Tuesday, November 19, 2013

Exxon Mobil (XOM)

OK, so this is really a strange coincidence.  I was honestly thinking about making a post about Exxon Mobil (XOM) recently. Of course, noone will believe me; they will think I am just posting this because of Buffett.  Well, yes.  I like to post about Buffett's picks because why not?  He is the greatest investor ever.  It would be silly not to take a good look at his picks.  But anyway, again, it's related to that book.  

XOM an Outsider CEO Company?
Yup.  The book, The Outsiders.  And yup again, XOM is mentioned in there.  Like the other outsider CEO companies, XOM really focuses on capital allocation.  They won't just invest for the sake of growth or size.  They want to invest when the returns are there.  If there is no opportunity, they will return cash to investors, and they aren't shy about doing so aggressively.  I think this is sort of first-level / second-level thinking too. 

Thorndike says in the book that many point to production and reserve growth and say XOM has no growth but XOM (like other outsider CEO companies) focuses on return on capital so if they don't see good opportunities to deploy capital, they will repurchase shares instead.

So I was going to take a quick look at XOM to show how 'outsider' this company is.  We all know how great a company it is.  But XOM still seems to be used as sort of an oil price proxy; people get bullish when they forecast higher oil prices and get bearish when they think oil prices will go down or will stay flat.

That's kind of like first-level thinking; determining investment merits of XOM based on crude oil price assumptions. Sure, prices are very important for XOM.   But there is more to it than that as we will see. 

Long Term Chart of XOM

The red line is the S&P 500 index.  I left out Berkshire Hathaway since the price history doesn't go back to 1970.

Inflation Hedge / Crude Oil Price Bet?
This is not to say that Buffett's purchase of XOM is not a bet on oil prices.  He has said more than once that he feels crude oil prices will be much, much higher over time.   Of course he bought ConocoPhillips (with poor timing) and has owned PetroChina in the past (primarily due to valuation gap between PTR and western majors).  He has expressed interest in the oil sands in Canada (having helicoptered over them with Bill Gates a while back; he said he was interested but not at available prices or something like that).

He has also said that with this pump priming by the Fed, inflation is inevitable.  He feels there is no question that what the Fed is doing will lead to inflation down the line.  It goes without saying that he probably thinks that the longer it goes on, the bigger the inflation when it hits.

Having said that, I would be the first to insist that Buffett doesn't really make bets like that based on big picture scenarios.  That really is not his game.  But that doesn't mean it is a zero consideration when looking at investments.

If a business is a good one with good returns on capital, good management and available at a reasonable price, and oh, by the way, it might benefit from higher oil prices and/or inflation, I don't think it is going to bother him.

XOM used to be a big part of Alleghany's (Y) equity portfolio.  They do say that they want to invest in stocks/businesses that is inversely correlated to interest rates (to hedge their big fixed income portfolio).  

 This is a snip from Y's 2012 letter to shareholders:

... and from the 2011 letter to shareholders:

Cumming and Steinberg of Leucadia also said that their portfolio (at the time) was geared toward inflation; every position that Leucadia owns would benefit from inflation which to them was inevitable.

This position at Berkshire might have a similar effect to what Alleghany talks about; it offsets the many financial positions Berkshire owns.  But again, that wouldn't be the main reason Buffett would do this.  First and foremost, he is investing in a great business at a fair price (or something like that).  I don't think he sat down and said, "Gee, Berkshire needs an inflation hedge...  Let's buy an oil stock!".  Maybe (well, highly unlikely but who knows) he read the The Outsiders book, slapped his forehead and said, damn, why don't we own a bunch of XOM?!  Duh!  Or maybe he has deeper insight on XOM through the Lubrizol position.

Return on Capital
Anyway,  here is one of the most important things when looking at XOM.  The return on capital across the segments is amazing.  This is not return on equity, but return on capital. 

Return on Capital Employed

So let's take a look at some things I plucked from the XOM annual meeting presentation and annual report.

Shareholder Returns Over Time

The long term return to shareholders has been pretty good.  If stocks were a good inflation hedge since the early 1980s, then XOM was an even better one.  Dividends have far outpaced CPI and the S&P 500 (S&P 500 dividends).

