Wrong Side Of Energy Transition and Other Headwinds Will Erode Revenues and Earnings

Key Takeaways

• Exxon is on the wrong side of secular market trends that favor sustainable energy investing.
• Revenues are reliant on fossil fuels and are vulnerable to industry headwinds and a potential recession.
• Poor relationships with various agencies will negatively impact its rebranding and diversification efforts.
• Lack of innovation, and questionable R&D efforts will likely create issues in the future.
• Multiple headwinds and risks will push revenues and earnings lower and valuation will follow suit.

Catalysts

Company Catalysts

Reliance on Fossil Fuels could spell disaster as we undergo an energy transition

The traditional oil and gas business model is under pressure. As McKinsey reports, the energy sector should be leading the renewable energy transition. However, Exxon's revenue breakdown shows that almost 80% of its revenues come from downstream operations – sales of fuels and other petroleum products.

Reuters reports that Exxon aims to diversify by getting into the lithium business and discussing partnerships with Tesla, Ford, and Volkswagen. However, there are significant differences between lithium and oil. 

While electric vehicles are growing in demand, their batteries are made of lithium (a one off expense), they don't burn it for fuel - meaning the “recurring revenue” from the consumable commodity is much less. Barron's estimates that an EV might have $1,000 worth of lithium while a conventional car burns as much as $20,000 of gasoline over its life. Clearly a much bigger revenue opportunity for an oil producer than a lithium producer.

If Exxon was to diversify into lithium, it likely wouldn’t contribute that much to overall revenues to make a notable difference. 

Ongoing Clash With Regulators and Activists hurts reputation

Exxon has continuously clashed with regulatory agencies and activists regarding climate change issues and other environmental concerns. In fact, Greenpeace published a comprehensive 65-year timeline of their knowledge about carbon dioxide's impact on the environment.

Most recently, Exxon's shareholders soundly rejected activist demands to take responsibility for curbing emissions, placing their net zero commitment goal by 2050 at risk. A pushback against environmental, social, and corporate governance issues (ESG) increases divestment risks as more investors join that trend.

Furthermore, Exxon's contractors in Guyana are being investigated for criminal activities such as drug trafficking, gold smuggling, and money laundering. Exxon hired those businessmen to develop a shore base for offshore oil operations despite repeated warnings from U.S. government officials. 

In this case, any sanctions would hurt Exxon's plans to expand Guyana operations to 1.2M barrels per day by 2027, which were already under pressure due to the court's requirement to provide unlimited insurance coverage for potential oil spills.

Lack of Competitiveness to Attract the Best Traders

Large commodity producers typically run trading desks to hedge production risks and engage in speculative trading. Exxon avoided speculative bets until announcing a global trading division in February.

According to Bloomberg, Exxon doesn't pay its traders large cash bonuses linked to trading profits like it is common for the industry. In fact, their traders are compensated more like engineers, with stock awards for best performers and typical benefits such as pensions.

While commodity speculation offers immense returns, if Exxon cannot attract top-level talent, it will struggle to take advantage of those opportunities. In a zero-sum game, their under-compensated employees will compete directly against the best commodity traders on the market.

Industry Catalysts

Renewable Energy Transition - Oil Industry is Losing its Appeal

A global shift to renewable energy sources is accelerating. Governments, businesses, and individuals increasingly recognize the need to reduce carbon emissions and combat climate change. This has led to a significant increase in investment and support for renewable energy technologies such as solar, wind, and hydropower. A recent CATL breakthrough in battery technology, which broke the 500 Wh/kg battery barrier, best shows rapid advances in that sector.

As the renewable energy sector grows and becomes more cost-competitive, it could gradually replace traditional fossil fuels like oil for various purposes, including electricity generation and transportation. While this will take years and years to play out, this transition would reduce the demand for oil and negatively impact the profitability of the oil sector.

Environmental Concerns and Regulations Make Continued Operation Harder and More Costly

Oil extraction significantly impacts the environment. Significant pollution and ecosystem degradation concerns have recently led to stricter regulations and policies. With governments worldwide imposing such requirements, this cost becomes an additional burden on oil companies – limiting their profitability and further restricting their operations.

The Securities and Exchange Commission (SEC) recently proposed a rule requiring US publicly traded companies to disclose their climate-related risk measures. SEC would standardize climate-related disclosures for investors, who would more clearly see the impact of their investments.

Recession Factor Still Looming Over The Market Could Hurt Consumer Demand

Despite the stock market rallying, inflation somewhat retracing, and unemployment being at historic lows, recession fears have not dissipated. Deutsche Bank believes a boom-bust cycle is nearing its end and that avoiding a hard landing would be historically unprecedented.

Economists at Fannie Mae share a similar sentiment, arguing that the current pace of consumer spending remains unsustainable given current income levels.

Recessions are problematic for the oil sector as their prosperity depends on the demand for oil, which declines alongside consumer demand. The Great Recession is one of the best examples when the price of a barrel fell from $133.88 to $39.09 in less than a year.

Questionable Returns of Research & Development

The Oil and gas sector has often been criticized for falling behind on innovation goals. As innovation into renewable industries accelerates, the oil industry might experience a further lack of research, considering that the return on those investments takes a long time.

Researcher Yana Matkovskaya explored this issue in a paper titled “Problems of Innovative Development of Oil Companies,” confirming the hypothesis that the ongoing inadequate R&D investment trajectory for oil companies will create issues in the near future.

Further research by the International Monetary Fund shows that the looming oil price super-cycle might likely be the last, indicating that production is fading and that global demand peaked in 2019.

Assumptions

• I believe that the oil industry will slowly decline while Exxon fails to reposition itself as a carbon-neutral, sustainable company. While the world might never run out of oil, society's appetite to use it is unquestionably shifting. Advancements in the renewable energy industry will catch up and eventually pass the oil industry, whose capex has already declined.
• I expect Exxon's trading division won't be successful enough to generate meaningful revenue due to a lack of competitive compensation and an inability to attract and/or retain the best performers.
• I expect that Exxon's clash with regulators and activists will continue to create issues, negatively contributing to intangible values like goodwill and brand value. Exxon often faced backlash due to questionable business practices, as evident from the latest examples in Guyana and Nigeria.
• I believe Exxon's latest $4.9b acquisition of Denbury is more of a greenwashing stunt than a serious turnaround for carbon control. Until now, Exxon's only U.S.-based carbon capture project was a natural gas facility in Wyoming. Acquisition of Denbury gives access to 1,300 miles of carbon dioxide pipelines and 2 billion metric tons of underground storage capacity. However, it also gives Denbury's Gulf Coast and Rocky Mountain oil and gas operations with over 200 million barrels of reserves. So far, activists like ClientEarth warn that ExxonMobil has not set a company-wide net-zero emissions target consistent with the Paris Agreement temperature goals.

Risks

• Exxon has a sizeable cash reserve (approx. $33b) and a considerable stock buyback plan. Altogether, I expect them to reduce the number of outstanding shares by 10% by 2028, resulting in 3.7b shares listed then.  While unlikely, it is not impossible that the management might decide to boost these numbers and more aggressively support the stock price.
• Furthermore, the company could successfully diversify into areas like waste management & recycling. One such project could be lithium processing facilities in Arkansas that could process as much as 15% of globally produced lithium in 2022.
• Finally, the last few years saw an increase in global geopolitical instability. If these conflicts escalate, it could hurt the global supply chains and drive energy prices upwards.