Updated on March 16th, 2021 by Bob Ciura
Long histories of dividend growth are not typical in the energy sector. The oil and gas industry is highly cyclical, which often prevents companies from raising their dividends every year without interruption. When oil and gas prices are high, energy companies enjoy a windfall that flows through to investors. But when commodity prices decline, profits evaporate, and in some cases, dividends as well.
As a result, there are just two oil and gas stocks on the list of Dividend Aristocrats. One of them, Exxon Mobil (XOM), is the largest oil company in the U.S.
You can download the full list of all 65 Dividend Aristocrats, with important metrics like dividend yield and price-to-earnings ratios, by clicking on the link below:
Oil and gas can be a “boom-and-bust” industry. Profits are highly dependent upon commodity prices, which can fluctuate wildly in any given year depending upon supply and demand forces.
But Exxon Mobil is different. It traces its roots to Standard Oil, which was founded by John D. Rockefeller all the way back in 1870.
In its early days, Standard Oil dominated the U.S. oil and gas industry. It did this with a laser-like focus on drilling innovation, production growth, and limiting costs to beat its competitors. Standard Oil was almost too successful—it grew at such a rapid pace that in 1911, it was dissolved by the U.S. Supreme Court on antitrust grounds. Standard Oil was broken up into 33 smaller companies, many of which became giants on their own, such as Chevron (CVX).
The company operates three large business segments. The Upstream segment includes oil and gas exploration and production. Downstream activities include refining and marketing. Manufactured chemicals include olefins, aromatics, polyethylene, and polypropylene plastics.
2020 was a difficult year for Exxon Mobil and the entire energy sector, due to the coronavirus pandemic which negatively impacted the global economy and oil prices. In early February, Exxon reported (2/2/21) financial results for the fourth quarter of fiscal 2020. but total production remained flat sequentially due to OPEC quotas. On the bright side, margins in chemicals improved and thus this segment posted its best results in 2 years.
As a result, Exxon switched from an adjusted loss per share of -$0.18 in the third quarter to an adjusted profit per share of $0.03 for the fourth quarter. Investing in higher-quality projects will allow Exxon Mobil to grow profits, even in an environment of stagnant oil and gas prices.
The climate for oil and gas majors remains challenged because oil prices are still down by nearly half from the peak levels of 2014. As a result, oil producers cannot rely on rising prices for revenue and earnings growth. Instead, rising production will be key. Thanks to its promising growth projects, Exxon expects to grow its production from about 4.0 to 5.0 million barrels per day by 2025.
The Permian will be a major growth driver, as the oil giant has about 10 billion barrels of oil equivalent in the area and expects to reach production of more than 700,000 barrels per day in the area by 2025. In the 2020 fourth quarter, production in the Permian grew 42% over the prior year’s quarter.
Source: Investor Presentation
Guyana, one of the most exciting growth projects in the energy sector, will be the other major growth driver of Exxon. The company has nearly tripled its estimated reserves in Guyana, from 3.2 billion barrels in early 2018 to nearly 9.0 billion barrels now.
Management has stated that 90% of new reserves have a production cost of $35 per barrel and thus it views the dividend as viable at Brent prices above $45. However, we believe that the dividend will come under pressure if the pandemic extends beyond this year. Overall, we expect Exxon to grow its earnings-per-share by 8.0% per year on average over the next five years off its mid-cycle level.
Competitive Advantages & Recession Performance
Exxon Mobil enjoys several competitive advantages, primarily its tremendous scale, which provides the ability to cut costs when times are tough.
It also has the financial strength to invest heavily in new growth opportunities. The company has allocated tens of billions of dollars in the past few years to capital expenditures to support future growth.
Another competitive advantage is Exxon Mobil’s industry-leading balance sheet. It has a credit rating of AA+, which helps it keep a low cost of capital.
Exxon Mobil’s integrated business model allows the company to remain profitable, even during recessions and periods of low commodity prices. The company saw volatility during the Great Recession, but still remained profitable:
- 2007 earnings-per-share of $7.26
- 2008 earnings-per-share of $8.66 (19% increase)
- 2009 earnings-per-share of $3.98 (54% decline)
- 2010 earnings-per-share of $6.22 (56% increase)
Continuing to generate steady profits allowed Exxon Mobil to keep raising its dividend each year. Exxon’s streak of dividend increases could be in jeopardy, if oil and gas prices decline further. For its part, the company remains committed to the dividend as a top priority within its capital allocation program.
Valuation & Expected Returns
Exxon’s industry is highly cyclical. Results are driven by commodity prices and hence they are highly volatile. We believe that the energy market is now near the bottom of its cycle and expect it to recover this year. In order to calculate future returns, we have used mid-cycle (5-year average) earnings-per-share of $3.26 as a base.
Using earnings-per-share of $3.26 for 2021, this implies a price-to-earnings multiple of 18.1. That compares extremely unfavorably to our fair value estimate of 13 times earnings. A declining multiple could reduce annual returns by -6.4% over the next five years.
As shown above, even modest increases in the prices of natural gas and oil could see Exxon Mobil produce sizable earnings growth. Indeed, we expect the company to produce 8% annual EPS growth. Of course, much of this depends on the direction of oil and gas prices, which are difficult to predict.
Dividends will add to shareholder returns. Exxon Mobil has increased its dividend for over 30 consecutive years, and is a high dividend stock with a 5.9% yield.
Expected earnings-per-share growth of 8% and the 5.9% dividend yield result in total expected returns of 7.5% per year through 2026. This is a satisfactory rate of return for a hold recommendation due to the high dividend yield, but not a buy at this time.
Exxon Mobil has had a difficult past few years demonstrating that it is susceptible to falling oil and gas prices. However, it has performed better than many other energy stocks in this time frame by maintaining its dividend and balance sheet.
Weak commodity prices continue to be a challenge, but Exxon Mobil has many promising new projects nearing completion, and it still generates enough cash to sustain the dividend. As a result, Exxon Mobil stock appears to be a strong holding for income investors based on its high dividend yield and growth potential through its recovery.
Further Reading: The Chowder Rule | How To Calculate The Chowder Number.