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Winter Is Coming For Upstream Oil And Gas

Companies In 2015, Part 1 - Exxon Mobil

Sep. 3, 2015 | David Addison

Bargains among upstream companies stocks are difficult to come by; current
valuations discount much higher energy prices.

Stress-testing upstream assets for lower oil and natural gas prices indicates that
massive reserve quantity and balance sheet impairments may be due in 2015s
annual reports to shareholders.

Panic-induced selling following the disclosures of these impending impairments

could finally create some buying opportunities among higher quality assets.

Exxon Mobil, as a company, will be able to weather lower energy prices.

Exxon Mobils stock valuation, like most other upstream companies, is tied to
commodity prices.

"Winter is coming" for many upstream oil and gas companies. The precipitous 50% drop
in crude oil prices over the past year will likely force many oil and gas exploration and
production (E&P) companies to impair their upstream assets in this coming winter's 10K and 20-F annuals reports to shareholders. If one assumes that current energy prices
(i.e., $60/Bbl oil, $39/Boe NGL, and $18/Boe natural gas) are the "new normal",
bargains in upstream oil and gas stocks are scarce. However, once the market digests
the impending impairments and true impacts of lower prices, bargains may begin to
appear. Until that time, even seasoned investors who are tempted to "buy the dip" in the
stock prices of even the best upstream oil and gas companies should exercise restraint.
Accounting regulations compel companies with significant E&P operations to
periodically test the book values of upstream oil and gas assets for impairments.
Furthermore, the SEC compels publicly held companies with significant upstream
assets to disclose standardized measures of the discounted net present values (NPV)
for their oil & gas producing properties in annual reports to shareholders. The
standardized measure was intended to increase transparency, but it is able to sanity
check the capitalized costs of upstream assets.
In this first portion of the series, I stress test the balance sheet of the super-major,
Exxon Mobil (NYSE:XOM) to lower prices. Based on this analysis, it is fairly clear that
Exxon Mobil, as a company, can survive through the current commodity environment.
However, Exxon Mobil's attractiveness as an investment in the company's stock is
dubious. In order for the economic value of its net assets to match up with the
company's stock price, energy prices must quickly recover to $100/Bbl oil and $30/Boe
(~$5/Mcf) natural gas.

Some Notes on Methodology

My core methodology for stress testing balance sheets is to estimate the economic
book values (EBV) of core assets. Estimating EBV simply involves creating an
economic balance sheet which converts certain accounting book values (ABV) to
estimates of their fair or intrinsic values and/or discounted net present values under
specific macro- and micro-economic conditions. If and when capitalized costs
significantly overstate the modeled intrinsic values of the upstream assets at current
commodity prices, one can assume that the economic values should be impaired. This
approach roughly mirrors common practices for impairment testing.
In this series, NPV analysis is applied to the upstream assets (i.e., oil and gas
producing properties) of various oil and gas exploration & production (E&P) companies.
Specifically, I estimate the NPV of a given company's oil & gas reserves using recent
commodity prices and the industry-standard 10% annualized discount rate which is
applied to future cash flows. When possible, I adjust the values of related upstream
items, especially when those values are both significant and tied to commodities prices.
I leave the values of Exploration & Evaluation (E&E) efforts, which can be either
extremely accretive or deleterious, to qualitative interpretation. The economic values of
downstream assets, when they are significant, are determined by a Nelson Complexity
analysis of their equivalent distillation capacities (see prior article on the fundamentals
of the refining business).
This methodology admittedly somewhat replicates reporting requirements. FASB
Accounting Standards Codification (ASC) 932 requires publicly traded E&P companies
to disclose a standardized measure of discounted future cash flows (i.e., SEC
Standardized Measure) in their annual 10-K or 20-F reports to the SEC. The SEC "Final
Rule" on the Modernization of Oil and Gas Reporting specifies that companies must use
the 12-month historical average of the beginning-of-month prices in determining reserve
The standardized measure was originally intended to help interested parties see
through accounting distortions caused by the use of disparate accounting methods. It
can also sanity check capitalized costs of upstream assets and, to an extent, predict
impairments - this is especially true for companies which use the FC method.
Under the FC method, E&E efforts are fully capitalized to the balance sheet. Natural
resource companies reporting under the FC method perform annual "ceiling tests"
which set the maximum value at which capitalized costs can be carried. The first step of
a ceiling test estimates the intrinsic value of oil and gas production under recent
commodity prices - overwhelmingly, managements utilize discounted cash flow
analyses, vis--vis the standardized measure. If the book value is greater than this
estimate, the company impairs capitalized assets by the amount of the difference.
Under the SE method, only E&E efforts which result in the addition of reserves are
capitalized. Companies using the SE method are only required to impair assets when
the carrying amounts of oil and gas properties are deemed to be unrecoverable (on an
undiscounted basis).

