Musings: Is The Oil Industry on The Verge of Major Restructuring?

A recent article in The Wall Street Journal highlighted the challenges Exxon Mobil is having in replacing its annual oil and gas production with new reserves. The article was based on the company's latest reserve report that showed it had added 3.5 billion oil-equivalent barrels (Bboe) to its proved developed reserves, or 209% of its 2010 production. This represented the 17th consecutive year that ExxonMobil has been able to more than replace its annual production with new reserves. Overall for the past ten years, ExxonMobil has averaged a 121% annual reserve-to-production replacement ratio. What was somewhat troubling, however, was the data showing that for every 100 barrels of oil the company has pumped out of the ground over the last decade, it has only been able to replace 95 barrels. On the other hand, for every 100 cubic feet of natural gas pumped, ExxonMobil has been able to find or acquire 158, which is largely due to the $41 billion purchase of XTO Energy Inc. last year.

At the end of 2010, ExxonMobil's proved reserves totaled 24.8 Bboe of which XTO accounted for 2.8 Bboe. Approximately 47% of the company's proved reserves are oil with 53% natural gas. The company stated that it added a total of 14.6 Bboe to its resource base marking the largest annual addition since the merger of Exxon and Mobil in 1998 and boosted the company's resource base to a record. According to ExxonMobil, the XTO resource base is 60 trillion cubic feet of gas, which based on the oil equivalency measure of 5.6 cubic feet of gas to one barrel of oil, represents slightly over 10 Bboe that was added in 2010 from that acquisition.

The point of the article was to highlight the struggles of the oil industry in finding new reserves of crude oil, but how it is having better luck with natural gas. The article included a comment made by Shell's chief executive in January that this year the company would produce more natural gas than oil for the first time in its 104-year history. The reserve results of ExxonMobil, Shell's gas production statement and the rash of major oil company purchases of gas shale assets in the U.S. and Canada are signaling a sea change in the petroleum industry.

The sea change is driven not only by the twin challenges of replacing reserves and growing production, but also by understanding what investors want from petroleum company managers. The recent corporate restructuring move by Marathon Oil (MRO-NYSE) to split the company into two separate businesses - one focused on its downstream assets and the other on its E&P assets, and the breakup of Williams Companies (WMB-NYSE) into a pipeline company and an exploration and development company, have been warmly welcomed by investors.

Exhibit 15. Marathon Oil Outperforms On Restructuring
Marathon Oil Outperforms On Restructuring

As shown by the chart in Exhibit 15, the Marathon Oil announcement caused a jump in the share price in early January. But importantly, coupled with the rise in crude oil prices due to the civil unrest in the Middle East, Marathon Oil has greatly outpaced the recent performance of either ExxonMobil or the overall stock market. In the case of Williams, the share price was matching the performance of ExxonMobil until the restructuring announcement that has helped it to outperform since the middle of February. (See Exhibit 16.)

The oil industry has historically represented a solid investment for people. Typified by Exxon and then ExxonMobil, the stocks of the largest petroleum companies have generally performed in line with the overall stock market while also being known as generous dividend payers. As shown by the chart in Exhibit 17, ExxonMobil's share price since 1980 has performed either in-line with the

Exhibit 16. Williams Gets Boost From Restructuring
Williams Gets Boost From Restructuring

Standard & Poor's 500 stock index, a reflection of the overall market, or it has outperformed such as the period since 2000. One can see that ExxonMobil's shares underperformed the overall market in the late 1990s due to the combination of the Asian currency crisis that caused a sharp drop in global crude oil prices and the tech stock bubble. Once the latter bubble burst, the price of energy stocks has been helped both by investors seeking safety amongst large capitalization stocks and the rise in oil and gas prices driven by economic growth and growing investor interest in commodity-oriented investments.

