Higher Oil Prices Lessen the Impact of Poor Performance

ExxonMobil (XOM), the largest corporation in the US, reported quarterly results on Thursday that were underwhelming despite a 38% surge in net income and impressive growth in production. For the quarter, Exxon earned $6.3 billion or $1.33 per share, from $4.55 billion or 92 cents a share in the period a year ago. Revenue grew 41% to $90.3 billion from $64 billion. Although the growth rates do look impressive, Exxon fell short on both the top and bottom lines compared to consensus analyst’s estimates for the quarter of $1.41 per share on revenue of $96.4 billion. Consider that the benchmark for US crude oil prices averaged almost $79 in the quarter compared to just $43 per barrel in the comparable quarter a year prior. Oil has continued to climb on Thursday, as it stands over $85 per barrel at the time of publication.

Exxon has long been known for keeping production costs low compared to their competitors, and with crude prices on average 83.7% higher than a year ago in addition to production growth of 4.5%, last quarter should have been far better. There were two big problems that held results down, the first of which was the effect of newly enacted healthcare reform legislation which cost the company $200 million or 4 cents per share. Were it not for these charges Exxon would have been closer to Wall Street’s view, yet it still would have fallen short, largely due to its downstream operations. For those unaware, downstream generally refers to refining and marketing activities, and upstream relates to exploration and production.

Refining profit margins have been squeezed over the last year, and Exxon’s downstream earnings dropped nearly 97% to $37 million from $1.1 billion a year ago. Total refined product sales slipped 4.5% from a year ago, which suggests higher energy prices are being met by resistance as demand contracts. However, no one expected downstream to carry the quarter for Exxon or the other major integrated energy companies for that matter, but it does speak to just how strong their upstream performance actually turned out to be. XOM was able to lift profits from their upstream operations by nearly two-thirds to $5.8 billion. One big reason for the surge in production was a major liquefied natural gas (LNG) operation in Qatar coming on-line; one of a few joint ventures Exxon has developed with Qatar Petroleum.

Production growth, higher oil prices, and even big improvements from their chemical segment all worked in Exxon’s favor in the quarter, and yet they were not able to match expectations. Coming into this week, we downgraded XOM to Overvalued as it just crossed an important valuation threshold according to our methodology. Given current fundamentals, we believe the stock should trade between $58 and $67 per share. With Exxon’s dependence on upstream operations for profits, their stock should be highly correlated to the price of oil but over the last year that correlation has been almost nonexistent. A year ago, Exxon traded at about the same price level, meanwhile crude prices have soared. It is possible that the market is pricing in XOM’s growing diversification into natural gas (XTO merger expected to close in the second quarter); natural gas prices have been crushed over the last year as supply has ballooned.

As expected, Exxon did announce a two-cent per quarter dividend hike which raises their implied yield to about 2.6%. This is a positive in our analysis and will be factored into upcoming ratings. As of right now, we are reaffirming our Overvalued rating on Exxon as its downstream operations flounder. In our view, their upstream performance continues to be solid, yet the market has not recognized this potential as oil prices have increased. With consumer demand showing signs of weakness at current prices, the upside in oil prices appears limited for now.

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