Irrespective of accounting method, companies may not reverse impairments once they
have taken effect, even if economic conditions improve.
Although natural resources accounting and reservoir management standards would
seem to improve corporate transparency, reported values may exist independently of
economic reality.
On the accounting end, if and when accounting convention significantly embellishes
economic reality, investors should notionally impair the asset even if management
chooses not to or is not compelled. Moreover, publicly traded companies are only
required to publish this information once annually - so when economic conditions
change, such as how energy prices have dropped in 2015, the company's latest
information may not reflect the current economic reality.
Moreover, there may be significant variability in how different reservoir managers
prepare standardized measures which severely limits their usefulness as a comparative
value metric. I wager that any petroleum engineer out there will corroborate that
reservoir management, from the financial perspective, is an art more than a science.
A 2014 S&P Capital IQ white paper, Drilling for Alpha in the Oil & Gas Industry, does not
support the idea that the standardized measure, as presented within company reports,
is a reliable tool for estimating future stock returns. The overwhelming problem,
however, is not the rationale behind the standardized measure, but rather
inconsistencies in its preparation.
To compensate for the information lag as well as for uncertainty and inconsistency in
managements' preparation of estimates, I utilize a uniform valuation methodology which
is accounting-methodology independent and which incorporates more recent
information on commodities prices. For simplicity, I assume constant commodities prices
($60/Bbl oil, $39/Boe NGL, and $18/Boe gas prices), adjusted for typical premiums/
discounts that different companies historically realize. A potential refinement in future
iterations would be to prepare NPV estimates using futures strip pricing (i.e., the term
structure of futures prices).
Although an "economic stress test" approach may seem foreign to some, this
methodology is actually very relevant to many types of investors since it removes
accounting distortions created by different accounting methods. Also, being premised on
estimating future cash flows, it give some insight into companies' abilities to sustain
dividends, buybacks, interest payments, and even operating costs. Furthermore, many
companies, especially independent producers, engage in debt covenants with lenders.
Lower cash flows and asset impairments can trigger breaches of these covenants which
can unleash a flurry of negative consequences... all of which can lead to massive
investor losses.
Some final notes regarding methodology:
The standardized measure, because it is based on proved (1P) reserves, may be
predisposed to underestimating the economic values of underlying oil and gas
assets. The SEC defines proved oil and gas reserves as those quantities of oil
and gas which are expected to be economically producible with "reasonable