Exhibit 17. Exxon Over Long-term Outperforms Market
Exxon Over Long-term Outperforms Market

Outstanding investment performance by large cap oil companies has not always been the case, however. During the past decade, ExxonMobil has fared poorly when measured against the performance of companies oriented toward natural gas. In Exhibit 18, we show the 10-year performance of ExxonMobil against Chesapeake Energy (CHK-NYSE) and a smaller integrated oil company that boosted its focus on natural gas through a major acquisition, ConocoPhillips (COP-NYSE). During the commodity boom of 2005-2008, these latter two stocks blew past the performance of the larger, less nimble ExxonMobil. Although Chesapeake and ConocoPhillips crashed in the 2008 financial crisis-driven stock market collapse in contrast to ExxonMobil that suffered a more modest correction, once financial and economic stability returned, these smaller petroleum companies resumed their outperformance.

Exhibit 18. ExxonMobil Trails Others In Last Decade
ExxonMobil Trails Others In Last Decade

What is interesting in examining the share price performance of these three petroleum companies is how much relative performance is influenced by the starting point and the length of the measurement period. Over the most recent five-year period, ExxonMobil has outperformed the other two stocks. In the case of ConocoPhillips, the outperformance gap has narrowed in recent weeks as the surge in oil prices has lifted its share price. ConocoPhillips's recent market performance was helped by the announcement it would dispose of assets to help improve its financial position and reduce the company's size, enabling it to grow its reserves and production faster. Chesapeake, on the other hand, has struggled with a huge debt load from its strategy of grabbing leases in gas shale plays, while straining to generate cash flow in the face of unusually low natural gas prices. Chesapeake's recent announcement of a business strategy shift and the sale of assets to reduce debt while not seriously damaging its expected production growth outlook has contributed to the better share performance recently.

In the shortest comparative period, one year, the restructuring moves of ConocoPhillips and Chesapeake were clearly seen by investors as positive catalysts to drive share outperformance. The big question is whether this short-term outperformance due to corporate moves and somewhat improved commodity prices and the outlook for future prices can be expected to continue. If we look at

Exhibit 19. Last Two Years Performance Goes To ExxonMobil
Last Two Years Performance Goes To    ExxonMobil

the stock market reaction to the Marathon Oil and Williams Companies moves, one would have to say the answer to the question is Yes!

Exhibit 20. ExxonMobil Wins And Loses In Short-term
ExxonMobil Wins And Loses In Short-term

It is interesting to note that of the top eight western integrated oil companies only three of them are headed by CEOs with technical educations. In Exhibit 21 we also show the education of the prior CEO, if the change was fairly recent. In only two companies have engineer-educated CEOs succeeded bosses with engineering educations. The fact that these CEOs have engineering backgrounds does not mean they are better or different managers, but it may suggest the approach they will take in analyzing their company's opportunities and the industry's outlook. In other words, these CEOs may be less willing to play the financial game to boost their share price performance.


Exhibit 21. Major Oil Company CEO Educations
Major Oil Company CEO Educations
Source: PPHB

While we'd like to think that engineers are less willing to engage in financial engineering, it is not a given that they have any better vision of the future for their company or industry than a financially-trained CEO. We reflect back on a conversation in the late 1970s with just retired Exxon chairman, Ken Jamieson, a civil engineer by education. That was a time when large oil and gas companies struggled to find new oil and gas (the North Sea was only just emerging and West Africa and Brazil were untested) and they were the targets of government regulation and public scorn. Mr. Jamieson told me over lunch that the future of Exxon was in “hard rock minerals.” Those were the days when Exxon was in coal and the mining of other minerals. It was also developing an office products business. There was soon to be a dalliance with electric motors as a play on energy efficiency. In the end all these businesses were abandoned. We always remembered Mr. Jamieson's comment whenever we heard Lee Raymond or Rex Tillerson say that ExxonMobil is an oil and gas company. Being committed to oil and gas, however, doesn't mean that there can't be smart financial moves to enhance shareholder returns.