Spare a thought for ExxonMobil shareholders. While the S&P 500 has rebounded from April’s Covid crash to hit a series of all-time highs this autumn, XOM stock is still down 40% year-to-date despite the recent vaccine-inspired market euphoria that has lifted Brent crude back above USD 50 per barrel.

This year has been indiscriminately cruel to oil stocks, but the way the pandemic has humbled Exxon has been a spectacle to behold. This once-proud US supermajor has gone from being the world’s most valuable company as recently as 2013 to flunking out of the Dow Jones Industrial Average this year, after limping to three consecutive quarterly losses. To offset in Q4’20 the USD 2.37 billion of losses accumulated over the previous nine months to finish the year in the black seems an impossible task.

But these are merely vanity metrics for Exxon investors, who tend to care about only one thing: the gold-plated XOM dividend. The company failed to raise the payout for the first time since 1982 following its disastrous Q3’20 earnings results, and there is widespread speculation that a cut is now inevitable.

Exxon has been borrowing ever greater sums to bridge the widening gap between diminishing free cash flow (FCF) and the growing dividend burden, which is fine for a while when interest rates are low and you have triple A credit metrics.

But this is not a sustainable strategy. Exxon’s FCF-dividend cash shortfall came to a staggering USD 2.6 billion in Q3’20, significantly worse than its peers, and there is little certainty that revenues will improve until Sars-Cov-2 vaccines are widely distributed in the latter half of next year.

Not even Exxon can keep ratcheting up its borrowing indefinitely to placate shareholders. But more debt seems inevitable, as the IOC must also invest large sums to sustain production and in growth projects turn around its ailing core business, if it is to break out of this cycle of retrenchment.

Instead, it is protecting the dividend by cutting away at capital expenditure, staff payroll and cancelling projects. These are all short-term fixes that build up problems for the future. With other IOCs also slashing upstream spending, the company seems to be banking on a post-Covid oil supply shock to bail it out.

While this is entirely plausible, shareholders are getting jittery. Exxon now faces a small but growing faction of activist investors who are calling for an overhaul of the board, business strategy and investment focus to better prepare the company for the energy transition. Exxon’s response — to proffer risible reductions in its carbon and methane emissions intensity (yes, that old chestnut) — convinced precisely nobody that the company is taking its climate risk exposure seriously. There is already palpable appetite for management to sketch out a credible pathway to a world beyond ExxonMobil.

Stronger together?

British oil major BP, by contrast, has pledged to become a net zero energy company by 2050 by investing heavily in renewables, electric car charging networks, hydrogen, bioenergy, digital solutions and carbon capture, all while curtailing oil production. Its transformational plan, previously dissected in Energy Flux, will see the company revive its defunct aspiration to go ‘Beyond Petroleum’.

There are few, if any, examples in corporate history of a USD 55 billion company successfully navigating profound and rapid disruption of the kind facing the energy industry by pivoting to an entirely new business model. Many observers question whether razor-thin wind and solar margins will allow even a slimmed-down BP to cover its overheads and invest for both today and tomorrow, all the while delivering above-market returns.

After pledging to reduce hydrocarbons production 40% by 2030, some warned BP is turning its back on oil too quickly. While a rapid ramp-down of oil production is precisely what the world needs to get emissions onto a Paris-aligned pathway for global heating, BP is really only tapping the brakes. It is still counting on a “high-graded” oil portfolio to deliver the cash flow required to bankroll its green revolution.

If it pulls off this high-wire balancing act, BP could become the new darling of the growing crowd of institutional investors and fund managers focussed on environmental, social and governance (ESG) metrics. For these same investors, climate laggard ExxonMobil will increasingly become an ESG pariah as oil replaces tobacco as the stock market’s latest bête noire.

An Exxon-BP mega-merger is appealing on many levels. Both have endured a lot of bloodletting this year, writing off out-of-the-money assets to the tune of USD 20 billion between them so far. Exxon has also flagged another USD 17-20 billion charge in Q4’20 results in January. Both companies are scrambling to lay off staff and offload marginal assets at steep losses while using pared-down capex budgets to develop ‘core’ upstream acreage. BP has already slashed its dividend too.

The pandemic has pushed Exxon’s ambitions to become a major player in liquefied natural gas (LNG) onto the backburner. The company this year shelved planned investments in new liquefaction capacity in Mozambique and Papua New Guinea, and company bosses have spoken bluntly about the gap between LNG margins in today’s oversupplied market and the yield required of projects competing for a slice of its diminished pool of capital.

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BP on the other hand is expanding the capacity of its already sizeable global LNG footprint, from 14.9 million tonnes per annum (mtpa) currently to 25 mtpa by 2025 and at least 30 mtpa by 2030. The company is building out projects in West Africa and Indonesia and ramping up spot LNG purchases, while opening strategic outlets for these volumes in Brazil, Vietnam, China, India and the Middle East. To link these up and optimise the portfolio, BP operates a fleet of LNG carriers and a 24/7 trading operation that also offers a route to market for third party independents.

