Monday, May 2, 2016

Exxon-Mobil Disappoints in the First Quarter

Amidst the excitement that surrounds the earning season, it is necessary for investors to take a fundamental turn on their analysis. As crude oil prices stage a rebound, the financials of energy companies should start to show more earnings potential for the rest of 2016. The year-to-date gain for the WTI spot price has grown to 11.3 percent with a three-month rebound nearing 20 percent. First quarter earnings might not reflect this recent growth, but an acute fundamental analysis can inform investors on which firm will be in the best position to rebound. Exxon-Mobil may be one of these companies that will shape up into a premium investment with the potential for increasing dividends and share appreciation. With bankruptcies in the oil and gas exploration and production increasing 380 percent since 2014 according to Wall Street Journal, fine-tuning one's analysis is the necessary response in these risky periods.

Last week, Exxon-Mobil reported a net income of $1.8 billion in the first quarter of 2016. The EPS was recorded at $0.43 per share down from $0.67 last quarter and $1.17 last year. The press release blamed "the impacts of sharply lower commodity prices and weaker refining margins" for the decline in this quarter's earnings as the upstream operations division recorded a loss of $76 million with a loss of $832 million in the U.S. accounting for a large chunk of the drop. The dramatic drop in upstream performance is almost painful to watch as this section, which once contributed to 51.9 percent of net income, is now a drag on the rest of the firm. Downstream operations continue to maintain their position in the business just under a majority of the income while the chemical division takes over accounting for 62 percent of income generated by operations. At first glance, this fact seems troubling as investors are certainly paying for Exxon's superiority in the oil and gas industry to support share appreciation and a solid dividend, but suddenly, this chemical division, which only support 17.8 percent of net income a year ago, has taken over a majority of the value of the company. But that shouldn't scare away investors. Instead, optimists could see the chemicals gains as a type of hedge against a bearish oil and gas market. Over the past four quarters, each of these divisions has rotated into the best earner position depending on market circumstances. While it makes Exxon unpredictable and difficult to accurately evaluate, its versatility should be nothing but positive for the investor (who himself should understand the importance of diversification). I'd like to see more data put forth from Exxon so that analysts could construct an assessment of each operation as its own business. Not only would this report speak to the sheer size of the company but also to its dynamic approach to a slacking market.

Just before the first quarter earnings report was put out by Exxon-Mobil, a development on the credit market made leverage ratios of particular interest this time around. Standards and Poor's downgraded the oil major from an AAA credit rating to an AA+ rating citing worries about debt. The agency had this to say, "The company's debt level has more than doubled in recent years, reflecting high capital spending on major projects in a high commodity price environment and dividends and share repurchases that substantially exceeded internally generated cash flow," according to RT. When looking at leverage ratios, it's clear that the low oil price environment has hurt operating cash flow growth and the ability to manage debt. Even though capital expenditures have been halved since the first quarter of 2015, operating cash flow still fell from $8.0 billion to $4.8 billion over the past year. As a result, cash flow to debt ratios over the past two years have fallen from a peak of 1.73 to 0.63 this quarter. Based on the trend in late 2014 and early 2015, Exxon employed a strategy to protect their leverage and excellent credit rating by boosting cash flow even though it was falling with smaller revenue. Unfortunately, management allowed debt to increase too much eventually taking over cash flow capabilities. Still, a cash flow to debt ratio of 0.63 is not horrible especially considering the state of the oil and gas industry. However, Exxon has allowed their cash assets to dwindle despite increases in debt. In the first quarter of 2016, the cash to debt ratio was recorded at a mere 0.11 less than half of what it was two years ago. The reduction in short-term liquidity probably played into S&P's decision to downgrade Exxon's credit rating as the oil major has done nothing but add more to total debt over the past two years with liabilities to be realizing soon. If the oil major gets caught in an oil price scenario that turns out more bearish than desired, current liabilities could begin to bite into the free cash flow and, at the worst, shareholder's dividends.

That brings us to Exxon-Mobil's most valuable assets, its crude oil and natural gas exploration and production operations. Despite a realized loss of $76 million in this division, the extraction rate continued to grow by 2.3 percent for crude oil and 1.1 percent for natural gas. The quiet increases in production came after larger jumps of 6.4 percent and 11.3 percent respectively in the last quarter of 2015. Based on these numbers, it's possible that Exxon played the bullish oil price scenario going into 2016 with large increases in drilling, especially natural gas production where an 11.3 percent jump reversed losses of -14.4 percent and -6.0 percent in the previous quarters. As equities and crude oil prices fell apart in January, the firm left their operations exposed to losses with a lack of proper hedging. Based on average realization data, Exxon-Mobil only got $27.11 for each barrel of oil and $1.60 for each mbtu of natural gas prices that were 21 percent and 11 percent lower than the quarter before. The effect was clear as negative realization accounted for most of the losses in upstream operations which dragged on overall net income. The loss should be corrected with the rebound of oil prices, but the numbers still call into question their increasingly weaker financial position. As forecasters continue to push back their projections of higher oil prices, Exxon needs to find a way to maximize their return on every extra barrel that comes out of the ground. Strategies geared towards meeting this objective include playing the futures market with better hedging or cutting high-cost barrels off in exchange for low-cost extraction. No matter what path is taken, a change is needed if investors are to believe that dividend increases are possible in the face of potential solvency problems.

Compared to historical quarterly reports, the first of four in 2016 was a tad disappointing when coupled with the credit downgrade. Exxon's status as an AAA rated company heralded the firm's securities as premium grade investments that investors simply couldn't ignore. A downgrade may have done little to the firm's ability to raise money, but the news hurt the general opinion surrounding its stock. Losses in upstream operations only augmented the pool of questions that need to be asked of the leadership at Exxon-Mobil. Does this report confirm that their operations are reliant on oil prices? If the answer is anything but no, it dramatically affects the earnings potential of the upstream assets. With energy firms declaring bankruptcy at high rates, investors don't want to see their investments exposure their position to volatile prices. If cyclicality can't be avoided, then Exxon-Mobil needs to restructure their operations so that it can successfully thrive in a market with low demand and high supply. A question might also be asked of the leadership in charge of setting production levels. Were the output increases in the fourth quarter of 2015 a product of mismanagement? Bad forecasting? In either case, the executives need to sit down and formulate plans based on different scenarios so that a volatile output does become a liability. The cost of switching operations on and off can become dangerous if the realized price for each barrel is averaging out to a loss. These are just a few of the small details that management must pay attention to in every day of operations.

Exxon-Mobil still reigns supreme in the oil and gas industry, but this earnings report has shown that oil prices can shake the energy giant. Their securities still remain of the highest quality relative to their industry, but among large-cap blue chips, their position could be threatened soon if the firm does not tighten up their operations.

Exxon's first quarter data and press release can be found here.

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