Dividend aristocrats such as ExxonMobil (XOM) have long been a favorite among conservative income investors.
The fact that a company has grown its payout for 25+ consecutive years tells you a lot about the predictability of a firm’s business, the quality of its management, and how shareholder-friendly the corporate culture is.
Investors can review information on all of the dividend aristocrats here.
Of course, it’s no secret that in the past few years the worst oil crash in over 50 years has wreaked havoc on the profits and balance sheets of this highly cyclical industry.
As a result, a number of high-yield energy stocks have been forced to cut or even suspend their dividends entirely, and many others have low Dividend Safety Scores.
Let’s take a look at ExxonMobil to see what makes this integrated oil giant different and likely capable of not only surviving the oil crash but coming out even stronger once it’s finally over.
ExxonMobil is one of the world’s oldest oil companies, founded in 1870 in Irving, Texas. It’s also the world’s largest publicly traded integrated oil conglomerate, with nearly 30,000 oil & gas wells on six continents. In fact, thanks to its refining and petrochemical business, Exxon operates in almost every country on earth.
The company operates in three distinct business segments: upstream oil & gas production, downstream refining, and specialty chemicals.
The logic behind such an integrated business, in which Exxon controls all aspects of the fossil fuel business (from production to refining to retail sales), is that it diversifies Exxon’s sales, earnings, and cash flow.
For example, as you can see below, low oil prices resulted in almost no profits from upstream oil & gas production in 2016. However, these low commodity prices resulted in cheaper input costs that allowed the midstream refining and chemical divisions to report stronger earnings and help Exxon to still report nearly $8 billion in annual profit.
Exxon’s scale and diversification are two of its greatest strengths:
- 2016 average daily oil & gas production: 4.1 million barrel equivalent
- 2016 refining capacity: 4.3 million barrels per day
- 2016 chemical production: 24.9 million tons
- 2016 petroleum product sales: 5.5 million barrels per day
For example, if Exxon were its own nation, its total liquids production would have made it the world’s 8th largest oil producer in the world in 2016, greater than even Middle East nations such as the UAE, Kuwait, and Qatar.
2016 Daily Liquids Production By Country
More important for long-term investors is the fact that Exxon’s proven reserves are enormous, meaning that its massive production is likely to continue for decades to come.
More specifically, the company’s massive resource base of more than 91 billion oil-equivalent barrels provides solid visibility; Exxon has a long reserve life of 13 years at current production rates, which leads all competition.
Exxon’s track record of profitably replacing its resources is also impressive. Like clockwork, Exxon has added around 1 billion to 2 billion oil-equivalent barrels of resources to proved oil and gas reserves each year, replacing more than 80% of production over the past decade.
To fully appreciate the company’s substantial resource base, if Exxon were a sovereign nation, its proven reserves of 20 billion barrels of oil equivalent would be the 15th largest on earth.
2016 Proven Oil Equivalent Reserves
Why is such impressive size a competitive advantage? Because the oil business is highly commoditized, meaning that the price a company can get for its products is almost entirely at the mercy of international markets.
And due to the highly volatile price of oil & gas, integrated oil companies are faced with inevitable boom and bust cycles, in which sales, earnings, and free cash flow (FCF) can swing wildly from one year to the next.
As a result, maintaining profitability can be highly challenging, even with large economies of scale such as Exxon’s. You can see that the company’s operating margin has slumped from 16.4% in 2012 to just 3.5% last year, for example.
However, while Exxon’s profitability may have declined substantially in recent years as oil prices crashed, it still boasts the best margins of its large integrated peers.
This is courtesy of Exxon’s quality management team, which has a long track record of excellent capital allocation decisions, far above those of its rivals such as Chevron (CVX), British Petroleum (BP), Royal Dutch Shell (RDS.B), and Total (TOT).
Management’s focus is primarily on long-lived assets in each of its business segments. Exxon focuses on assets that can return the highest profitability in all types of energy price and interest rate environments, which has helped the company enjoy higher returns on capital than all of its major peers.
