Humbled Exxon Seeks Redemption

Exxon Mobil once put the “super” in supermajor. Its unmatched returns, scale and integration made it the most prominent remaining sister of the famed Seven, sometimes graced with the reputation of being a quasi-state. Now, the company is struggling for relevance with investors and wider society, and sits at one of the most challenging inflection points in its 136-year history. What went wrong? Can Exxon bounce back? Much ink has been spilled about the brutal year since the upending of global oil markets by the pandemic left Exxon facing a combination of financial crisis and investor dissent. But the problems go much deeper and are almost two decades in the making. Put simply, Exxon centered its strategy on scale and growth -- an approach built on its deep cultural belief in long-term oil and gas demand. Unable or unwilling to see possible downsides to its assumptions, the company’s asset base and investment program increasingly required high oil prices to succeed. Those prices failed to materialize.

Exxon’s high-spend, high-growth approach was already struggling in recent years at $60-$70 oil prices. When Covid-19 caused oil markets to crash, Exxon’s strategy crashed, too. The result was a humbling year. Exxon was removed from the Dow Jones index after a 92-year run (OD Aug.25'20). US rival Chevron, which produces 25% less oil and gas and holds less than half of Exxon’s refining capacity, briefly had a higher market value. So, too, did NextEra, a much lower-profile US utility that was buoyed by its focus on solar and wind power.

Exxon’s very real financial struggles were made worse because they coincided with a fundamental shift in investor sentiment, as climate-change concerns accelerated. Investors were already becoming disillusioned with Exxon’s eroding returns and cash flow performance and inability to sustainably fund its counter-cyclical growth strategy. As climate moved up the agenda in the pandemic, Exxon’s confident, unwavering approach to oil and gas demand growth was left looking outdated and out of touch. On earnings calls, analysts became more critical or simply stayed away. Activist investors entered the mix.

Exxon responded with cost-cutting so deep that it extended to chopping corporate contributions to employees’ retirement accounts. Layoffs, once anathema, swept across the organization.

It also responded with a dramatic rethink of strategy. Exxon abandoned production growth and shifted its tone on climate change. The company is now working to rebuild its strategy -- and itself.

Much is at stake, for Exxon’s experience, to a large extent, mirrors that of the wider US oil industry. To thrive in the post-Covid-19 environment, oil companies can no longer rely on relentless growth. They must also get serious about carbon emissions, whether by diversifying or by decarbonizing production at scale. The future of the US industry hinges on the latter. And here, Exxon has suddenly -- and somewhat surprisingly -- emerged as the standard-bearer, with grand ambitions to develop large-scale carbon capture.

Love of Scale

Understanding the history is critical both to understanding the company’s current woes and to gauging what comes next. The creation of Exxon Mobil from two US majors in 1998 sets the stage. This was not a marriage of equals. “Let’s get this straight: I work for Lee, and I’m very happy to do that,” Lucio Noto, Mobil’s former chief, told reporters a year later, deferring to Exxon boss Lee Raymond.

Despite the apparent lack of bad blood, Noto was out by early 2001, top managers and executives were heavily weighted toward Exxon, and Mobil’s assets became absorbed into Exxon’s well-disciplined efficiency machine. Those assets proved invaluable in supporting Exxon’s leading returns in the 2000s. As Energy Intelligence analysis in the mid-1990s showed, some of the industry’s top returns were found in early LNG projects (particularly in Qatar), in Nigeria and from the Groningen gas field in the Netherlands (EIF Jun.10'95). Mobil gave Exxon the first two, while Exxon already shared Groningen with Royal Dutch Shell.

These assets all had one thing in common: They could move the needle even for a larger Exxon and reinforced management’s mindset that top returns came from beating others at scale. It was through this lens that Exxon surveyed the global energy landscape. Early this century, rising economies such as China and India were expected to drive insatiable demand growth, yet oil supply -- particularly cheap production -- was becoming harder to find. Exxon decided it would outcompete by bringing its scale and technological advantage to some of the industry’s largest, most complex resources.

Exxon delivered. It pushed new boundaries on Arctic developments. It pioneered new technologies in the Canadian oil sands and scooped up vast holdings. It advanced high-pressure, high-temperature resources offshore. It held onto assets such as the massive but high-CO2 Natuna gas field in Indonesia. It entered Iraq’s oil sector.