certainty". The Society of Petroleum Engineers' (SPE) Petroleum Resources

Management System (PRMS) guides that if deterministic methods are used to
measure reserve quantities, the SEC criteria (with some trivial differences in
wording) suffice. SPE further guides that if probabilistic methods are used,
proved reserves are those which are expected to be economically recovered with
at least 90% certainty. Although it would be preferable to model NPV using an
estimate of proved and probable (1P + 2P) reserves (i.e., those which are
expected to be economically recoverable under a most likely scenario), no US
regulatory body requires the disclosure of anything other than 1P reserves. Since
my estimate of economic value is also premised on 1P reserves, I also am likely
to understate the base case for economic value.
Industry analysts often use the terms standardized measure and PV-10 (i.e.,
present value, 10% discount rate) interchangeably. To avoid confusion, I refrain
from couching value in terms of PV-10 since its preparation is non-uniform and its
presentation non-standard.
The approach used in this series attempts to model out net asset values (NAV).
Especially in cases where investors lack full owners' rights (i.e., a call on residual
asset values), NAV-centric approaches may not be appropriate.
Exxon Mobil Overview
Exxon Mobil is the super-major. In 2014, the company's upstream segment produced
approximately 3,970 MBoe/d. Its downstream segment is capable of distilling about
5,248 MBbl/d of crude oil at a weighted average Nelson Complexity of 10.4. In 2014, its
refineries produced about 4,480 MBbl/d of refined products. Its chemical division, which
is reported separately, produced nearly 24 metric tons of ethylene, polyethylene,
polypropylene and paraxylene in 2014. In addition, the company markets its products
through 4,754 owned/leased and 15,463 distributor/reseller retail sites globally through
the Exxon, Esso and Mobil brands.
The Standardized Measure, Restated for Recent Prices
Table 1, below, contrasts Exxon Mobil's standardized measure of discounted cash flows
from oil and gas assets as presented in its 2014 10-K with an estimate of their value at
current commodity prices (i.e., $60/Bbl oil, $39/Boe NGL, and $18/Boe natural gas). I
take into account that Exxon Mobil typically realizes slightly lower than market prices on
oil but also receives significantly greater than market price for its natural gas. The drag
on realized oil prices can be attributed to the fact that the company also produces
significant quantities of bitumen and synthoil. Exxon Mobil receives an uplift on gas
prices due to the fact the international natural prices are typically much higher than they
are in the United States.

Table 1: Standardized Measure of Discounted Cash Flows from Oil and Gas
Assets, Exxon Mobil
(all values in millions, USD)

source(s): Exxon Mobil, 2014 10-k; Author's calculations

If energy prices hold constant, Exxon Mobil's the future value of expected revenues
from oil and gas producing properties are expected to decrease by about $500 billion
(33%) from 2014's estimates. However, the company could expect to save about $330
billion in combined operating expenses and income taxes. Despite these cost savings,
the expected net present value of discounted cash flows can be expected to decrease
by $95 billion (46%) from 2014 estimates.
Operating expense can be expected to decrease if low prices are here to stay. Lower
prices mean that: a) E&P companies will have to payout lower amounts to revenue/
royalty interests, and b) these companies will become more efficient and be able
negotiate better terms with service providers and vendors.
Furthermore, the Exxon Mobil's 2014 presentation of the standardized measure likely
overstates future income taxes. Actual income taxes are likely to be much lower due to
offsetting depreciation, amortization, and depletion expenses which can be charged
against net income.

Since Exxon Mobil uses the SE method to capitalize reserve quantities, I do not believe
management will be compelled to impair proved reserve quantities or significantly
reduce future development expenses. Although many projects will have negative NPVs
at a 10% discount rate and at $60/Bbl crude oil (i.e., Alberta oil sands), simplifying
assumptions indicate the great majority of Exxon Mobil's proven undeveloped reserve
quantities still yield positive undiscounted cash flows even at $60/Bbl oil.
Exxon Mobil's lack of an expected impairment of reserve quantities is something of an
anomaly in relation to other E&P companies.
Economic Book Value Analysis
The following EBV analysis contrasts the accounting and economic book values of
Exxon Mobil's common stock using inputs from the restated standardized measure as
well as a few other key adjustments.
Table 2: EBV Analysis, Exxon Mobil
(all amounts are in millions USD, except as otherwise noted)

