Exxon Mobil: Drill Drill Baby

Summary:

• Major oil and gas demand and supply has shifted towards developing nations.
• Driven by GDP and population growth, geopolitics, and lack of substitutes, oil and gas sales are likely to explode.
• Exxon Mobil Corporation is well-positioned to benefit from the strong demand for oil and gas.
• We are initiating on Exxon Mobil stock with a Buy Rating and $150/share Price Target.

Investment Conclusion

Until oil and gas remain the cheapest fuels, demand will be maintained. The economic growth engine has shifted towards poorer countries. They are not going to compromise raising the living standards for their teeming masses by adopting sustainable fuels, which are expensive, unreliable, and inefficient. They are not going to tell their people, please be a little less comfortable, and a little more poorer and colder. Per capita use of oil and gas in developing countries is 1/15th of the developed world. They have to play catch up. And the Middle East with ~80% of global oil reserves, is not going to keep its liquid gold buried in the desert.

That puts the going away of oil and gas to rest, at least for the next few decades. That’s good news for Exxon Mobil Corporation (NYSE:XOM). It might not be able to peddle as much oil and gas it desires in the countries comprising the Organization for Economic Cooperation And Development (OECD), but it can certainly push its products in the global South, where demand for fuel is positioned to explode.

Oil and gas have been around for centuries, powering the industrial revolution of the West. The fuels are cheap, efficient, and reliable. The infrastructure is in place to produce and transport them. Sustainable energy is prohibitively expensive for poor nations. ~$33.3 Trillion is required to fund the electrification of the planet. Infrastructure has to be built, transmission lines have to be laid, and grid storage established. Global warming is real, and efforts to limit the global average temperature to within 1.5 degrees centigrade to that evidenced before industrialization is a worthy cause. However, wiping out the fossil fuels industry is not the solution.

The solution is to invent/discover fuel sources that are as cheap and efficient as fossil fuels. In the meanwhile, try carbon capture and storage, limit methane leakage, switch to battery electric vehicles (BEVs), optimize energy efficiency in buildings, etc. Lower the air conditioner temperature on sweltering days. These measures will provide time to confirm whether global warming is due to fossil fuels or an artifact of the planet’s heating patterns. After all, the earth is currently experiencing one of its coldest periods, an interglacial era, between glaciations of an ice age. Squandering trillions of dollars to switch to energy sources that are less than optimal, when there is an urgent need for clean drinking water, housing, and healthcare, is a sacrilege.

Considering the above narrative, demand growth for oil and gas is unlikely to abate any time soon. As a major participant of the oil and gas industry, XOM is well positioned to benefit from the demand over abundance. Internally for the firm, it is about cost and efficiency. XOM’s objective is to focus on its low cost of supply oil and gas sources, to drive the cost of an oil equivalent barrel down to levels where a market price of $35/barrel, generates a profit margin of 10%. Considering that an oil equivalent barrel currently trades at ~$75, that is a significant amount of additional margin per barrel, that could potentially hit XOM’s bottom line.

Overall, it appears that the oil major’s glory days are ahead of it, not behind it. We are initiating on XOM with a Buy Rating and $150/share Price Target, derived utilizing a 10-year Discounted Cash Flow (“DCF”) model, that includes a terminal value.

Investment Thesis

Exxon Mobil was founded as Standard Oil in 1879 by John D. Rockefeller and Henry Flagler. Following the company’s split by the U.S. Supreme Court into 33 independent firms in 1911, Exxon (then called Standard Oil of New Jersey), represented the largest faction of the original Standard Oil. Exxon was rechristened as ExxonMobil in 1999, on its merger with Mobil (Standard Oil of New York).

XOM’s business is comprised of three segments: upstream, which includes its crude oil and natural gas exploration, extraction, production, shipping, and wholesale operations categories; downstream, that is divided into the firm’s oil and gas retail business under the Exxon, Mobil, Esso, and XTO brands, as well as its petrochemicals segment, which includes the production and marketing of olefins and aromatics; and the company’s low carbon solutions enterprise, which focuses on low emission fuels, as well as its emerging categories, such as carbon capture and storage, hydrogen production, and lithium mining.