Exxon’s high returns are also thanks to its integrated business model, which enables it to react more effectively, efficiently, and quickly to changes in the business environment.
The company’s diverse asset base provides market optionality and operational flexibility while allowing Exxon to optimize profits throughout various commodity cycles better than most of its peers.
The company’s scale further helps it maintain lower costs than its peers. For example, Exxon’s Downstream and Chemical businesses generated over $50 billion in earnings over the last five years, nearly twice as much as its nearest competitor.
While the industry is mature and dealing with low commodity prices that challenge the return on many capital investments, Exxon’s current growth pipeline still includes over 100 global projects. These are mainly focused on two key areas right now.
The first is liquified natural gas (LNG) projects such as those in Papua New Guinea, Mozambique, and Australia. The reason that Exxon, as well as many of its rivals, are so excited about LNG is that their production tends to decline slower than oil.
In addition, demand for LNG, especially from Asia, is expected to grow enormously in the coming decades because natural gas-fired power plants are far cleaner, less carbon intensive, and more cost effective than coal plants.
The other key area Exxon is actively investing in is low-cost shale production in the Permian basin, which is estimated to hold 75 billion barrels of recoverable oil equivalents, and in very favorable geological formations.
Specifically, this means that the largest and most cost-effective pockets of oil & gas are located in shale layers that are tightly stacked on top of each other and often overlap; a single well can tap several pockets simultaneously.
Combined with state of the art fracking technology such as super-spec rigs (which can move and drill up to eight wells per drill pad), horizontal laterals of two miles or more, increased fracking stages per lateral, and up to 10,000 tons of frack sand per well (which props open shattered rock and increases oil & gas flow), the cost of production in the Permian has fallen to levels once thought impossible.
This is why back in January of 2017 Exxon paid $5.6 billion in stock to acquire 250,000 net acres of prime Permian land, 95% of which is undeveloped. This acquisition also netted the company 3.4 billion in proven reserves that management believes it can achieve a 10% internal rate of return even at oil prices as low as $40 per barrel.
Overall, Exxon’s capital discipline, quality assets, integrated operations, diverse resource base, and scale will continue to serve the company well for many years to come.
While Exxon’s dividend aristocrat status suggests that it could be a relatively low risk company to invest in, there are several factors to watch for going forward.
For one thing, as we’ll soon see, Exxon’s recent strong growth in sales, earnings, and cash flow ($11 billion in FCF in the last year thanks to oil prices doubling off their 2016 lows) still isn’t enough to cover the dividend, which was $12.5 billion in the past 12 months.
In other words, Exxon will still need long-term energy prices to rise from their current $46 per barrel levels in order to be able to both invest in future growth, as well as continue increasing its payout. For now, the company continues to tap debt markets.
Unfortunately, oil prices are impossible to predict because they are a result of international markets, which are driven by hundreds of unpredictable variables.
For example, OPEC, led by Saudi Arabia, along with Russia, recently agreed to extend their 10% production cut for another nine months, through March of 2018. This is to allow the global supply glut to decrease and hopefully raise long-term oil prices to the group’s target of $60 to $70 per barrel.
Unfortunately for OPEC (and oil companies such as Exxon), U.S. shale producers aren’t playing ball. In fact, thanks to fracking technology becoming so much more efficient since the oil crash began in mid-2014, the number of U.S. rigs operating in the field has been rising for a record 22 straight weeks, up to 933 from a low of 404 in May of 2016.
A recent Wall Street Journal article noted that “shale producers operating in a number of fields can break even at $50 to $60 oil today,” and some companies have been able to make money at prices as low as $40 per barrel.
This is why the U.S. Energy Information Administration (EIA) predicts that U.S. oil production will actually increase in 2017 and hit a new all-time high in 2018 despite low oil prices.
In other words, U.S. shale producers, of which there are thousands of independent operators, have become the new global swing producer; one that is hindering OPEC’s attempts to end the global oil glut and stabilize prices.
