Every few years, the potential of an Exxon Mobil (XOM)-Chevron (CVX) merger rears its head. Just a few weeks ago, this idea was discussed in Barron’s, and of course then made its way through the financial press. While somewhat ludicrous on its face, it is a question that even astute investors have considered at times. Recent trends in valuations have made it all the more alluring to some, as the two giants have seen their market caps converge. So-called stock for stock “merger of equals” have been the soup du jour of senior executives looking to scale up in an oil and gas market that, even with factoring in the recent recovery trade, remains in bedlam. With both valued similarly now, why not combine?
One Man’s Opinion: No Deal
Unfortunately, reasons are numerous that creating such a massive business will not past muster. At the top of my mind, besides the culture differences, there are the significant regulatory hang-ups. Number one is the Gorgon Project in Australia, a $50B+ play that turned Barrow Island – once most known for its native wildlife – into a LNG powerhouse fed by the Jansz-Io and Gorgon offshore gas fields. It is the one of the world’s largest natural gas assets and a cornerstone of the Australian oil and gas economy; Chevron owns 47.3% of Gorgon while Exxon Mobil owns 25%. Regulators would never allow majority control by a combined entity, and both parties count Gorgon as an important part of their future plans. The list of potential buyers for a partial stake is small and, quite frankly, those buyers are not lining up to spend tens of billions of dollars. Similar headaches would be found in the retail business. Regulators would frown upon one singular entity controlling (or leasing the sales rights to) nearly 20,000 retail gas stations. For perspective, the FTC required Alimentation Couche-Tard (OTCPK:ANCUF) to divest north of one thousand stores when it acquired Speedway from Marathon Petroleum (MPC); the firms would see similar involvement here to avoid geographic overlap. Any combination of the two would require, in total, tens of billions of dollars in asset sales to ease concerns of regulators around the world.
Aggravatingly – and echoing constant discussion on Seeking Alpha – the dividend is an issue as well. Today, Chevron pays less of a dividend than Exxon Mobil. If combined, would the new pro forma entity cut the payout to Chevron levels (aggravating the retail ownership base of Exxon Mobil, also a key voting bloc on the deal) or bump the dividend for Chevron investors, arguably erasing part of the reason many investors have gravitated to that oil major in the first place (better capital discipline)? It’s a tough ask. In my view, both are better off independent.
The Better Buy: Chevron Or Exxon Mobil
If a merger is off the table, which is the better buy? Today, both Chevron and Exxon Mobil trade at roughly 6.5x 2022 debt-adjusted cash flow (“DACF”), the first normalized year which should see largely recovered fossil fuel demand across most products. The question is what asset base is better, and whose management team is more strongly aligned with investors. Chevron has (in my opinion) done a much better job at managing itself on a variety of assets. Exxon Mobil has committed more heavily to longer term, more conventional plays (e.g., Guyana) that are characterized by the inflexibility of high fixed costs; they cannot be ramped up or down. Onshore North American shale, for all its problems, is more easily oscillated in response to current pricing. Further, the leverage on the Exxon balance sheet – tens of billions of dollars of more nominal net debt by 2023 – and lower dividend obligation gives more control to management. Chevron, without a doubt, has the better setup for navigating energy markets which have become increasingly more cyclical in recent years. In my view, investors need to look past the (incrementally) better credit rating at Exxon Mobil to realize this reality.
There is a caveat. Exxon Mobil and its downstream businesses (refining, chemicals) have been historically extremely underappreciated by most investors. While the focus from many continues to be oil and gas prices, that is the wrong approach for highly integrated majors like Exxon. Refining crack spreads and chemicals margins are far more important to driving improvement in free cash flow versus small changes in oil prices. By comparison, Chevron does not have this structure, and has traditionally generated most of its earnings from its upstream segment.
While still well above the five-year average of 125mm barrels, as shown above, distillates have seen massive draws since the stubbornly high levels seen between July and September. Lower refinery utilization rates is a driver of that, but so too is the nearly 3mm barrels of refining capacity that has been idled permanently globally, especially in the United States which has been far more quick to respond (Marathon Petroleum, Shell (RDS.A) (NYSE:RDS.B), PBF Energy (PBF) are just a few that have shuttered operations). Distillate cracks have improved alongside that, as have jet fuel cracks which have basically tripled since the beginning of October. While improvement has always been expected, the vaccine news plus the rapid adjustments in supply have really driven a turnaround in refining markets, shifting forward a recovery in the downstream markets by several quarters. As an integrated player, Exxon Mobil stands to benefit heavily from this. While true mid-cycle refining margins is still a long way away, improving downstream margins (alongside capital spend budget cuts) is the biggest driver of the improvement seen in Exxon Mobil’s prospective cash flows from 2020 to 2021.
Both have their allure, but I still lean towards Chevron – as I have for several years now. Oil companies, whether they are a small shop operation in a tertiary basin or a supermajor, have continued to be rewarded for balanced capital allocation policies. Smaller investors like you or me have the advantage of being able to nimbly move in and out of firms as they come into favor. It is a massive one and something that large funds, for all their advantages, just cannot do. Being contrarian works, but it has to be done at the right time. While the proverbial “skate to where the puck is going, not where it has been” is relevant in investing, there is no reason to get there so early.
So long as the market continues to view fossil fuel demand as likely to enter a constant state of decline with pricing only held up by OPEC+ constraints, ambitious projects that significantly add to production and are years away from production are going to get severely discounted. Flexibility is the name of the game, and while Exxon Mobil has made it a habit of counter-cycle investing, it will take time for investor feelings to change.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.