Exxon’s forays into new energies is limited to funding research into carbon-munching algae to produce bio-oil, which remains an interesting but distant commercial prospect. BP is miles ahead of Exxon in the field of bioenergy thanks to its Bunge joint venture in Brazil, in solar power via its 50% stake in global developer Lightsource BP, and in offshore wind via its acquisition of a 50% interest in Equinor’s Empire Wind and Beacon Wind projects in the US. The British major is even investing in forestry projects, and last week acquired a majority stake in carbon offset developer Finite Carbon.

Whether these investments will pay off is another matter. But they could offer Exxon a shortcut to burnishing its ESG credentials and moderating its position as a climate outlier among its Big Oil peers. Perhaps a merger with BP could be promoted via a slick, tongue-in-cheek ‘Beyond Exxon’ marketing campaign.

The political angle

Talk of a putative Exxon-BP merger has cropped up sporadically over the last decade, but each time failed to overcome some major obstacles.

In the wake of the 2010 Deepwater Horizon oil spill and landmark settlements with the US government and Gulf Coast states, BP’s ~USD 20 billion liabilities deterred takeover interest. This is believed to be because a chunk of the settlement, which was to be paid in instalments over almost two decades, would fall due for repayment in full upon closure of a corporate merger.

The Gulf of Mexico blowout disaster also caused political acrimony between the US and UK governments over the ferocity of language used by American lawmakers and the resultant impact on BP’s share price, to the detriment of British pension funds.

BP’s oil spill settlement payments are now tapering down, and Washington is about to enter a new political chapter with the incoming Biden administration — which is expected to draw a line under the Trump administration’s wilful aggravation of America’s transatlantic allies.

The UK government led by prime minister Boris Johnson seems to be encouraged by the prospect of a renewed ‘special relationship’ with the US. This concept is a well-worn trope of British exceptionalism that in reality has meant very little, if anything, to any inhabitant of the White House since at least the Obama era.

Still, incoming president Joe Biden will at some point consider post-Brexit relations with the UK. London has in recent weeks expressed its inexplicable preference to prioritise a trade deal with the US over one with the EU after the Brexit transition period expires on New Year’s Day (although at the time of writing, on Thursday 17th December, a last-minute EU trade deal is said to be close).

A major corporate merger might grease the wheels of US-UK trade talks and give British politicians something to point at when pressed on the elusive benefits of leaving the EU. In keeping with all things Brexit, this would of course be disingenuous; ExxonMobil would acquire rather than merge with BP — and only on terms that benefit long-suffering XOM shareholders.

Universal desperation

This raises the question: on what terms would BP investors agree to a buyout? If BP’s green pivot is seen to be failing just as oil prices are approaching their post-pandemic peak, say in 2023, selling out to one of the world’s biggest publicly traded oil companies might appeal. And, having doubled down on oil bets in Guyana and Brazil, Exxon should be momentarily flush with cash during the next oil spike, assuming one is coming.

A fly in the ointment remains BP’s 21.93% stake in Russian state-run oil company Rosneft, which BP still considers a “fundamental part” of its portfolio despite its pledge to “reimagine energy”. Exxon would relish the opportunity to regain access to Russian oil and gas production licences, having walked away from its lucrative Arctic oil joint venture with Rosneft under threat of US sanctions following Russia’s annexation of Crimea.

Even if the Democrats seize control of the Senate by pulling off a shock victory in the January run-off in Georgia, the Biden administration is unlikely to go soft on Russia. A hard stance towards the Kremlin has been perhaps the only truly bipartisan policy issue during Donald Trump’s presidency, so US ownership of a Russian state oil major is a non-starter. BP would have to negotiate its separation from Rosneft, for which Moscow would surely extract a hefty premium if this were to enable a deal that strengthens two big rival producers.

A BP-Exxon merger, while still hard to imagine, would create a true oil behemoth with combined pro-forma 2019 production of 6.6 million barrels per day in 2019 — equal to more than 6% of total global consumption. Its combined reserves base of nearly 34 billion barrels of oil equivalent would be comparable to Rosneft’s 42 billion boe.

Their combined market capitalisation of USD 240 billion at today’s share prices would be significant, although comparable only to that of Adobe or Netflix, and an order of magnitude less than Apple. Exxon alone was worth USD 375 billion as recently as 2018.

Still, such a combination would dwarf the recent spate of mostly US oil mergers and acquisitions forged over the summer, as C-suite executives digested the reality of a rebased oil price and accelerating climate agenda. Fundamentally, Exxon would buy BP for the same reasons that ConocoPhillips is merging with Concho Resources, Chevron with Noble Energy, Premier Oil with Chrysaor, Devon Energy with WPX, etc.

Facing protracted and bumpy structural decline, the urge to consolidate the oil market will only strengthen over time. Cyclicality and price shocks will periodically distract from this underlying megatrend, but the logic of marrying up the biggest players will become ever more compelling as demand flattens and carbon taxes swell. Incumbents face a desperate struggle to maintain market share and get ahead of the curve. Bulking up will buy them precious time.

Seb Kennedy | Energy Flux | 21st December 2020

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