Oil Price Shock Expected to Pressure Exxon's Spending Plans
On March 5, Exxon (XOM) reaffirmed its contrarian plans to boost its capital spending in the years ahead with hopes of doubling its earnings power between 2018 and 2025:
"Capacity investments have overwhelmed the growth in demand, leading to the down cycle and waiting for demand to catch up. These are typical cycles. Unfortunately, they're hitting multiple businesses at once, creating a short-term issue. That, unfortunately, is impacting short-term industry earnings...
We expect these down markets to discourage industry investment, setting a stage for a significant upswing. And we believe the best time to invest in these businesses is during a low, which will lead to greater value capture in the coming upswing. You can do that if you have the opportunities and the financial capacity, which we do." – CEO Darren Woods
Less than a week later, the price of oil crashed as much as 30% as Saudi Arabia and Russia engaged in a price war that threatens to take market share from higher-cost U.S. shale producers.
We analyzed this event in a note here, but the bottom line is that we believe oil prices could now remain at historically weak levels near $35 per barrel or lower for at least a few quarters, if not for more than a year.
Prior to the price war, an oil environment near $50 per barrel or higher seemed realistic and served as a core assumption around many of the forecasts communicated by Exxon.
If today's dramatically lower oil price environment persists for more than a few quarters, then Exxon will lose flexibility to execute on its full investment plans, maintain its current dividend, and preserve its excellent balance sheet.
Therefore, we are downgrading Exxon's Dividend Safety Score from Safe to Borderline Safe. We plan to continue holding our Exxon shares in our Conservative Retirees portfolio.
For more background information on Exxon's investment plans and cash flow, please see our February 2020 note on the company here.
As part of that analysis, we created the table below to look at Exxon's historical and projected dividend coverage after the firm covered all of its capital spending and divested select assets.
In one scenario, we assumed that Exxon generated no free cash flow in 2020 and 2021 (i.e. its operating cash flow covered only its capital expenditures) as weak industry conditions persisted, creating a $30 billion cumulative cash flow deficit after accounting for the firm's $15 billion annual dividend.
We concluded that Exxon had the firepower to do this for a period of time, but this was a rather fragile situation that couldn't afford more macro weakness:
"Between asset divestitures ($10 billion to $20 billion) and balance sheet capacity ($20 billion to $30 billion), Exxon appears positioned to continue paying its dividend for several years until market conditions improve and its growth projects come online.
However, the stakes are high for Exxon's investments to deliver their expected returns. The company can't operate at a cash flow deficit forever. Pressure will rise if the macro environment deteriorates further and Exxon's profits have not improved considerably within a few years."
With the price of Brent oil plunging from $59 per barrel at the time our February note was published to $33 today, it's fair to say that the environment has taken a big step back.
Exxon doesn't disclose how sensitive its cash flow is for every $1 a barrel change in oil prices. Shell pegs its sensitivity at $600 million, and Chevron discloses that its cash flow fluctuates $450 million.
If we assume that Exxon's cash flow moves $500 million for every $1 change in Brent oil prices, then the fall in prices could reduce the firm's annual operating cash flow by about $15 billion. (Brent oil averaged $64 per barrel in 2019.)
That could pull Exxon's operating cash flow down to about $20 billion, not far from where it sat in 2016 ($22.1 billion) when the price of oil averaged $44 per barrel.
If Exxon maintained its annual capital spending at $30 billion in this environment, the low end of its current plan, then the firm would generate negative free cash flow of $10 billion, with another $15 billion spent on dividends to bring its burn rate up to $25 billion per year.
Excluding potential asset sales, this requires Exxon to borrow to fill the gap. At its investor day last week, Exxon showed a slide suggesting that it would be comfortable taking its debt to capital ratio up from about 20% to 30%, which management says would still be "within the range of peers."
Based on Exxon's current book value, this works out to about $40 billion of incremental debt that could be borrowed to take the balance sheet to a 30% debt to capital ratio.
It's hard to say how stubborn management will be in today's commodity price environment. On one hand, the energy market's plunge seems likely to only increase the appeal of today's low-cost environment for firms putting capital to work. Plus, interest rates have plumbed new lows.
On the other hand, management has indicated that the firm's spending plans are flexible if their long-term outlook has changed. We will hopefully learn more about how management views oil's price weakness on Exxon's next earnings call.
"Being at the low end of all of our businesses for the 5-year period, we haven't ever seen that in the past...if we found ourselves in this unprecedented environment for 5 years, we would change our plans." – CEO Darren Woods
Until then, we looked at three dividend coverage scenarios below based on capital investment levels ranging from $19 billion (slightly above 2016 spending) to $30 billion. We assumed operating cash flow remains depressed at $20 billion.
As you can see, Exxon's annual cash flow deficit after paying dividends (and assuming no asset sales) ranges from about $14 billion to $25 billion.
Assuming the firm could borrow up to $40 billion, these coverage deficits could only be sustained for 1.5 years to 2.8 years before management would be forced to pick between prioritizing dividends, investment, or stretching the balance sheet beyond a 30% debt to capital ratio.
No matter how you look at it, today's energy environment is unsupportive Exxon's dividend if conditions do not improve within a few years. We don't expect $35 per barrel oil to last forever, but the short-term outlook is anyone's guess.
Thankfully, the oil price shock occurred before Exxon was too deep into its spending plans and had less balance sheet flexibility. Management has time to decide if plowing ahead with $30 billion to $35 billion of annual spending the next five years is really the most prudent course of action.
While possible, it seems very unlikely at this stage that the company would reduce its dividend in order to prioritize its original investment plans. After all, Exxon and its predecessors have paid uninterrupted dividends since 1882, and management continues to emphasize that "a reliable growing dividend" remains a priority.
Until more clarity is provided on the company's investment plans at $35 per barrel, we expect Exxon to maintain its Borderline Safe Dividend Safety Score.