Exxon wasn’t the only major in many of these ventures. But it stood above its peers in the breadth of its participation and size of the resources. Yet the strategy also had drawbacks: The new resources carried a much higher break-even cost than Exxon’s legacy assets, despite their scale. And that’s where the trouble began.

Bullish View

Exxon has never been an overt oil price bull. In fact, management has long avoided sharing views on prices, opting instead to say its focus remains on the parts of the business it can control. But at some point, robust long-term pricing became embedded in Exxon’s thinking. Such views sprang from an unwavering belief that oil and gas demand growth would remain strong for the foreseeable future -- even as countries began to more seriously question their reliance on fossil fuels amid climate change concerns.

Unable to see a clear path to an alternative energy source that could match oil and gas in terms of geographic reach and energy density, Exxon felt that being bullish on oil and gas, in terms of both volume and price, was a safe bet.

To be sure, Exxon was hardly alone. Former Chevron CEO John Watson famously said in 2014 that $100 oil was the new $20, based on his view of the marginal cost of supply required to meet robust future demand. Many in the sector used oil prices of $70-$80 or higher to screen projects. The run of $100 oil in the early 2010s bolstered their view.

But realities shifted: US shale ushered in a wave of low-cost supply, profitable megaprojects proved hard to come by, and the Paris climate agreement added new urgency to the energy transition. Others charted a new path that moderated spending and invested more selectively. Exxon maintained an almost dogmatic confidence in its long-term outlook and pushed ahead. However, the same disciplined culture that allowed Exxon to shrug off critics and outmaneuver its peers for years now worked against it -- by encouraging the company to repeatedly act as if very real changes were not happening around it.

Elephant in the Room

Exxon’s $36 billion acquisition of XTO Energy is often cited as the cause of its current woes (OD Dec.15'09). Instead, it was more a symptom of this systemic problem. Hydraulic fracturing and horizontal drilling changed the game for US gas in the mid-to-late 2000s, moving the country from dwindling supply and growing imports to soaring production and self-sufficiency. Exxon watched the shale gas revolution and decided to play it in Exxon fashion -- buying in at the biggest scale on offer.

Few at the time of that December 2009 deal foresaw US shale’s ability to disrupt global oil markets. The shale revolution had already fundamentally disrupted a captive domestic gas market. Exxon stepped in without seeming concern that the disruption might become broader. Analysts noted that the deal assumed a long-term gas price of $6-$7.50/MMBtu (NGW Dec.28'09). Benchmark Henry Hub gas prices have instead averaged around $3.20/MMBtu since the acquisition was agreed and struggled to break $3/MMBtu in recent years.

XTO had a reputation as an effective shale operator, but also for paying any price to amass acres in core plays. Much of the dry gas Exxon acquired was out of the money almost from the start. Exxon’s returns on US upstream capital employed -- which comprise a much larger place in its global business post-XTO -- continue to reflect this weakness, despite Exxon’s pivot toward profitable Permian oil in recent years.

Gas' Structural Shift Post-XTO Gas Hit Returns Despite Exxon's Oil Pivot

US gas markets went on to witness further disruption over the years, as the abundance of cheap gas continued. Yet it took last year’s forced reset of medium-term capital spending for Exxon to finally take impairments on most of its XTO assets.

Shrinking Cash Flow

On balance, Exxon’s underlying portfolio has deteriorated in returns and cash-flow generation quality over the past 15-plus years as result of both its own decisions and events outside its control. Qatari LNG remains a crown jewel, but its Qatargas-1 joint venture will expire this year. Groningen output has been severely diminished since 2013 due to earthquakes linked to gas extraction and will be fully off line by mid-2022. Higher-cost start-ups -- and US dry gas -- came to fill much of the producing portfolio.

By 2019, the year before the pandemic upended markets, Exxon’s cash flows were 38% lower than in 2005. By contrast, most peers saw cash flows from operations improve -- in some cases, materially (see chart).