Over nine months ended September 2023, as a percent of total sales, the upstream segment accounted for 7.7%, the retail business 80.1%, the petrochemicals category 6.7%, and the low carbon enterprise 5.5%.

The predominant investor concerns surrounding XOM are related to the sustainability and expansion of global oil and gas demand, and the company’s long-term financial outlook. With Exxon Mobil reporting earnings pre-market on February 2nd, we analyze both elements below.

XOM Is Positioned For Strong Long-Term Growth On Global Oil and Gas Demand Dynamics

We expect a sustained global economic expansion for the most part through 2050. As primary energy providers, we believe oil and gas companies will participate strongly, in the dramatic industrialization the under-developed world is poised to experience, over upcoming decades. Several factors support our conviction that the hegemony of oil and gas as energy sources, is likely to persist over decades. These include:

GDP And Population Growth. The global GDP is projected to double by 2050 and the population expand by 1.7 billion to 8.7 billion. GDP growth in the Asia-Pacific region is anticipated to outstrip the global average. In addition, 94% of world’s population growth will be derived from Africa, Asia-Pacific countries, and India, where the population is projected to peak only in 2065. Based on substantial historical data, it appears that economic and population growth reflect in higher demand for fossil fuels. Indeed, statistics from China and India demonstrate that the per capita utilization of fossil fuels increases as folks in these countries ascend the economic ladder. Net-net, potential global GDP and population growth dynamics support growth in demand for oil and gas, numerous years into the future.

Geo-Political Dynamics. Most of the reserves, supply, and future demand for oil and gas is situated in non-OECD countries. However, it is the OECD consortium, comprised primarily of the European Union nations, the U.S., Canada, and Australia, that are clamoring most for the phase out of fossil fuels. The Organization Of Petroleum Exporting Countries (OPEC) accounts for ~80% of the world’s proven oil and gas reserves, with Saudi Arabia at ~21.5%. Venezuela is at ~24.4%, but doesn’t count as its oil and gas reserves are located in deep waters which renders production difficult and expensive. Russia has ~6% of the global oil and gas reserves and the U.S. ~4%.

In regard to exports, OPEC is the largest provider of crude oil, representing 1/3rd of the global supply. Among, OPEC countries, Saudi Arabia is the key contributor, fulfilling ~16.7% of the global crude oil demand. Canada comes in second at ~8.9%, Russia is third at ~8.9%, and the U.S. fourth at ~8.7%. However, it is noteworthy that the U.S. imports roughly the same amount of crude oil as it exports, because a majority of the nation’s refineries are configured to process heavy sour crude, as compared to the light sweet crude variety produced domestically. Europe accounted for just ~3.3% of the world’s crude oil supplies in 2022. Therefore, as the region’s strict emission control regulations that mandate 55% reduction in CO2 emissions by 2030 (compared to 2005) and net zero by 2050, impact Europe’s crude oil exports, the shortfall will not be missed.

The U.S. is unlikely to implement an emissions regime as stringent as Europe’s, as it has significant oil reserves, which it will be reluctant to not monetize. In addition, domestic politics and the large national debt will inadvertently reduce subsidies associated with sustainable energy projects. Overall, in our judgment, the U.S. will continue to be a large exporter of oil. Further, the OPEC countries are unlikely to let their oil, the liquid gold that powers their economies, stay buried in the desert. Indeed ~45% of Saudi Arabia’s GDP is derived from oil revenues, the product represents ~90% of it exports, and comprises ~75% of government earnings. Similarly, almost all of the OPEC countries depend on oil trading to power their economies. Russia, too which produced ~11% of the world’s oil in 2022 is unlikely to quit leveraging its oil exports, waylaying fiscal progress and helping western sanctions cripple its economy.

The almost unanimous negative sentiment towards the phasing out of oil and gas was reflected during the composition of the final draft associated with the COP28 climate meeting, held in November/December. Phrasing alluding to the phase out of fossil fuels was changed to transition away from fossil fuels, as the OPEC countries wouldn’t agree.

With respect to the demand side, China at ~23% is the largest importer of global oil, followed by the U.S. at ~12.9%, India at ~10.9%, South Korea at ~6.7%, and Japan at ~6.4%. Although, China has agreed to cut emissions by half by 2035, and turn CO2 neutral by 2065, its credibility is far from solid. The country is still a developing nation, and we don’t believe that it is likely to compromise economic growth by refusing to purchase cheap oil offered by Russia. U.S. oil imports are likely to decline due to decrease in demand for gasoline driven by the shift towards remote work and BEVs, higher gasoline prices, and greater fuel efficiency.