The other major risk to consider is the fact that, in the long-term, an increased focus on transitioning the world to cleaner, renewable energy, such as hydro, solar, and wind, means that the age of fossil fuels may come to an end earlier than many people, and oil companies, expect.
For example, as you can see below, Exxon expects demand for oil & gas to increase at around 0.8% per year through at least 2040. This forecast is what underpins the company’s return on capital expenditure (ROCE) models that determine the long-term investment plans.
However, while a growing world population and fast economic growth in developing nations such as India and China mean that oil & gas demand is likely to rise for the foreseeable future, we can’t forget that growing pollution concerns in these nations mean that an increasing amount of investment is finding its way into renewable sources.
For example, between 2016 and 2020 alone, China plans to invest $361 billion ($72 billion per year) into renewable energy,according to the National Energy Administration (NEA).
India’s clean energy plan is even more ambitious. Specifically, that country hopes to generate 60% of national electricity capacity from non-fossil fuel sources by 2027.
Then there’s the threat to oil demand from electric vehicles (EVs). Up until now the number of EVs has been relatively small. In fact, according to the EIA, at the end of 2016 there were only about 2 million EVs in the entire world.
However, the number of new EV sales last year was up 37% in 2016, to over 750,000, 40% of which were in China. And according to a report by ARK Research, the number of new global EV sales over the next six years will grow annually by 68% to 17 million.
Overall, the biggest risk to Exxon over the medium-term is that oil & gas prices remain depressed thanks to the adaptability of U.S. shale producers. While the company continues to cut costs and remain financially disciplined, low energy prices have forced Exxon to take on debt to continue investing in its business while paying dividends to shareholders.
In fact, S&P (SPGI) downgraded Exxon last year from its coveted AAA credit rating, which it held since 1949. Specifically the rating agency said that “credit measures, including free operating cash flow (FOCF) to debt and discretionary cash flow (DCF) to debt, will remain below [its] expectations for the ‘AAA’ rating through 2018.”
No one knows where oil prices will go from here, but the industry’s structural change with the continued rise of U.S. shale production seems likely to keep prices lower (e.g. under $70 per barrel) for longer.
The good news is that the oil majors have stated they can generate enough cash flow at $60 a barrel to cover capital investments and shareholder payouts this year, according to The Wall Street Journal. Investors holding Exxon should remain aware that the company remains reasonably safe today but ultimately needs oil prices to rise and favorable credit market conditions.
Exxon’s Dividend Safety
We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.
Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.
Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.
We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.
Exxon has a dividend Safety Score of 65, which while average for stocks in general, is actually impressive for a vertically-integrated oil giant, especially compared to the Dividend Safety Scores of its peers:
- Chevron Safety Score: 25
- Total’s Safety Score: 25
- Royal Dutch Shell’s Safety Score: 11
- BP’s Safety Score: 6
That’s not surprising given that Exxon has one of the best dividend growth records of any major oil company. For example, the company has been increasing its dividend every year since 1983 (34 years and counting).
Even more impressive? Exxon has paid an uninterrupted quarterly dividend for 135 consecutive years (since 1882).
The key to Exxon’s dividend longevity is two old. First, other than in years of very low oil prices, such as 2009 and 2015 through today, Exxon’s management team has maintained a disciplined payout growth strategy to ensure that its EPS and FCF payout ratios are very low.
You can see that Exxon’s payout ratios sat near 20% to 30% during most years over the past decade.
This allows the company to generally have a strong safety cushion, in which it retains a lot of earnings and free cash flow to reinvest in its business, as well as buy back shares.
In fact, over the past 12 years Exxon has reduced its share count by 3.4% annually. The reason this is important is because the boom and bust cycle of the oil industry means that, in order to grow the dividend over the long-term, periods of large excess FCF need to somehow be translated into permanent benefit to shareholders.
By reducing its share count over time Exxon is reducing the annual cost of its dividend and effectively lowering its payout ratios. This makes it easier to continue growing the dividend in leaner years.
The other important factor in Exxon’s safe dividend is its industry-leading balance sheet. That’s because the oil industry is incredibly capital intensive.
