The investment thesis
In Nov 2021, I published an article entitled “$ 80 Target Price Supported With Oil Price Well Above Breakeven” for Exxon Mobil (XOM). The main arguments were:
A) the oil prices were well above Exxon’s breakeven price (about $ 45 per barrel based on my analysis)
B) Even at its compressed valuation (~ 8x price to cash flow multiple), each additional $ 1 of oil price increase should boost the stock price by about $ 1.6 per share, therefore supporting an $ 80 target price.
C) Key catalysts include the resurgent petroleum demand for travel recovery post-COVID-19 and also the expected supply shortage in the near future.
And now XOM’s price has already reached ~ $ 82, surpassing my prediction sooner. These above catalysts have actually played out better than I expected. However, these catalysts are far from done and are still unfolding. The shortage turns out to be more severe and President Biden’s ability to influence oil prices is rapidly diminishing. As a result, I’m still bullish about XOM and you will see that investing in XOM not only provides good odds for a sizable return (I now anticipate a $ 115 target price), but also serves as a hedge against inflation and political uncertainties.
Short-term issues and long-term oil commodity cycle
According to the latest fuel data from the American Automobile Association, the average gasoline price at gas stations in the US has risen to $ 3,435 per gallon, the highest in the United States since 2014.
President Biden is working hard to curb the rise in oil prices. Biden is trying to keep crude oil at around $ 80 and gasoline at around $ 3.30. But the oil price hikes suggest that Biden’s ability to influence oil prices is rapidly diminishing. He could choose to release the Strategic Petroleum Reserves (“SPR”) to fight the surging oil prices.
The SPR is a US government complex of four sites with deep underground storage caverns created in salt domes along the Texas and Louisiana Gulf Coasts. But currently, the use of SPR is a tough decision for several reasons: A) the build-up of geopolitical tensions in the Russia region, and B) at the same time, the US SPR stocks are at their lowest level since October 2002. According to the Department of Energy inventory, the current SPR inventory is only at 587 million barrels. To put things under perspective, the SPR was filled to its then 727 million barrel authorized storage capacity on December 27, 2009, the inventory of 726.6 million barrels was the highest ever held in the SPR.
Expanding our horizon to the longer term, the oil price rally is overdue and now might be the starting point of a new oil commodity cycle. The oil price has been consistently beaten inflation in the past until it stopped for the past 10 years or so as you can see from the following chart. Crude oil price is now where it was 10 years ago. As a result, a rally in oil prices is overdue. The recent rally to $ 90 per barrel is only the beginning and oil prices have more catch up to do in the near future, especially as inflation is surging.
Oil prices have been consistently rising faster than inflation in the past as shown by the long-term data tracked by the US Energy Information Administration (“EIA”) in the next chart. In this chart, the orange shows the prices of oil unadjusted for inflation, and the blue line shows the real prices adjusted for inflation. And according to EIA, these prices are adjusted in the following way:
The real prices are computed by dividing the nominal price in a given month by the ratio of the Consumer Price Index in that month to the CPI in some “base” period. The Real Petroleum Prices spreadsheet and charts are updated every month so that the current month is the base period in the monthly price series. Consequently, all real prices are expressed in “current” dollars and any current month price may be compared directly with any past or projected real prices.
As now you can see, the nominal oil prices over the past 50-plus years have been rising at 5.9% CAGR. Over this same period of time, inflation has been 3.9% CAGR on average. So as a result, oil prices have consistently beaten inflation by a whole 2%.
However, commodity prices are notoriously cyclical and oil is no exception. As you can see from the second chart, oil prices stopped rising, not even keeping up with inflation, for the past 10 years or so. Crude oil price today is where it was more than 10 years ago. It should be at least $ 125 per barrel now even if it just kept pace with the average inflation!
The recent oil price rally marks the beginning of the next cycle, and there’s more catch-up left to do in the near future.
A $ 115 target price
The next table shows how much stock price change can be driven by a $ 1 change in oil price. Currently, the stock is valued at about 10x cash flow, right around its historical average.
As long as the oil price is above the breakeven point, every $ 1 increase in oil price would contribute $ 2.3M of additional income per day for XOM at its current production rate. And on an annual basis, this translates into about $ 0.84B of additional income or $ 0.2 per share as shown below. Therefore, at this average valuation, each additional $ 1 of the oil price increase can still boost the stock price by about $ 2.0 per share ($ 0.2 per share of additional cash flow * 10x cash flow multiple). Hence, at this average valuation multiple, another $ 15 oil price rally (ie, around $ 105) would send the stock price above $ 110. And recall that oil price should be at least $ 125 per barrel now even if it just kept pace with the average inflation over the past decade.
The table below considers more combinations of possible effects of oil price and valuation multiples on the target price. The color in the background shows the possibility of each combination. The darker the background color, the more probable the scenario is expected to materialize. And the numbers highlighted in red are the most likely scenario given the business fundamentals and catalysts in the near term. As seen, even with a combination of a modest $ 105 per barrel oil price and a stagnant valuation of 10x cash flow, a target price near $ 115 can be supported conservatively.
Upside risks. This analysis only considers the profits driven by oil price and ignores all the other profit drivers such as natural gas and its downstream chemicals as two notable examples.
Downside risks. There are some downside risks too.
- The biggest one as I can see is the pace and degree of the post-COVID economy recovery. Although the vaccination is progressing extensively and the economy is re-opening at a good pace. However, the pandemic is far from over yet and uncertainties like the delta and omicron variant still exist, which can trigger another wave of travel restrictions and contraction of fuel demand.
- Another near-term risk involves domestic political uncertainties. Research from Bank of America shows that Biden’s approval ratings are being impacted by inflation: They’re showing a divergent trend as seen. As inflation surged from 1.4% in January last year to 7% in January this year, Biden’s Approval is falling from 56% to 42%. With oil being a key component in the inflation index and restrictions Biden faces in using the SPR, such political uncertainty could cause market fear and impact XOM. However, given XOM’s very reasonable valuation and the temporary shortage of oil supply, the impact of such political uncertainties on XOM should be smaller than those on other stocks in the general market. So XOM can effectively serve as a hedge against such uncertainties
- In the long term, our world needs to, and is, moving away from fossil fuels. It is uncertain how soon the world can totally transitions into a carbon-free future, and how effective XOM can adapt in the meantime.
Conclusion and final thought
My last article argued an $ 80 Target Price for XOM as oil price well above breakeven based on a few near-term catalysts, including its compressed valuation (~ 8x price to cash flow multiple at that time), resurgent petroleum demand of travel recovery post- COVID-19, and also the expected supply shortage in the near future.
These catalysts have played out better and XOM price reached $ 80 sooner than I expected. However, these catalysts are far from done and are still unfolding. The shortage turns out to be more severe and President Biden’s ability to influence oil prices is rapidly diminishing. As a result, I’m still bullish about XOM. Investment here not only provides good odds for a sizable return (I now anticipate a $ 115 target price), but also serves as a hedge against inflation and political uncertainties.