Return on Capital Employed Versus Industry 

The chart on the right shows XOM's returns on capital versus the industry.  This is pretty consistent going back in time too.   This is from a past annual meeting presentation showing rolling average five year ROCE through 2007:

Here's a different way to look at the same stuff:

Return on Incremental Capital
And by the way, let's take a quick look at return on incremental capital.  Average capital employed was $88,342 million in  2002 and $179,094 in 2012 for an increase of $90,752 million.  Net income excluding financing cost was $11,895 million in 2002 and $45,438 million in 2012 for an increase of $33,453 million.  So return on incremental capital was around 37% over the past decade.  There was a large gain on sale in 2012 which makes this number look especially good. Excluding the $8,731 million gain in 2012, earnings would have been $36,707 so return on incremental capital would have been a still pretty good 27%.

Gain on sales are included in the return on capital employed figures going all the way back, so to keep it consistent with the way they present it, I will leave it all in there for the incremental returns below (otherwise you would have to back out all gains in previous years too).

So let's take a look at the same using a three year average instead (which is what should have been done in the first place):

And on this basis, over a ten year period return on incremental capital employed is 31%, so that's pretty good (excluding the 2012 gain would still leave you with 28% return on incremental capital).  I didn't look at the five year period as that includes the XTO acquisition, great recession and the crude oil price spike to $150 so I figured it wouldn't be representative of what XOM is capable of over time.

No Spinoff?
And as if to counter calls for breaking up XOM, they show that XOM integrated is greater than the sum of the parts.  Of course, outsider-type CEOs don't just do what's popular and what investors demand.  They will do what makes sense.  The chart below sort of reminds me of a slide that J.P. Morgan had in one of their presentations too showing the synergies of having asset management and other businesses together.

ROCE in the downstream business is impressive (the 2012 spike includes gain from restructuring):

With low cost / efficient operations:

Their chemical business ROCE is impressive too:

All of this leads to significant cash flow:

Shareholder Friendly
And this is where it gets really good:

Just like outsider CEO companies working hard to increase the per share intrinsic value of their businesses, XOM focuses on per-share interest in production.  If capital is better utilized by repurchasing shares, they will do so.  Conventional management would think more about expanding the empire, increasing reserves or production.  XOM focuses on shareholder value.

This is the longer term look at the combined downstream and chemical ROCE.

What is remarkable about the consistently high returns is that the recent ten years have not only included the great recession, but a wild range of crude oil prices and refining margins.  Crude has been as low as $20-40 to as high as $150 and yet XOM cranks out high returns consistently.

Shareholder Friendliness

This is a table that shows how much XOM has paid in dividends and how much in stock they repurchased.  For example, in 2012, they paid out $10 billion in dividends and bought back $21 billion in stock.  To show what the dividend yield would have been if they paid a dividend instead of repurchased shares, I added the dividends paid and amount of cash spent on shares repurchased and divded by the average shares outstanding to show a sort of adjusted dividend yield.   The column to the right shows the amount compared to the year-end stock price.  You will see that even though the actual dividend yield is in the 2% range, there is a lot more cash being returned to shareholders every year.  This is impressive given that this is not a business in runoff or anything like that.

They recently started separating out share repurchases that are actual distributions to shareholders and repurchases that offset shares issued under benefit plans:

Just for reference, here is some operating information on XOM:

Reserve figures will go up and down according to crude oil prices (higher prices = higher reserves etc).  We see from here that even though earnings and other financial metrics have been improving over time, there hasn't been any growth in production over the past decade.  Their refinery throughput is also down since 2001.  Their reserves are higher and they have been able to replace reserves every year (2010 includes the XTO acquisition).

So, none of this is really new to value investors, but again, many themes seemed to come together in this idea.  And then Buffett discloses a big stake in it, so that's an excuse to make a post.  As I said, I was going to eventually make a post about it anyway (well, let's say it was on my list of post ideas) but the Berkshire purchase made me push it up the queue a little bit.

I will probably overuse this outsider CEO thing and the first-level / second-level thinking, but you know, those are good models to have so I don't mind overdoing it a bit.