Combined with the highly volatile nature of its earnings and FCF, all oil companies need to occasionally fund dividends via debt when energy prices are low.
Fortunately, Exxon’s low relative debt levels mean that it has plenty of access to cheap debt with which to sustain and even grow the payout during times of low oil prices.
Now, at first glance you might not think Exxon’s credit profile is all that strong. After all, its absolute debt level is high and its current ratio (short-term assets/short-term liabilities) is below one.
However, when we compare Exxon’s debt metrics against its peers, we can see that it has one of the strongest balance sheet of any oil major.
Specifically, its leverage ratio is about half the industry average, its debt to capital ratio is about 2/3 smaller, and its interest coverage ratio is sky-high. That means that Exxon’s cash flow, even in a period of low oil prices, is easily enough to cover its debt service payments and other short-term liabilities.
That explains why its credit rating is so high, ensuring it can easily borrow funds at low interest rates to continue running its business smoothly through the various cycles.
In fact, Exxon’s balance sheet is so strong that it’s debt load could double from its current level and its debt to capital ratio would still be slightly below industry average.
Or to put it another way, no integrated oil company is as well situated to ride out the current oil crash, while maintaining and growing its dividend, as much as ExxonMobil.
Exxon’s Dividend Growth
Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.
Exxon’s Dividend Growth Score of 25 indicates that investors can expect below average dividend growth in the coming years, at least until energy prices recover.
Given that Exxon’s EPS and FCF/share are currently not covering the dividend, this is to be expected. After all, this is why Exxon’s dividend growth rate has slowed in recent years.
Fortunately, while we can’t be sure of the timing, oil prices are likely to rise at some point, with analysts expecting long-term Brent (the world standard) price rising to $60 per barrel by 2019 and beyond.
Combined with its ongoing cost cutting efforts, moderate production growth, and future share buybacks, Exxon should be able to squeeze out at least low to mid-single-digit EPS and FCF per share growth over the long-term.
However, given the conservative nature of its long-term payout ratios, it’s likely that management will want to grow the dividend more slowly than earnings and cash flow, in order to once more build up a strong safety buffer.
That’s why long-term dividend growth is likely to come in slightly lower than bottom line growth, on the order of perhaps 4% to 6% per year (somewhat below the company’s 20-year average).
Thanks to the oil crash, Exxon shares have underperformed the market by about 25% in the past year. Many contrarian-oriented investors are wondering if today could be a reasonable long-term opportunity.
At first glance you may not think so because Exxon’s forward P/E of 21.1 is above the S&P 500’s 17.8 and far above its 13-year median norm of 11.8.
However, remember that during oil crashes earnings are substantially reduced, resulting in inflated P/E ratios. Looking further out to 2019, which begins to capture moderate production growth from some of Exxon’s major projects, somewhat higher oil prices, and continued efficiency gains, XOM’s 2019 forward P/E is 17.3 – still not an obvious bargain.
That’s why it’s far more important to look at the dividend yield, especially since the steadily growing payout is the key reason for owning this dividend aristocrat.
Another way for income investors to look at the stock is by reviewing its dividend yield. Exxon’s current dividend yield of 3.8% is significantly higher than its 22-year average of 2.6%, likely reflecting the firm’s lower growth outlook and the structural change that has taken place in the oil market.
From a total return perspective, Exxon seems to have potential to generate long-term annual total returns between 9% and 11% (3.8% dividend yield plus 5% to 7% annual earnings growth). That’s not bad for a low risk, industry leader.
While no oil stock’s dividend is ever completely secure in today’s environment, when it comes to dependable high-yield in the oil sector, you can’t get much better than dividend aristocrat ExxonMobil.
It’s hard to make a compelling valuation case for many of these stocks if oil prices remain below $50 or $60 a barrel, but ExxonMobil is one of the very few energy stocks I am comfortable owning in a diversified income portfolio given the structural change that has taken place in the global oil market.
Conservative investors seeking current income and safety might consider looking outside of the energy sector, including some of the best high dividend stocks here.