Exxon Mobil: The Positives and the Negatives

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Exxon Mobil (NYSE:XOM), the world’s largest publicly traded energy company, recently held its annual analyst day. The company not only lowered its production guidance for 2014 but also guided to a higher-than-expected capex for the year. However, on a more positive note, XOM has negotiated a deal with Iraq at a higher profit return than the previous flat fee agreed.

Declining production

The company’s 2014 total production is expected to be 4 mmboe/d, representing a year-over-year decrease of 4 percent in the production volumes. Exxon Mobil has not only revised down its 2014 production volumes but has also cut it long-term growth outlook. According to new estimates, by 2017, the production is expected to increase to only 4.3 mmboe/d compared to company’s previous given guidance of 4.8 mmboe/d.

The decrease in the production growth could mainly be attributed to Dutch government’s recent decision to cut the production at the Groningen natural gas field due to concerns about increasing earthquakes that may be caused by the drilling process. The company has operations in Netherlands and estimates that the Dutch government’s decision will impact the production by approximately 100 million cubic feet per day. Moreover, ADCO license, which entitled Exxon to operate in Abu Dhabi, also expired due to the takeover of the state-owned company over production. The company would lose an estimated 140,000 barrels per day as a result.

Capex still higher than expected

The other major factor that investors should be concerned about is the increasing capex. XOM raised its capex guidance for 2014 to $39.8 billion, which is higher than the market expectations. The company had previously stated that 2013 capex of $38.2 billion (excluding $4.3 billion acquisitions) represents peak capex spend for XOM. Still, the company increased its capex year over year. Going forward, the company expects 2015-2017 capex to drop to $37 billion.

Energy companies bear high costs during the oil and gas exploration process (upstream activity) with no certain possibilities of high returns. XOM has invested heavily in these relatively low-yielding activities in the past. However, the company plans to reduce its upstream spending in the future strictly below the 2013 levels. The increase in capex levels is fundamentally driven by increase in spending on the downstream projects, delivering higher returns in shorter time frame.

The positives

XOM is moving toward free cash flow inflection after 2013, as it has cut down on its extensive upstream investment activity. The company is expected to increase its cash flow by increased profitability mix, capex rollover, higher returns from its increased downstream activity, and higher upstream volume production growth in future.

Exxon Mobil has also revised its contract terms with Iraqi government for the West QurnaI project and has negotiated higher profit return than the previously agreed flat fee rate of $1.9 per barrel. Since 2000, the economic conditions were largely in favor of the oil-producing countries, given the perception that the world is increasingly moving toward resource deficiency. Companies were forced to enter these contracts and as a result suffered deteriorating returns in the past.

In 2008, following the credit crisis, the trend shifted again. The unconventional oil and gas revolution compounded, giving the companies an advantage over the oil-producing countries. To adapt to the changing demands of the economy, countries are now improving their fiscal terms. Although the market would not see a significant change in the short-term, this could be an important theme for long-term investors. In the next few years, markets should also begin to value the huge size of companies like XOM again as a competitive advantage, which in turn could lead to their multiple expansion.

As things stand, not only is XOM’s dividend yield low compared to its large-cap peers, its valuation is also not as compelling compared to other mega-cap integrated oil companies.

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