Valuentum Exclusive Analysis for the Discerning Investor

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Image Source: Exxon Mobil Corporation – 2020 IR Presentation

In ticker by alphabetical order: CVX, XOM

By Callum Turcan

Several integrated oil and gas companies recently reported earnings for the final quarter of 2020, and as expected, these were brutal reports. The coronavirus (‘COVID-19’) pandemic weighed negatively on global demand for raw energy resources (crude oil, natural gas, natural gas liquids), refined petroleum products (gasoline, diesel, kerosene), and certain petrochemicals last year which created massive headwinds for the oil and gas industry across the board. Subdued raw energy resources pricing and lackluster refined petroleum product demand were the two big obstacles for the industry as those dynamics severely weakened the economics of upstream (involved in the extraction of raw energy resources from the ground) and downstream (refineries and petrochemical plants) operations. However, things are starting to look up as raw energy resources pricing is now recovering.

During the first several weeks of 2021, near-term crude oil futures posted a nice recovery, and ongoing efforts by the OPEC+ cartel to limit global oil supplies supports the outlook for raw energy resources pricing going forward. When global health authorities are finally able to put an end to the COVID-19 pandemic, aided by ongoing vaccine distribution efforts, travel activities will be able to resume in earnest, which will go a long way to boost demand for refined petroleum products (creating a powerful tailwind for the financial performance of downstream operations) and thus demand for crude oil. That in turn should create a nice tailwind for raw energy resources pricing (and upstream operations more broadly), though we caution that compliance rates regarding the OPEC+ supply curtailment deal will be crucial here.

We added Energy Select Sector SPDR Fund (XLE) to the Best Ideas Newsletter on January 12 (link here) to gain broad exposure to the oil and gas industry now that a recovery is likely underway. Chevron Corporation (CVX) and Exxon Mobil Corporation (XOM) combined represented ~46% of the ETF’s holdings and the ETF had about two dozen holdings as of February 5. The XLE ETF had a 30-day SEC yield of ~5.1% as of February 5, though we are most interested in the ETF’s capital appreciation upside.

Chevron (CVX)

On January 29, Chevron reported fourth quarter earnings for 2020 that missed both consensus top- and bottom-line estimates. Last year was brutal, though Chevron noted it was still able to increase its annual dividend for its 33rd consecutive year in 2020. We caution that Chevron’s current dividend policy is heavily reliant on the firm maintaining access to capital markets going forward, ideally at attractive rates, while Chevron waits for energy markets to post a sustained recovery (one that currently could be well underway).

Chevron’s upstream production base grew from 3,058 million net barrels of oil equivalent per day (‘BOE/d’) in 2019 to 3,083 million net BOE/d in 2020. The uplift from new projects coming online and the favorable impact its ~$13.0 billion deal (including debt) to acquire Noble Energy had on its production base (the deal closed in October 2020) were key, as those dynamics more than offset declines from mature fields. Furthermore, Chevron’s upstream output was up over 6% year-over-year in the final quarter of 2020 (aided by acquisition activity), indicating Chevron entered 2021 with favorable production momentum at a time when raw energy resources pricing is on an upswing.

Though Chevron’s domestic and international upstream divisions took a beating in 2020, the financial outlook for these divisions has improved materially in recent months. In the final quarter of 2020, both Chevron’s domestic and international upstream divisions posted positive segment-level operating income. Assuming current trends hold, Chevron’s upstream divisions should post a promising rebound this year, though we caution Chevron intends to modestly step up its exploration and capital expenditure spend in 2021 versus 2020 levels (to better position the firm to capitalize on the pending global recovery in energy demand and to maintain its upstream production base).

Subdued demand for refined petroleum products last year took a toll on Chevron’s downstream business as these operations reported a year-over-year decline in crude throughput volumes and refined petroleum product sales by volume. In the fourth quarter of 2020, Chevron’s downstream operations on both a domestic and international basis continued to face major headwinds and both divisions posted negative segment-level operating income. When the world economy can resume pre-pandemic activities in earnest, Chevron’s downstream operations should be able to post a sustained recovery. Until then, the economics of its downstream operations (particularly its refining operations) will continue to face hurdles due to subdued utilization rates and the impact that has when dealing with hefty fixed operational costs.

