- Free cash flow and revenue declines have more to do with current oil prices rather than fundamental problems.
- Investing in energy at the moment makes sense. One can reduce cost basis in Exxon by re-investing dividends or selling covered calls.
- Exxon's declining reserve replacement ratio is a sign that production will be under pressure but competitors have lower ratios.
Every investment carries some form of risk. Exxon Mobil (XOM) is no different despite being the largest company in the energy sector with a present market cap of $338 billion. Many investors have decided to not invest in this sector due to the volatility and the potential for lower oil prices in the near term but is this the right mindset for investing? We may actually have printed a bottom in the price of crude oil recently which in my opinion is reason enough to start scaling into a proven dividend aristocrat like Exxon Mobil.
Investing in Exxon is far less riskier now (with oil at just over $30 a barrel) than less than 24 months ago when oil was up around $100 a barrel. A good strategy in conditions such as we have now is to reduce cost basis as much as possible. This means to ultimately acquire Exxon stock for as cheap as possible over time which ultimately reduces one's risk. However let's look first at the company's fundamentals and why Exxon stock should be in your portfolio. We can start by looking at its main fundamental metrics over the last 10 years
|Years Of Dividend Increases||34 Years - Pass|
|Free Cash Flow||$-751 million (10-Year Trend Is Down) - Fail (Very Important For Dividend Investors - Dividend Currently Is 3.57%)|
|Revenues||$268.8 billion (10-Year Trend Is Down) - Fail|
|Profit Margins||7% - (10-Year Trend Is Down) - Fail|
|Price History of the stock||Up 36% in the last 10 years excluding dividends - Pass|
|Healthy balance sheet||Total assets = $340 billion (10-Year Trend Is Up) - Pass|
|Resistant to recessions?||Downstream acts as a huge advantage in recessions and periods of commodity deflation as we are witnessing at the moment - Pass|
Bears will immediately point to the fact that some of the company's main metrics are declining ( Free cash flow, revenues and profit margins) but investors should remember that this is a cyclical business and the above metrics have nothing to do with the company's core fundamentals.
Current upstream realizations are absolutely destroying earnings ($16 billion reported in 2015 compared to double that amount in 2014) and there is nothing the company can do about this except cut capex ($8 billion less projected in 2016), sell off more assets and cut its share buyback program However on a fundamental view, the company continues to increase its dividend whilst also increasing the size of its balance sheet. Furthermore, downstream US GAAP earnings more than doubled to $6.56 billion in 2015 and I expect margins to keep improving in this division which illustrates the importance of being hedged or integrated at the moment.
So how do we reduce basis to make sure we get Exxon Mobil stock at the lowest possible price? Well, one way is to invest all of the dividends back into the stock over the next 12 months. The current yield is 3.57% but the quarterly pay-out is expected to rise this year (probably to around $0.76 per share). If you buy 100 shares of Exxon Mobil today which would be an investment of $8,172, you would potentially receive ($304 = $0.76 x 4x 100) over the next 12 months in dividend payments. If we assume Exxon Mobil can keep raising the dividend by an average of 6% a year, here is how things would pan out over the next 5 years if we keep re-investing our dividends back into the stock. For example purposes, let's assume Exxon stays at around $80 a share
|Year 1||Basis reduced by $304 (as described above)|
|Year 2||In Year 2, we have approximately 104 shares & now the dividend payout has risen to $335|
|Year 3||In Year 3, now we have approximately 108 shares & now the dividend has risen to $383|
|Year 4||In Year 4, now we have approximately 112 shares & now the dividend has risen to $454|
|Year 5||In Year 5, now we have approximately 117 shares & now the dividend has risen to $563|
|BASIS Reduction||The investor now own 17 more shares meaning (at a value of $80 a share), cost basis has been reduced by $1,360 or approximately 17% on the original investment over 5 years|
What's the takeaway? Well if you want to go long a stock but are unsure of the direction in the near term, reducing cost basis is a very safe and sensible strategy as it will lower your risk whilst also keep you in position for any upside movement in the stock. Many investors prefer to reduce cost basis through re-investing dividends rather than selling covered calls because covered calls can cap your upside meaning that one is more likely to lose their shares especially if Exxon's stock price were to spike from here.
Finally and to sum up, investors should take note of Exxon's reserve replacement ratio which declined meaningfully to 67% last year. Exxon has always had ratio's above 100% but the oil rout has affected everyone from the small players all the way up to the biggest majors. How do I see this playing out? Well if a production cliff becomes a distinct possibility, you are going to see far more small companies defaulting which should suit Exxon Mobil in gaining valuable market share. The longer oil prices stay where we are (which will keep high cost shale out of the picture), the more you are going to see capex budgets being slashed. This is why investing in a strict upstream company is very risky at this point. One needs to be integrated if the investor wants as little risk as possible in this sector.