India, on the other hand expected to become the largest importer of oil by 2027, will continue to purchase cheap Russian oil with both hands to power the development of its economy. Considering that the country has at ~$2,100 (versus the U.S.’s ~$62,000) one of lowest per capita GDPs in the world, India is unlikely to curb its dependence on foreign oil and jeopardize improving the quality of life of its teeming masses. Indeed, leaked United Nation’s documents show that the country has categorically indicated that it will continue to power its electricity grid with coal (which is by far the largest source of CO2 emissions per unit of energy generated), decades into the future. Considering India’s attitude towards coal, it would be far from a stretch to imagine that oil too would be fair game.

South Korea and Japan are the next largest importers of oil. Renewable energy accounts for ~9% of South Korea’s electricity grid, and though the country has pledged CO2 neutrality by 2050, it posits that clean energy alone is insufficient to power its economy.

Japan’s stance at COP28 was to reduce fossil fuel deployment as much as possible, but considers a zero fossil fuels outlook as impossible. ~30% of Japan’s electricity is generated from coal and the nation declined to participate in the Powering Past Coal alliance at COP28. The agreement obliges developed countries to stop the utilization of coal to generate power by 2030. Considering Japan’s attitude towards coal, it would be erroneous to conclude that the country is likely to curb its oil imports.

In the context of gas, supply and demand is likely to expand as power generation shifts from oil to gas as CO2 emissions per unit of electricity generated using gas is 20% and 40% lower than CO2 emissions associated with power produced using oil and coal. In addition, there appears to be unfolding a global oversupply of gas, rendering the cost of generating a unit of power using gas significantly cheaper than that associated with oil or coal.

The U.S. is the largest exporter of gas usurping Russia’s prior leadership position, lost due to economic sanctions imposed because of its aggression against Ukraine. Russia, Qatar, and Norway, in that order are substantial exporters of gas. Based on internal fiscal dynamics, we believe the nations will continue to export significant quantities of gas. The European Union is the largest importer of gas, followed by Japan, South Korea, and the U.S., in that order. Considering that country specific dynamics associated with oil and gas remain the same, we expect gas exports to be sustained for the most part. Europe might be the anomaly, with gas imports likely to decline, as the region’s CO2 emissions mandates take hold. The shortfall associated with the decrease in European imports of gas, is likely to be offset by strong demand growth originating from the Asia-Pacific region and Sub-Saharan Africa.

Lack Of Substitutes. ~3.5% of global power is generated utilizing oil (~33%) and gas (~25%). The decades long call for a switch to renewable fuels has delivered mixed results. Europe has embraced green energy with large scale projects for harnessing wind and solar power, which is pragmatic, considering that the region has historically imported ~75% of its fuel. However, the U.S., despite its rhetoric on climate change and government funding for sustainable energy projects, is unlikely to enforce a strict emission control regime, as it is sitting on 300 years’ worth of probable shale oil and gas reserves, at current annual production levels. Additional countries that account for large amounts of CO2 emissions such as China, India, and Russia, don’t appear unequivocally committed either.

Even Europe and the U.S. have challenges lined in their path towards sustainable fuels. Europe’s 2022 energy squeeze was attributed to the rapid proliferation of wind and solar power, because folks had to access fossil fuel power, when solar and wind power was unavailable, typically during high demand high price periods of the day. In the U.S., the best regions for wind and solar power projects have already been taken. To harness remote geographies to deliver additional renewable power, thousands of miles of additional transmission lines will have to be laid and the electricity grid capacity doubled, to support the nation’s shift to green energy. It is noteworthy, that these figures are based on current electricity demand, which is expected to expand by ~90% by 2050.

China, the largest emitter of CO2 accounting for ~33% of the world total (the U.S. is at ~14%, Europe and India at ~7%, and Russia at ~5%) has wholeheartedly adopted BEVs, with half of global BEVs sales derived from the nation. In addition, China is by far the leader in manufacturing capacity for batteries and PV solar. Undoubtedly, the country appears to be progressing towards its objective of CO2 neutrality by 2065. However, although China is switching some fraction of its power generation to gas from coal, a majority of its electricity grid remains coal based.

