOM’s cash flow generation doesn’t improve, either from rising oil prices and production, substantial reductions in capital expenditures and costs, or additional asset sales, it will need to continue tapping debt or equity markets to fund the gap.
While XOM mentioned that its cash balance was only down $100 million compared to Q2, the company’s net debt amount has nearly doubled compared to 3Q14 to finance its shareholder distributions:
With a little over $4 billion in cash on hand and a $1.1 billion dividend deficit in Q3, it seems likely to us that XOM will need to raise another $4 to $6 billion in debt over the next year unless oil prices recover, its costs drop significantly, it sells off substantial assets, or share repurchases are temporarily halted.
Fortunately, XOM remains relatively strong compared to its peers. YTD, CVX has generated negative free cash flow of about $5 billion (closer to flat including asset sales), and COP’s free cash flow checks in at negative $2.1 billion (including asset sales). Furthermore, while XOM’s upstream operations generated an operating loss, it was about half that of CVX’s loss on a per-barrel basis. The company’s capital discipline, quality assets, scale, and integrated portfolio have allowed it to generate superior returns on capital relative to its peers:
Perhaps most importantly, XOM’s credit rating remains very strong, recently receiving a “AAA” rating from Morningstar. We continue to believe that the dividend is safe for at least the next 6-8 quarters, even if oil prices remain depressed. XOM has many levers it can pull to continue bridging the gap – more asset sales, more debt financing, and even tougher cost controls.
From a dividend growth perspective, don’t expect much for the next few years. While XOM raised its dividend by 5.8% earlier this year to maintain its status in the list of S&P 500 Dividend Aristocrats, future hikes seem likely be less than 5% given the current dividend gap and uncertainty surrounding oil prices.
XOM trades at about 22x earnings, which are expected to be down about 50% in 2015 compared to last year. As with most cyclicals, its earnings multiple will appear the highest when results are at their lowest point because investors are anticipating higher earnings in the future. To this point, XOM last traded at 21x earnings in 2009 (its low P/E ratio was 16x that year).
While we cannot predict when oil will stabilize and possibly begin to recover, we continue to like the company’s dividend and competitive strengths. Looking out several years, XOM trades around 13-14x earnings estimates built on a more normalized operating environment. The stock isn’t necessarily a bargain today but appears to be a reasonable long-term hold for dividend investors.
Predicting the direction of oil prices over the next 1-2 years is a fool’s errand. However, XOM has the financial firepower and assets to keep paying its dividend and opportunistically acquire weaker rivals in most oil scenarios that could play out. While we are less optimistic that oil prices can sustainably recover to prices above $90 per barrel as the result of new and abundant supply in the U.S., the current price looks equally unsustainable for OPEC’s member countries. The geopolitical unrest and budget deficits resulting from today’s depressed oil prices are not going away for these nations and will need to be resolved by moderately higher oil prices within several years.
For patient dividend investors living off dividends in retirement, XOM remains a solid long-term hold today. Should the stock retrace back into the $70s, it will look even more interesting.
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