Exxon's Lagging Cash Flows, Indexed to 2005

Dividend Squeeze

That deterioration was obviously concerning. When paired with a doubling in dividend obligations over the same period, it proved perilous. Annual dividend growth has been a point of pride for Exxon since the early 1980s, and the company expected its big post-Mobil resource bets to provide the cash to keep that going. When its portfolio began to underperform, Exxon doubled down.

As the other majors moved away from setting lofty -- and unmet -- goals to grow oil and gas volumes profitably, Exxon said in 2018 that it would add more than 1 million barrels of oil equivalent per day of output by 2025. The move puzzled observers, but Exxon argued that it reflected a position of strength. Even as the industry reined in investment, Exxon was sure demand growth would come through, so investing counter-cyclically would allow it to ride that wave of new demand -- and presumably higher prices. Earnings, cash flows and returns would rise in kind.

This strategy reflected Exxon’s supply-demand outlook, which as recently as last year pegged demand far above Paris Agreement-compliant levels. It also encouraged Exxon to keep scale and size as its edge, instead of joining others in becoming more selective in investment.

The problem was, this approach stretched the company’s balance sheet even at Brent crude prices of $60-$70 per barrel, never mind the below-$40 level witnessed in 2020. Exxon’s capital program already left it with a $10.8 billion free cash flow deficit in 2019, and would have created a near-$30 billion gap last year had it not ratcheted down spending. Even with cuts, Exxon’s outlay on dividends and capex exceeded cash flow from operations by $19 billion. The company’s debt ballooned, and it could no longer credibly argue it had a sustainable plan in place.

Exxon's Tumbling Free Cash Flow

What Next?

The crisis has forced Exxon to make some major reversals in recent months. Production and dividend growth were suspended. Exxon’s capital spending this year is at a post-merger low -- and will stay that way no matter how high oil prices might go. Reductions in medium-term spending forced billions of dollars in impairments. Now, everything comes down to preserving the current dividend.

In a bid to recover its standing, Exxon put forward a very different strategy update last month, striking a decidedly different tone. Paris climate-linked outlooks now frame the conversation, rather than Exxon’s internal views of oil and gas demand. The company still believes in technology advancement and leading scale, but will now focus that on carbon capture and storage -- Exxon’s preferred answer to demands for decarbonization. A portfolio reset will come from asset sales and selective investments as production holds flat. Any excess cash this year will pay down debt.

Questions linger, however, as to whether Exxon has fully shed its long-standing assumptions, or is fully equipped to navigate the existential challenges facing the industry.

Paris-linked outlooks feature in its latest strategy materials, but its bullish 2019 framework is still on its website. Last year’s impairments reflected a change in spending plans rather than any shift in Exxon’s long-term oil and gas price assumptions. Its peers all revised their assumptions down and took write-downs accordingly. Even Exxon’s approach to CCS -- which includes floating a massive cross-industry US CCS hub equivalent to 2½ times the world’s current capacity -- reflects the traditional thinking that seeks answers in unmatched scale and technology (OD Apr.19'21).

What is clear is that financial realities -- not to mention emboldened investors -- are likely to prevent Exxon deviating from its new corporate conservatism any time soon. Exxon will probably emerge a smaller company on the other side, with billions of dollars in assets divested and its portfolio hinging on its successes in just three regions: Guyana, the US Permian Basin and Brazil.

Exxon’s immediate survival isn’t on the line. But its industry status has diminished in a way it has never experienced before. And more pressure could still come. Some activist investors are looking to force greater change (OD Apr.26'21). Investors still comfortable with oil stocks could prefer the sustainable, rising dividends of rival Chevron or even Canada’s cash-cow oil sands producers. Exxon’s grand ambitions for CCS leadership remain at an early stage and could struggle to blossom given more immediate pressures or a lack of policy support (OD Apr.19'21).

The days of Exxon’s “trust us!” relationship with investors have passed. Shareholders are now leading the conversation, and their message is “show us!” Exxon’s recent share price recovery and favorable responses from the likes of activist D.E. Shaw suggest some investor willingness to stick around and let Exxon make its case. Persuading them to stay long-term may be the tougher challenge.

Casey Merriman is editorial director, Western Hemisphere, and head of Competitive Intelligence Service for Energy Intelligence.