Berkshire Hathaway bought a bunch of XOM earlier this year.  It has all of the factors that Buffett seems to like:
  • Good management
  • High returns on capital
  • Shareholder friendliness (share repurchases)
  • High moat (technology, scale and integration that allows high returns can be considered moats)

And merging it with the outsider CEO themes and first-level / second-level thinking:
  • Many see XOM as too big to grow; they point to subpar reserve and production growth while others look at XOM as a proxy on oil prices.  This sort of looks like first-level thinking whereas...
  • The reality is that XOM is focused not on superficial growth but rational capital allocation so would rather repurchase shares at reasonable prices than spend money to grow reserves/production just to please or impress Wall Street.  Focusing on this outsider-CEO-esque behavior seems more like second-level thinking...
  • If opportunities aren't available for reasonable returns (this is not true; there are still opportunities), then XOM will simply just keep repurchasing shares and the per share share of production will continue to go up.  This is the same as Coke, Washington Post, IBM etc.

From a business standpoint, the history of XOM shows that you don't really have to have a strong view on the direction of oil prices to make the assumption that they will continue to do well.

There are a lot of debates going on, like peak oil (or not), alternative sources pushing out carbon-based energy (Gore scenario).  But I think those are extreme scenarios that won't be a factor for many years to come.

I suppose if one has a view on any of those things that are extreme, they may see XOM a bit differently. But that's OK.  I don't have such an extreme view.

XOM did fine with crude oil trading in the $10s and $20s (and lower), did fine at close to $150, and is doing fine now at below $100.  They will probably continue to do well under most moderate scenarios.

But it is interesting that you have a company/stock like this that:
  • fits the Buffett model
  • fits the outsider CEO model
  • and may benefit from higher crude oil prices and inflation

Anyway, I just looked at one aspect of XOM.  There are certainly other issues.  Cost of finding new reserves, what the cost of producing those new reserves are and what the return on investments will be in those projects that will be more expensive and more complicated etc.  But knowing XOM's strict discipline in capital allocation, I do think we can take comfort in the fact that they will invest prudently and not make unwise investments for the sake of size.  Oh yeah, and XTO has yet to prove itself, but time will tell; they are putting up impressive figures despite it.


  1. Agree with everything you said about XOM, the company.

    The only thing you left out in the analysis is the stock price.
    Buffett bought around 86. Not sure if it qualifies as cheap. This is probably him buying a good business at a fair price like BNSF.

    1. Yes, I didn't mention price. It hasn't done much recently. If you think they can earn $8.00 or so, then it's a 12x p/e at the current $96/share which is very reasonable. That's an earnings yield of over 8%. If they repurchase shares even at the current $96, that's a nice yield which would be equivalent to a 13% pretax yield. If you think they earn $7.45 (yahoo consensus for this year), that's 13x earnings, still not bad.

      There are probably many better investments for smaller investors, but from Buffett's point of view, this is not a bad investment even at the current price, and if XOM can buy back shares at even these levels, that would be a good use of capital. Of course, investing at 20-30% would be better at XOM if possible, but huge buybacks at 7-8% earnings yield wouldn't be bad at all.

      Thanks for reading.

      And yes, I probably should've put a paragraph of the above in the post but I figured it's been trading more or less in a 'normal'-ish range for a while so...

  2. Good stuff as always kk!

    Anyways, what's your thought on XOM's net income to free cash flow conversion? Oil is a capital intensive industry. XOM, CVX, BP, and the like pour billions into capex. The conversation rate is around 50-60% I believe. So in 2012, XOM reported net income of $44.9 billion and free cash flow of $21.9 billion. Wouldn't ROC be much lower if free cash flow was used in the calculation?

    I'm not sure how to analysis basic material companies. It must be since I'm still thinking on the first level. But it seems like these type of companies have extremely high capex so their free cash flows are fairly inconsistent year over year.

    1. Hi,
      That's a good point. The XOM chart above shows that they generated $138 billion in free cash from the beginning of 2008 through the end of 2012. The net income in those five years totalled $181 billion, so free cash conversion would come in at 76%. I'm not sure exactly how they calculate free cash, though, as operating cash flow minus capex yields a different number. These things are hard as we don't know what's maintenance capex.

      That's why I think it's useful to just see what XOM distributed to shareholders via dividends and buybacks. That is certainly free cash flow (or we hope it approximates it).

      If you look at my 10 year table above and compare net earnings and total distributed to shareholders via dividends and buybacks, they distributed 84% of net income in the past ten years. So that's a pretty good free cash conversion.

      Thanks for reading.

  3. Great post, and good for you to address this -- we were scratching our heads when this was disclosed. I think XOM has the best operating record of all the supermajors, but I'm not sure I agree with some aspects of your analysis.

