Exxon Apostasy

Wait a second, this does sound like a perfect stock! This type of superficial, on the surface analysis is only granted to religious stocks. Their long-term track and an aura of reverence establish the leap of faith that eases us into drawing straight lines from the past into the future, and this is very dangerous.

Arguably, a similar “religious” attitude created by a consistent 12% a year, ruler-like performance and a blue chip pedigree ( as a founder of Nasdaq) allowed Bernard Madoff to lower the guard of even very sophisticated investors and deprive them of billions.

If you were to take off the religious veil from Exxon and look under the surface, you’ll find quite a different story. The incredible double-digit revenue and earnings growth came completely from the big rise in oil and natural gas prices. XOM spent close to $90 billion finding new oil and natural gas, but oil reserves have not increased at all. Gas reserves are up 25% since 2003, but gas production increased very little.

I invite you to spend some time with XOM’s annual report. You’ll find that volumes of production and reserves in all its segments have not moved much since 2003. In many cases, they declined. So the magic behind all that growth over the last five years had little to do with XOM’s operating performance but was totally driven by commodity prices and share buybacks.

You might say that XOM is at only nine times earnings, and there’s not much growth built into the stock. Keep in mind, however, that XOM only trades at that valuation if it can earn what it earned in 2008 when oil prices were between $85 and $150. Unfortunately for XOM, fortunately for rest of us, oil prices are making five-year lows, revisiting the mid-30s.

My motto in life that I borrowed from Keynes is “I’d rather be vaguely right than precisely wrong.” Let’s figure what XOM’s vaguely right valuation is.

Exxon’s earnings overstate its true earnings power. To estimate XOM’s earning power at today’s prices, let’s look what it made when oil prices were in the 30s and 40s. In 2003 and 2004, when oil prices averaged $28 and $38, XOM made about $3 and $4 a share, respectively. Since XOM’s reserves are not growing, it is reasonable to expect no growth of production in the future. Don’t deceive yourself: XOM is just an operationally leveraged proxy for oil (and natural gas).