Energy: Stayin’ Alive.
t might be hard to take the pop music created during the 1970s seriously, but it sure was fun and memorable. Who could forget Debby Boone, the Bee Gees, or Donna Summer? Five of Billboard’s top 11 songs in the decade were sung by the Bee Gees or the group’s most famous brother, Andy Gibb. No artist has the same dominance so far in the current decade, but there’s still a little time.
The 1970s are back for the US oil industry. In December, US oil production hit record levels that exceeded anything the industry has enjoyed even during the heydays of the 1970s (Fig. 1). Production continued to rise into the new year, with weekly production hitting 10.251 million barrels a day (mbd) last week (Fig. 2).
The renaissance in US production owes everything to fracking technology that has turned the industry’s world order on its head. The US petroleum trade deficit was 2.5 mbd at year-end 2017, down from the peak deficit of 12.5 mbd in 2007 (Fig. 3). The market seemed to be absorbing the additional supply with little concern, until this week. The price of Brent crude oil hit a recent high of $70.53 on January 24 and fell back slightly to $66.86 as of Tuesday’s close (Fig. 4). The recent price represents a sharp recovery from Brent’s low of $27.88 during January 2016, but it remains far below the $100 price fetched early in the decade.
The major jump in the price of oil over the past year will help the Energy sector’s Q4 earnings. The S&P 500 Energy sector is expected to have 140.3% y/y earnings growth in Q4 and 51.0% consensus expected forward earnings growth, making it the fastest-growing sector in the S&P 500. Here’s how the other sectors’ forward earnings stack up through the week of February 1: Energy (51.0%), Financials (24.8), Materials (19.0), S&P 500 (16.1), Industrials (15.4), Consumer Discretionary (14.5), Tech (13.3), Health Care (12.1), Telecom (11.8), Consumer Staples (10.1), Utilities (5.2), and Real Estate (-10.2) (Table 1).
Not surprisingly, some of the industries with the fastest consensus expected forward earnings growth reside in the S&P 500 Energy sector: Oil & Gas Exploration & Production’s is at 208.3%, while Oil & Gas Equipment & Services’ is at 60.4% and the Oil & Gas Refining & Marketing industry’s is at 41.8%. Exxon Mobil and Valero Energy reported Q4 earnings last week. I asked Jackie to take a look at what they had to say about future growth prospects and the impact of the Tax Cuts and Jobs Act (TCJA):
(1) Exxon: Betting on the USA. Exxon Mobil’s (XOM) earnings didn’t hit expectations, but the company is going to spend lots of money in an effort to ensure that such a miss doesn’t happen again. Exxon reported Q4 operating earnings of 88 cents a share, below the $1.04 analysts expected, as production fell 3% and the amount of volume processed at the company’s refineries dropped 4%.
Exxon anticipates spending $50 billion in the US over the next five years—about two-thirds on oil & gas exploration & development, “a lot” of which will be spent on hydraulic fracturing wells—though that’s not set in stone, explained Vice President of Investor Relations Jeff Woodbury on the company’s Q4 earnings conference call: “The $50 billion that we’ve talked about is a projection. We haven’t made a decision to move forward with those investments at this point, but certainly the US tax reform is going to strengthen and build that investment confidence.”
The company has current production of roughly 200,000 oil equivalent barrels per day in the Bakken and Permian regions, but that’s expected to surge to 700,000-800,000 by 2025. By year-end, Exxon plans to increase the number of rigs in the region from 26 to 36. The company also aims to boost productivity by drilling horizontally for longer distances. The longer wells may allow the company to increase its expected recovery from the wells by 15%-20%, Woodbury explained.
Exxon has been knitting together acreage in the US since 2009, when it agreed to buy XTO Energy for $41 billion. Last year, the company spent another $6.6 billion to buy 250,000 acres in the Permian from the Bass family. And in September, Exxon announced it had acquired 22,000 Permian acres since May but didn’t disclose the price, according to a 9/27 article in Oil and Gas Investor.
Exxon’s 2017 tax rate was 35% excluding the impacts of tax reform and asset impairments. This year, the company estimates its effective tax rate will be between 25% and 35%. The new tax plan meant Exxon enjoyed a non-cash earnings gain in Q4 of $5.9 billion related to the company’s large deferred income tax liability. Because of the tax plan, those liabilities were revalued at the lower tax rate, which resulted in the gain. Despite its massive operations abroad, Exxon won’t be paying a repatriation tax because it has been paying taxes on its non-US earnings at rates above 35% on average.
Exxon is a member of the S&P 500 Integrated Oil and Gas stock price index, which has fallen 1.8% y/y (Fig. 5). The industry’s consensus expected forward revenue growth is 13.4%, and expected forward earnings growth is 31.6% (Fig. 6). The industry’s forward P/E appears elevated at 19.6, but it reflects far lower earnings than earlier this decade when oil prices were elevated (Fig. 7).
(2) Valero: Refined results. As a refiner, Valero’s (VLO) fate is determined by the volume of oil it processes and the spread between the price of crude oil and the price of the product once refined. In Q4, Valero reported operating profit of $509 million, or $1.16 a share, which beat analysts’ estimates by eight cents a share. The adjusted results exclude a $1.9 billion income tax benefit from the TCJA. Valero expects the TCJA to lower its tax rate from 30% in Q4, excluding the income tax benefit, to 22% this year, boosting both earnings and cash flow.
“[W]e pro-forma’ed our 2017 results, and we had $3.2 billion of pretax income. We wanted to determine the change in our tax provision as well as the cash taxes, so we assumed that all available capital in 2017 was available for full expensing,” explained CEO Joe Gorder on the company’s Q4 conference call. “So, in regard to our income statement, the tax provision would be lower by approximately $230 million, or $0.50 per share. On the cash side, … our US cash taxes would decrease by approximately $400 million based on those assumptions. And then when you include the repatriation tax to transition to the Territorial system, the savings would be $350 million.”
In January, Valero’s board approved a 14% increase in its quarterly dividend to 80 cents a share. It also upped the $1.2 billion available on the company’s share buyback plan by an additional $2.5 billion.
“To the extent that we continue to throw off significant amounts of free cash flow, we’re going to have the opportunity to continue to buy back our shares and create higher lows and higher highs in the stock price,” said Gorder. “So, if you ask me personally if I think we’re overvalued today, I would say the answer is no. And do I think there is upside in the stock price? I’d say yes. And as a result, I think that you should expect that we’re going to continue to balance out our payout with repurchases.”
The company plans a moderate bump in capital spending. Last year, it spent $2.4 billion on capital expenditures, divided between $1.3 billion spent on sustaining the business and $1.1 billion on boosting the company’s growth. This year, it will increase that amount to $2.7 billion, with $1.7 billion to sustain the business and $1 billion on growth.
The change in tax policy could even change the calculus when considering mergers and acquisitions because the purchase price of the property plant and equipment can be deducted in the first year of a deal. However, since sellers are aware of this benefit, it’s likely they’ll start asking for more to sell their assets.
Valero is a member of the S&P 500 Oil & Gas Refining and Marketing stock price index, which has jumped 30.7% y/y (Fig. 8). The industry’s forward revenue growth is 6.3%, while its forward earnings growth is 41.8% (Fig. 9). At 12.9, the industry’s forward P/E is just shy of some of the highest levels it has touched over the past 20 years (Fig. 10).
Dr. Ed Yardeni is the President of Yardeni Research, Inc., a provider of independent global investment strategy research.
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