    Like Henry, my thoughts are around ROIC as defined by historical cost depreciation captures the full cycle costs of replacing extracted reserves.

    I posted the following on reddit SecurityAnalysis (http://www.reddit.com/r/SecurityAnalysis/comments/1qzwxz/exxon_mobil_xom/), not sure if you visit there so thought I should bring it to you...

    "I think ROIC as measured for the XOM upstream assets isn't a fair comparison to other businesses.

    Because oil and gas properties are continuously depleting, and depletion is based on historical costs (not replacement / all-in F&D costs, let alone costs of corporate acquisitions), ROIC doesn't really reflect the IRR of the business projected at a steady state if all-in F&D costs have substantially increased (with the rise in oil prices).

    Thinking about recent capital allocation: looking at their acquisition history they paid 12x trailing EBIT (i.e. 8% pretax EBIT yield) for XTO in 2009, when gas prices were WAY higher than they are today. I'm not familiar with the specific economics or development stage of the XTO assets, but I can't imagine they are earning a reasonable IRR in the present state of the North American natural gas market."

    1. Hi,

      That's a good point. This is an issue not just for oil companies. Of course, there is nothing wrong with owning old, low cost wells/fields even though replacement cost may not be on the books. But then as you say, it won't reflect steady-state reality as those older fields get depleted they will have to be replaced with higher cost ones. For example, replacing conventional crude reserves with oil sands reserves looks OK in the proved reserves line, but the cost will be totally different.

      Over time, though, XOM has been good at capital allocation and that probably won't change, so they should do well relative to others.

      XTO is the reason the U.S. ROCE is so low. We have yet to see anything there but it ain't over yet...

      Thanks for reading.

  4. Regarding peak oil: I found this study very interesting.

    Oil: The Next Revolution


    1. They recently started separating out share repurchases that are actual distributions to shareholders and repurchases that offset shares issued under benefit plans:

      would love to see this disclosed by IBM ?

  5. Conventional management would think more about expanding the empire, increasing reserves or production. XOM focuses on shareholder value. """

    I often wonder, is buffett , empire building, or focusing on shareholder value, based on his reluctance to authorize a buyback until sept 2011 , with a gun to his head ?

    1. In Buffett's case, he has done well. I meant that conventional management would expand the empire without regard for shareholder value. In fact, they would do it at the expense of shareholder value. Buffett clearly has benefitted his shareholders with most of his purchases.

  6. kk, thanks, buffett and munger have benefitted us partners by working free for 30 years and not taking billions of our equity year after year forever. However, the question remains, why did it take so long for brk to authorize a buyback and once they did, why did buffett use the 110 % of book limit which he knew would be exceeded shortly after the press release was released ? Why not just authorize buybacks at, material discounts to IV, if he rally has any interest in buying back brk ?

    1. prob because he doesnt want to constantly be discussing what IV is and so on

    2. It's an interesting question of what BRK would be like today if they bought back stock over time, like say, Loews. Their equity base would be much smaller so Buffett's stockpicking skills would be of more value (bigger universe to choose from).

      But then BRK never really has been that cheap until recently. Maybe it was cheap back in 1999/2000 but that was only briefly. As for buying back stock in 2009 or whenever, well, he could've bought BAC even cheaper. Or many other things that were cheap at the time.

      So at any given point in time, other stocks were available too, not just BRK.

      The other big factor that people forget about is liquidity. If BRK wanted to buy back $3 billion in BRK stock, I think that would be a lot harder than trying to buy $3 billion in IBM or XOM, for example. So that's the other issue. You know Buffett is picky about price and doesn't want to keep lifting offers to fill an order (that's how he missed WMT years ago, I think...)

      So that's the other major factor.

      Otherwise, Buffett has been doing fine. I think eventually they will buy back stock and pay dividends. We may be very close to that point, but who knows... I don't obsess over that sort of thing at all. It doesn't matter to me that much.

    3. Sorry to disagree but I think the day Buffet starts paying a dividend is the day when hell freezes over. It is just less efficient than buying back his own stock (he could buy back at a significantly higher price/book ratio and still be more efficient if you factor in the tax effect).

    4. Well, you never know. I don't have a strong opinion either way. But I do agree share repurchases is better as long as they can do it under intrinsic value.

  7. Chanos disagrees: http://www.reuters.com/article/2013/11/19/us-investment-summit-chanos-idUSBRE9AI0QC20131119

    1. Yes, he has a good point. I wouldn't worry too much about what is happening in the short term. You are betting on XOM management over time, not over nine months or two years.

