Exxon Mobil Corp. (NYSE:XOM) has had a rough time lately. Years of low oil prices have cut into the Texas-based oil titan’s cash flow, which has caused it to shed much of its market capitalization. Things reached a new low last year thanks to the economic disruptions wrought by the coronavirus pandemic. Like so many other oil producers, Exxon faced profound financial difficulties as oil prices plummeted.
As 2021 kicks off, there are some signs that Exxon’s years of underperformance may be coming to an end. Morgan Stanley (NYSE:MS) is the latest Wall Street firm to highlight Exxon’s potential. On Dec. 11, the investment bank anointed Exxon as its new top pick among big oil stocks, replacing Chevron Corp. (NYSE:CVX). I am not so sure.
Cutting back on overhead and growth investment
According to Morgan Stanley, there are three drivers behind Exxon’s turnaround story. First and foremost is its successful efforts to cut costs:
“In response to the 2020 oil price collapse, XOM prudently deferred its countercyclical growth plans, cutting 2022-2025 capex from $30-35B to $20-25B, with larger reductions to $16-19B in 2021. On top of this, management has disclosed plans to cut cash operating costs by at least 15% with complete details likely to be disclosed over the coming months. We have analyzed XOM’s cost structure relative to CVX and estimate reductions can reach ~23% from 2019 levels, exceeding guidance and consensus expectations.”
Exxon’s planned 15% reduction in operating overhead would undoubtedly allow it to better weather future economic shocks. The 23% reduction predicted by Morgan Stanley would be even better. If the company can continue to execute on its cost-cutting efforts successfully, there is ample reason to believe it will recover at least some of its lustre in the near term.
However, Exxon’s cost reductions also include plans to slash growth capex. While that may support the company’s financial health in the short run, it also risks hampering growth over the long run. Bringing new extraction projects online requires considerable investments of time and resources. Exxon could end up paying a high price for its economizing down the line.
Cash flow fueled by oil price rebound
The second driver identified by Morgan Stanley concerns Exxon’s free cash flow expectations. Specifically, the investment bank predicts that rebounding oil and gas prices will act as a tailwind:
“A tightening global oil market, rebounding gas prices, forward crack spreads that have begun to rally, and an improving chemicals outlook supports margins moving back within historical ranges for all of XOM’s core business units.”
According to Morgan Stanley, the price of Brent crude should reach $60 per barrel in the second half of 2021, which would allow Exxon to boost free cash flow significantly. Indeed, the investment bank predicts that the company will produce approximately $17.5 billion in free cash flow this year, well above the Wall Street consensus estimate of approximately $12 billion.
The price of oil is crucially important to the operational and financial health of Exxon, as it is for all oil producers. If Morgan Stanley’s oil price prediction holds true, the company could indeed enjoy a surge in cash flow. However, the prospect of $60 per barrel is far from certain. Indeed, while demand is undoubtedly picking up, so too is supply, which, according to the U.S. Energy Information Administration’s December market outlook, is set to increase by 5.8 million barrels per day in the new year. In the longer run, oil may face still further pricing pressures as the rate of oil discovery increases in the coming years.
Dividend no longer in danger
The third and final arrow of Morgan Stanley’s Exxon thesis is all about the dividend. The company’s dividend has been under pressure for some time. It failed to cover the dividend and capital expenditures organically in both 2018 and 2019. Last year’s crisis-driven collapse of the oil price drove Exxon’s dividend cover deeply negative, leading many to question whether it could afford to continue paying. According to Morgan Stanley, this is set to change in 2021:
“Proactive cost & capex cuts coupled with rebounding commodity prices and downstream & chemicals margins support outsized rate of change in FCF and dividend cover for XOM in 2021.”
Morgan Stanley predicts that Exxon’s dividend cover will improve significantly in 2021 as rebounding energy prices drive more cash flow. But that prediction relies on the assumption that the oil price rally will continue indefinitely. According to Morgan Stanley’s calculations, Exxon will need the price of Brent to remain at or above $49 per barrel in order to cover even its reduced capital expenditure plans and dividend. Yet even now Brent is hovering around $51 per barrel.
Further oil price declines in the face of growing supply are certainly not off the table. Indeed, Exxon’s own internal forecast, published by the Wall Street Journal on Nov. 25, predicts a prevailing oil price of $50 to 55 per barrel over the next five years. Under such conditions, Exxon’s dividend could again come under pressure.
With an 8% yield and comfortable cover in 2021, Exxon’s dividend may prove increasingly appealing to income investors. A near-term stock price rebound may also be on the cards if oil prices continue to firm up during the year.
However, I am not sure about Exxon’s prospects over the long run. Its future is at the mercy of prevailing oil prices. Further demand shocks, in addition to secular supply increases, could well undermine the price of oil. That could prove problematic for Exxon’s generous dividend. Moreover, cutting back on growth investments may pressure cash flow in the years ahead.
In my assessment, investors would do well to view Morgan Stanley’s fresh optimism with a healthy dose of skepticism. Exxon’s future may prove brighter than its recent past, but it might well fall short of bulls’ expectations.
Disclosure: No positions.
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About the author:
John Engle is president of Almington Capital Merchant Bankers and chief investment officer of the Cannabis Capital Group. John specializes in value and special situation strategies. He holds a bachelor’s degree in economics from Trinity College Dublin, a diploma in finance from the London School of Economics and an MBA from the University of Oxford.