source(s): Exxon Mobil, 2014 10-k; Author's calculations

The EBV analysis yields a $51 billion net impairment of Exxon Mobil's net property,
plant, and equipment. An upside revision of about $28 billion to downstream assets
offsets the $79 billion impairment to downstream assets (which notionally include those
held by the chemicals segment).
The upward adjustment of downstream assets reflects my belief that Exxon Mobil's
5,250 MBbl/d atmospheric crude distillation capacity (52,480 MBbl/d of equivalent
distillation capacity (EDC) at a weighted average Nelson Complexity of 10.4) at a longrun utilization rate of 85% warrants a significantly higher valuation than its 2014 book
value of $37.6 billion. Put into context with 2014's oil and gas production of 3968.5
MBoe/d, Exxon Mobil is every bit, if not more, a downstream enterprise as it is
The fact that downstream assets are major beneficiaries of falling crude oil and natural
gas prices did not influence my upward adjustment of Exxon Mobil's downstream asset

If energy prices do not recover, I estimate that the accounting basis of Exxon Mobil's net
assets will exceed their economic values (i.e., net value will not have been created).
Although this indicates that the company is dependent on external economic conditions
for long-term shareholder value creation, the fact that equity is expected to remain
significantly positive indicates that the company itself will be able to survive lower
energy prices for as long as its legacy reserve base keeps producing.
From an investment perspective, as of 1 September, the company's EBV is
approximately 60% lower than it current market price at current energy prices. In order
for the EBV and market value to balance each other out, energy prices need to return to
much higher levels (i.e., $100/Bbl WTI Crude and $5/Mcf Henry Hub Natural Gas).
As a company, Exxon Mobil displays all the trappings of a survivor: its management
team has a long term focus, it has diversified and integrated operations, displays
conservative accountancy, is historically a low cost producer, has a long-lived reserves,
has been able to consistently replace its reserves, possesses a technological edge over
most competitors in finding and developing oil and gas properties, possesses immense
economies of scale, and has access to cheap capital (2014 cost of debt was around
1%; 2014 all-in cost of capital was around 3.5%).
In addition, I believe that the company's sophisticated downstream and chemicals
divisions hide the real strength of sensible vertical integration in the oil and gas
business: survivability. Relatively stable cash flows from downstream operations buffer
the hyper-cyclical economics of upstream operations. Furthermore, downstream
operations are typically beneficiaries of lower commodity prices since the prices of
refined products and consumer goods tend to be "sticky". When energy prices tank, as
they have, increased profits from downstream activities are expected to offset lower
profits from upstream activities. Exxon's downstream, in effect, hedges a significant
amount of its upstream commodity risk in addition to providing its own sources of cash.
Rational vertical integration helps explains how Exxon Mobil has been able to thrive
through multiple commodities cycles without significant hedges in place.
All in all, Exxon Mobil, as a company, will be fine.
However, as an investment, Exxon Mobil's story may not be as rosy. Even though
Exxon Mobil's underlying asset base is still able to produce significant cash and has
immense value, the stock price is too high if current commodity prices prevail. If crude
oil prices do not snap back to $100/Bbl, it will take some time for Exxon Mobil's
underlying net assets values to catch up with the market.
Moreover, even under a best case scenario, the stock has little potential for asymmetric
Unfortunately, the intrinsic value of Exxon Mobil's stock is tied to commodity prices
which are beyond even its control. If I really believe that oil prices are going to recover,
why would I make an investment that just barely breaks even in the event? Why
wouldn't I just go out and buy crude oil or natural gas futures contracts?