In the face of headwinds created by the COVID-19 pandemic, Chevron aggressively reduced its capital expenditures on a year-over-year basis in 2020. Chevron generated $1.7 billion in free cash flow last year. A recovery in Chevron’s upstream cash flows in 2021 should more than offset expected capital expenditure increases, assuming current trends hold, and we appreciate Chevron’s ability to navigate the storm. Chevron embarked on a major cost reduction strategy a couple of years ago, which picked up pace last year and that strategy involved major workforce rationalization efforts and synergies from its Noble Energy deal.

We caution that Chevron’s net debt load remains sizable, which weighs negatively on its forward-looking dividend coverage strength (based on its net debt load at the end of September 2020 as Chevron did not include its latest balance sheet statement in its fourth quarter earnings press release and has yet to file its 10-Q SEC filing covering its performance during this period as of this writing). Chevron needs to retain constant access to capital markets to refinance that burden.

On a final note, Chevron recently announced an offer to acquire the outstanding limited partner units of Noble Midstream Partners LP (NBLX) that Chevron does not already own (the midstream spinoff of Noble Energy, which is now part of Chevron). Chevron offered $12.47 per unit of NBLX in the form of a fraction of an CVX share, and we view the corporate consolidation favorably (simplifying the corporate structure offers room for further cost reductions and improved operational focus).

Exxon Mobil (XOM)

When Exxon Mobil Corporation reported fourth quarter earnings for 2020 on February 2, the energy giant missed consensus top-line estimates but beat consensus bottom-line estimates. Exxon Mobil’s upstream division posted a modest year-over-year decline in its annual net BOE/d production in 2020 as the uplift from the company commencing oil production at its intriguing offshore Guyana venture in December 2019 was more than offset by mature output declines across its portfolio. Additionally, Exxon Mobil reported year-over-year volume sales declines at its refining and petrochemical operations last year due to subdued demand for such offerings.

Looking ahead, Exxon Mobil is leaning heavily on cost structure improvements to improve its profit generating abilities. In 2020, Exxon Mobil generated $8.0 billion in operating cost savings and $3.0 billion of that was represented by structural reductions, with the company targeting an additional $3.0 billion in annual structural reductions to its cost structure by 2023. That brings its total targeted annualized savings goal to $6.0 billion by 2023, with workforce rationalization efforts playing a big role. Management also intends to keep Exxon Mobil’s capital expenditures contained over the coming years after pushing through a major year-over-year reduction in 2020, something Exxon Mobil stressed during its latest earnings call.

In the fourth quarter of 2020, Exxon Mobil took major impairment charges (special expense items totaled $20.2 billion during this period according to the firm), though its upstream and petrochemical operations started to stage an operational comeback (raw energy resources production at Exxon Mobil’s upstream segment rose year-over-year as did ‘prime product sales’ at its ‘Chemical’ division). Exxon Mobil’s outlook is improving, and various upstream growth developments at its Guyana venture combined with ongoing investments towards its domestic “fracking” operations should help support its raw energy resources production over the coming years.

Concluding Thoughts

2020 was a brutal year for the oil and gas industry, but things are finally starting to look up. Rebounding raw energy resource pricing will go a long way toward improving the cash flows of Chevron, Exxon Mobil, and other entities with large upstream operations. Cost structure improvements, if sustained, will further enable the oil and gas industry to repair their financial positions in the coming years.

A lot of this recovery rests on private upstream firms keeping their capital investment expectations contained while OPEC+ continues to keep ample crude supplies off the market--so supply does not overwhelm demand at a time when global health authorities are working to put an end to the COVID-19 pandemic (which would allow worldwide energy demand to recover in earnest). We continue to like exposure to the XLE ETF in the Best Ideas Newsletter portfolio. Members interested in reading more about our thoughts on the oil and gas industry are encouraged to check out this article here.

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Related: CVX, NBLX, XLE, XOM

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Callum Turcan does not own shares in any of the securities mentioned above. The Energy Select Sector SPDR Fund (XLE) is included in Valuentum’s simulated Best Ideas Newsletter portfolio. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.