      It is true that we are taking out a lot of the cheap resources and future resources will come at a higher cost. But the situation is dynamic, not static. If we do deplete cheap oil, then prices will have to go up, right? So we can't just say, hey, crude development and production cost is going up but crude prices are down, uh oh... Over time, crude prices must go up. If the peak oil disbelievers are right, then there is plenty more low cost crude to get out.

      The question would then be who is best situated to take advantage of either scenario?

  8. KK,

    Thank you again for sharing so many great ideas and concepts.

    Have you look at Crown Holding? Good free cash flow (estimated FCF of 500m for 2013 and total market cap of around 6b); one of three major players in the industry (the other competitor BLL is interesting too); good allocation of FCF (buy backs, acquisitions and production expansion in emerging markets); and Lou Simpson holds a position.

    1. Hi,

      I haven't looked at Crown recently. Maybe I should take a look. Thanks for the tip.

  9. You asked yourself if Buffett read "The Outsiders", and said it is highly unlikely. Well, I guess he did read the book since he recommended "The Outsiders" on Berkshire's 2012 annual letter.

    Great minds think alike :-)

    Excerpt from the letter, p.22:
    The Outsiders, by William Thorndike, Jr., is an outstanding book about CEOs who excelled at capital
    allocation. It has an insightful chapter on our director, Tom Murphy, overall the best business manager I’ve ever
    met. I also recommend The Clash of the Cultures by Jack Bogle and Laura Rittenhouse’s Investing Between the
    Lines. Should you need to ship your book purchases, a shipping service will be available nearby

    1. Hi,

      Yes, I know Buffett read the book; that's why I read it. I meant that I thought it unlikely that that was the reason he bought XOM stock; that Thorndike said it acts like an outsider CEO company. I'm sure Buffett was aware of that long before reading the book. That's what I meant.

      Thanks for reading!

  10. Any current thoughts on Exxon? I would be interested in how you thought about actually valuing it, as you usually don’t see actually valuations of oil companies.

    I wrote this article on seeking alpha a while back (sorry I couldn't figure out how to hyperlink)


    It was meant for people with a little less background in finance, but it’s pretty simple:

    1. The long-term price of oil needs to be high enough to support needed capex, which would entail an industry ROIC perhaps ~10%.
    2. Due to a good corporate culture, smart capital allocation, and technical excellence, ROIC should continue to be at least 5% or so higher than industry ROIC.
    3. Assuming ~5% growth in invested capital, a 15% ROIC would get you to 5% earnings growth and fcf = 10% of invested capital. A 10% return hurdle would get to a valuation of 2x invested capital.

    The article went into a lot more depth, but those are the spark notes. Again, I would be interested to hear your thoughts on how you might take a stab at valuation.

    1. Hi,
      I don't have any particular thoughts on XOM other than that it will probably do very well over time. I agree with your writeup; over time XOM will be fine. They have lived in $5/barrel and $150/barrel oil markets. As you say, the costs take time to work through the system. Drilling/finding costs went through the roof over the past few years due to the high price of oil and the oil price tanked. The oil price (to the extent not hedged) will hit the revenue line right away but the costs will take time to work their way down.

      To the extent that costs are up permanently (harder to low cost oil having to drill deeper etc.), as you say, the cost of production will go up increasing the floor price of oil.

      So over time, oil companies should earn decent returns. It's just that when prices move so fast, companies can look better than they are (when crude hit $150) and worse (like now) because of that lead-lag.

      The only issue I might have is that you calculate capital employed per share. Capital employed includes debt, so if you want to get back to a per share equity value, you should calculate the fair value of the total capital, and then deduct the debt and divide that by number of shares. Either that, or you have to deduct interest expense from the return part of the ROCE.

      Otherwise, I agree with the gist of your post.

    2. Yes, you're right. I didn't put the debt cost in because it's pretty small, at least for now - the interest costs something like $2.1 billion after tax based on last quarter's numbers, but that's almost certainly going up a bit. That comes out to somewhere around a .5% deduction to the value at 2x, but if they decided to pay the debt back down the road and keep net debt / capital around 0 then the cost would be higher, and perhaps significantly.

      Anyways, thanks for the response, and I was wondering if there was any way I could send you a private message?


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