However, Exxon Mobil's somewhat drab future at lower energy prices appears to
glimmer when compared to that of other integrated majors.
Winter is Coming
Initial results of stress-testing other companies' undeveloped reserves and sanctioned
development projects indicate that "winter is coming". A lot of expected future
production is not economic if current prices are to prevail. As a result, the values of
balance sheet and reserve quantity impairments disclosed in this winter's 10-K and 20-F
annual reports could be staggering.
Carbon Tracker Initiative's Oil & Gas Majors: Fact Sheets strongly corroborates my
position. The info paper utilizes Rystad's Energy UCube database (among the most
thorough of any upstream oil and gas project database) to analyze capital spending and
potential production in order to arrive at estimated "break-even" costs for associated
development projects. This break-even cost is the price of oil which is required for
economic rationalization (i.e., "sanction").
The paper concludes that 34% of oil majors' total planned capital expenditures require
oil prices of $95+/Bbl for economic sanction. The info paper was published in of August
2014, when oil prices were right around $95/Bbl. Even so, the paper claims that up to
22% of planned future spending on projects were candidates for deferral or outright
Forget for a moment that petroleum is a finite and depleting resource which society may
not be able to do without if 33% of anticipated future production would not work at
$95/Bbl, then how much does not work at $60/Bbl?
Clearly, the low oil price environment we are currently in is not sustainable.
However, prices could remain lower for longer. According to this nugget on EIA's
education portal:
"The volatility of oil prices is inherently tied to the low responsiveness or inelasticity of
supply and demand to price changes in the short term. Crude oil production capacity
and equipment that uses petroleum products as its main source of energy are relatively
fixed in the near term. It takes years to develop new supply sources or vary production,
and it is hard for consumers to switch to other fuels or to increase fuel efficiency in the
near term when prices rise. Under such conditions, a large price change can be
necessary to rebalance physical supply and demand."
In other words, prices will have to either a) remain low long enough drive excess
capacity out of the markets, or b) disincent production growth long enough to allow for
demand to catch up. Either scenario could take months or years because as long as
prices remain above lifting costs and associated non-income related taxes ($15-$30/Bbl
is typical, according to SA contributor Christopher Aublinger's research on production
costs), producers will keep on pumping. Moreover, lower prices may have actually
incented many producers to maintain and even increase production levels in order to
meet interest payments and stay in good financial standing with lenders.
Eventually, energy prices will recover. When producers are forced to reinvest to keep
production levels consistent with demand, the marginal producers will begin to feel the

sting of replacing (i.e., finding and developing (F&D)) depleted reserves. After one
factors in F&D and non-core costs (i.e., G&A, R&D, interest, cost of equity, etcetera),
the marginal barrel of oil required to sate current demand could easily exceed $75-90/
Even if a rational price which balances long-term supply and demand does exist, it is
possible that oil prices could over-correct to the upside if/when under-investment affects
production. If production contracts too rapidly, global prices could respond very violently
to the upside. Even though much higher prices would seem a boon to oil and gas
producers, extreme price fluctuations doom the boom and bust commodities cycle to
repeat itself.
All of this speculation about commodity prices should be, of course, tangential to a
sound investment thesis. However, closer inspection reveals that investing in almost
any oil and gas producer is tantamount to speculating in commodities.
Concluding Remarks
When oil prices began to tank nearly 10 months ago, in October 2014, I devoted much
of my free time to learning the industry in order to capitalize on the panic that was sure
to ensue. I had originally envisioned buying cheap, over-looked upstream oil and gas
assets and then watching my net worth skyrocket. However, sanity checks revealed that
the oil and gas sector was already being very closely monitored by legions of analysts
who were already eagerly gobbling up any low-hanging fruit. It was also quickly clear
that the stock prices of most upstream companies were still being discounted for much
higher energy prices.
Even though my machinations of cruising around town in a brand-new Cadillac, adorned
in crocodile leather boots and a Stetson hat ( la J.R. Ewing of TV show Dallas), have
been temporarily foiled by reality, I do still cling to the idea that opportunities for
investing in upstream assets may present themselves.
Perhaps, the "winter is coming" thesis will play out, allowing patient investors to dive in
and scoop up some sweet deals. When asset write-downs that I am projecting become
public knowledge, the ensuing sell-off could result in more easily spotted bargains. Until
that time, I believe that potential investors in upstream oil and gas companies should
either move on to greener pastures or continue to face scouring the wasteland in search
of elusive value.