India, the third largest emitter of CO2 is sold on coal, which generates ~70% of its power. Given, the nation’s economically challenged condition, and that its per capita CO2 footprint is ~2 trillion tons versus ~16 trillion tons associated with the U.S. and Europe, it is unlikely to switch to sustainable energy, beyond the hydro and nuclear power that account for ~33% of its power grid, and which positions the country to achieve the 35% reduction in CO2 emissions by 2030, required by the Paris Accord.

Russia’s President Putin is a climate change denier. Less than 1% of the nation’s power is generated by wind and solar, but ~36% is generated through hydro and nuclear energy, so the country will be compliant with the 2030 global CO2 emissions reduction mandate, without any movement towards renewable power.

In regard to transportation, batter electric vehicles, or BEVs, are mainstream in China, the U.S., and Europe. Further, there is likely to be strong uptake in some form of BEVs in additional regions of the world. However, even if BEVs sales were to expand to half of total vehicle sales by 2030, BEVs would still comprise <20% of the total global fleet by 2050. Moreover, BEV’s sales will have to expand to 90% of total sales by 2050, to reduce the fraction of internal combustible engine (ICE) vehicles to 1/3rd of the world’s total vehicle fleet.

With respect to road transportation, due to the dynamics associated with battery weight required to secure a reasonable range, and the resulting decrease in freight carrying capacity, render battery powered trucks economically suboptimal. A similar scenario applies to bunker fuel (utilized by ships) and jet fuel. There appears to be a lack of substitutes associated with both categories. Bunker fuel and jet fuel at ~5% and ~5.8% of refined crude oil, represent substantial fractions of the product. Further, in regard to industrial use, there appear few options to achieve the high temperatures mandatory for producing cement and asphalt, other than oil and gas.

Petrochemicals is another segment where oil and gas appear indispensable. Given that the U.S. and Europe currently utilize ~20x as much plastic and ~10x as much fertilizer, on a per capita basis, compared to underdeveloped economies such as India and Indonesia, it seems that global demand for petrochemicals to manufacture plastics and fertilizers will expand sharply as economic growth unfolds through the global South. Indeed, based on estimates provided by the International Energy Association (IEA), petrochemicals are anticipated to account for ~33% of the growth in oil demand through 2030, and for ~50% by 2050. In regard to gas, estimates indicate that by 2030, an additional 56 billion cubic meters of gas, which is as much as half of Canada’s current gas consumption, will be utilized to produce petrochemicals.

Net-net, present conditions don’t indicate that oil and gas utilization is likely to disappear anytime soon. Demand growth might decrease, but the scenario will probably play out due to economic factors, such as the U.S, shifting to gas power from oil and coal because gas power has turned relatively cheaper, Europe switching to renewable energy and BEVs because it has historically imported ~75% of its fuel, or China adopting BEVs, so it can sidestep substantial imports of oil. Until there appear equivalent alternatives, in terms of affordability and efficiency, uptake of oil and gas will remain strong, in our assessment. Therefore, we believe the IEA is inaccurate in its projection that oil and gas growth will peak in 2028. Peak oil and gas, in our opinion, is likely to be a 2040’s phenomenon (if climate change is not relegated to history books by then).

XOM, as the second largest oil and gas company in the world, with its reserves, production and refining capacity, unlimited resources, as well as scale and scope, is well positioned to benefit from the potential windfall demand for oil and gas. At the end of 2022, the firm had 17.7 billion oil equivalent barrels in proven reserves. In addition, XOM has indicated probable reserves of 16 billion and 11 billion oil equivalent barrels associated with its operations in the Permian and Guyana.

At the end of third quarter 2023, XOM was producing 3.7 million oil equivalent barrels per day and had a refining capacity of 4.1 million oil equivalent barrels per day. During 2024, the company expects to produce 3.8 million oil equivalent barrels per day, with the potential to expand to 4.2 million oil equivalent barrels per day by 2027. XOM anticipates expanding production associated with the Permian to 2 million oil equivalent barrels per day from the 1.3 million oil equivalent barrels per day expected in 2024. In Guyana, the firm expects that production will increase to 800,000 oil equivalent barrels per day by 2027.

Given XOM’s supply dynamics, the company appears to be a reliable and secure source of oil and gas, well positioned to fulfill substantial demand for its product.

Favorable Oil Price Outlook Signifies XOM’s Long-Term Financial Outperformance

Although industry factors such as supply cuts and inventory levels, as well as company specific elements including cost of supply, economies of scale, a downsized employee base, and technical innovation matter, oil and gas profits for the most part are dependent on demand.

In that regard, 2022 and 2023 have been a fabulous couple of years for oil and gas companies, as prices of oil and gas rallied significantly relative to the oversupply days of 2014 through 2016 and the demand destruction period of the pandemic. Although, during 2023, oil prices declined by ~$20/barrel from 2022 levels, refining gross margins at ~$33/barrel compared to the historic average of ~$10.50/barrel remained strong. Similarly, over 2023, gas prices decreased relative to 2022, due to oversupply associated with U.S. sources.

As a major participant of the oil and gas industry, XOM’s profits skyrocketed during 2022 and 2023, compared to recent years. However, as oil and gas prices were lower compared to 2022, earnings, although still robust, declined on a year-over-year basis.

To be specific, for nine months ended 2023, relative to the same period in 2022, total revenues decreased 18% to $260 billion, net income declined 34% to $28 billion, and earnings per share came in at $6.98 versus $10.70. Consequently, profit margins decreased 260 bps to 10.9% over the period. The shortfall in total revenues was reflected within segments, with upstream down by 41%, energy products 14%, petrochemicals 23%, and specialty products 7.5%. Sales by geography were similarly impacted with declines of 13%, 28%, 21%, 22%, 10%, 13%, and 15%, reported for Canada, the U.K., Singapore, France, Italy, Belgium, and Australia.

Further, earnings decreased compared to nine months ended September 2022, with upstream which accounted for 69.5% of total earnings, down by 39%, energy products which represented 31.5% of cumulative earnings, lower by 18%, and petrochemicals that accounted for 5.1% of consolidated earnings declining 56%. However, earnings associated with specialty products which represented 7.2% of total earnings, expanded by 25%. At the end of third quarter 2023, XOM had a cash and cash equivalents balance of $32.9 billion and long-term debt of $36.5 billion on its balance sheet.

XOM shared it expanded five years corporate outlook through 2027, in December. Objectives include doubling earnings between 2019 and 2027 (reflecting a CAGR of 18%), and delivering additional profits of $14 billion over the upcoming four years. Further, the firm anticipates generating $6 billion in structural cost savings, in addition to the $9 billion already derived between 2019 and 2023. Moreover, XOM expects capital expenditure and exploration spending of between $23 billion and $25 billion for 2024, and in the range of $22 billion and $27 billion during 2025 through 2027, to generate average returns of 30%. Furthermore, the company indicated that 90% of its investments are likely to be directed towards oil and gas reserves that are primed to yield an annual return of 10% on oil prices of $35/barrel.

Considering XOM’s business dynamics, we believe the company is well positioned to achieve its lofty earnings objectives. Our conviction is based on several factors, including XOM’s focus on short cycle shale drilling (which can produce oil and gas within six months to a year versus five to seven years associated with offshore drilling), which position the firm to benefit from the expected volatility in oil and gas prices, its strategy to leverage its low cost of supply oil fields situated in the Permian, Guyana (which produces the high demand high price light sweet crude oil), and Brazil, and its policy to control inventory by limiting capacity expansion to that secured through mergers and acquisitions.

In addition, we anticipate higher profits from XOM’s secondary segments such as petrochemicals and low carbon fuels, and earnings contributions from its emerging businesses of carbon capture and storage, hydrogen production, and lithium mining. Moreover, we anticipate margin expansion, based on synergies derived from potential mergers and acquisitions, and as the ongoing cost-cutting efforts continue to deliver.

However, as we noted above, oil and gas prices, are by far the greatest predictor of oil and gas company profits. Based on our expectations of a global economic boom and supply shortfall, we anticipate higher oil and gas prices over the upcoming five to seven years period. Several factors implying that an oil and gas squeeze is imminent are gaining traction.

Primarily, European big oil firms such as British Petroleum, Shell, Total, and Equinor, are likely to continue their transition into green energy companies, and divest their oil and gas reserves to be compliant with the mandated Scope 3 regulations (which ban emissions associated with the utilization of oil and gas) being implemented in the region. It is notable that oil and gas companies in the U.S. are not subject to Scope 3 emission control. XOM has agreed to lower its Scope 1 (CO2 emissions associated with its oil fields, factories, and facilities) and Scope 2 (CO2 emissions linked to its deployment of fossil fuels electricity) emissions by 50% by 2030 and become carbon neutral by 2050.

In addition, Western economic sanctions on state controlled oil and gas companies in Russia, Iran, and Venezuela, will continue to limit oil and gas supplies from those geographies. Further, OPEC is highly likely to persist with its long-term strategy of sacrificing volume for price, cutting production to artificially oil and gas prices.

In regard to anticipated tailwinds associated with the global economy, estimates indicate that GDP growth over the next five years is likely to average at roughly 7%, 5%, 6%, 2%, and 4% for India, China, Africa, the U.S., and Europe. However, all bets are off, and oil and gas prices will possibly turn volatile if the conflicts in Ukraine and/or Gaza escalate to include additional countries, OPEC reverses its oil and gas policies, China acts on its threats of aggression against Taiwan, and the European economy fails to recover. We are modeling an average oil price of $105/barrel over the next five to seven years.

Nevertheless, beyond a five to seven years period, we expect oil and gas prices to decrease as the demand shift accelerates towards economically challenged countries. In our opinion, oil and gas firms are likely to favor volume over price to appeal to these poorer nations, being projected as global growth engines through 2050. Further, oil and gas companies are likely to lower prices in developed economies, to compete with the potential proliferation of sustainable energy as solar and wind power become mainstream in OECD countries. We project average price of $75/barrel of oil from 2030 through 2050.

Incorporating the above described qualitative narrative into our 10-years Discounted Cash Flow model, we arrive at a Price Target of $150/share for XOM. Our valuation assumes a normalized 10-year revenue growth rate of 5% (vs. the FY22 revenue growth rate of 44%). In addition, we derive our net income for 10-years using a net profit margin of 10% (vs. net profit margin of 14.6% during FY22). Based on our analysis of XOM’s historic financial reports, we model normalized 10-year operating cash flows as 13% of revenues/year and straight line 10-year capital expenditure as 8% of revenue/year. Furthermore, we deploy a perpetual growth rate of 3% and a weighted average cost of capital of 7% to reach our terminal value and present value of free cash flow figures. We utilize the current diluted outstanding share count of 4,083 million to arrive at our 1-year Price Target.

Risks

Uptrend In Sustainable Energy In Global North Could Crimp Demand. Although XOM markets its products, particularly refinery products largely globally, major demand for its wares accrues from North America and Europe. Given that many of those countries have mandated stringent Scope 3 emissions regulations for 2030 through 2050, decrease in demand for XOM’s oil and gas associated with the geographies will only accelerate as dependence on wind and solar power expands. To counter the effects, XOM will have to shift sales to markets in Asia, Africa, and Latin America, where the growth in potential demand is located.

In addition, considering that the firm will be competing for sales with Russia’s oil and gas, which is typically priced below U.S. oil and gas levels, XOM will be forced to lower prices of its products to remain competitive.

Bottom Line

Someone, tell the OECD countries that they can no longer push around the poor nations. And while at that, let them know that they are unfair, because they built their current prosperity on the back of cheap fossil fuels, and now want the economically challenged countries to limit their growth, render their populations colder, poorer, and in even more privation, by adopting more expensive, less reliable, and less efficient, renewable energy, and other low carbon fuels. If the West wants to combat the rise of the global temperature which rose because of the greenhouse gases emitted due to Western industrialization, provide the developing world alternative fuels that are as cheap and efficient as oil and gas. Most of the globe, aside from the OECD countries is poor, and the nations rich in oil and gas, some which themselves are poverty stricken, and their counterparts are going to continue to buy and sell fossil fuels, to achieve prosperity levels in line with that prevalent in the West. No one has the power to stop them. Try sanctioning 80% of the world. All good news for oil and gas companies. Long Big Oil. Long XOM.

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Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such 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.

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