Oct. 14, 2021 12:15 PM ET
Seeking Alpha
Summary
Even after navigating the severe oil price crash of 2020, Exxon Mobil still faces long-term hurdles from the clean energy transition that will one day see oil demand peak.
Whilst some investors are likely hoping that oil will essentially become the new tobacco, sadly its characteristics mean it will be more like thermal coal rather than tobacco.
The oil industry is very competitive with no pricing power, which is similar to the coal industry and completely different than the tobacco industry.
This means that they may not be the great dividend investment one day in the future and given the lack of free cash flow coverage, this could easily put their dividends at risk in the long term.
Whilst their dividends appear safe for now, this could very easily change one day in the future and thus I believe that only a neutral rating is appropriate.
Introduction
The oil age is undoubtedly approaching its final innings with the clean energy transition only gaining momentum as the years pass, thereby creating hurdles for the oil and gas supermajor, Exxon Mobil (XOM), which surpasses the recent demand destruction caused by the Covid-19 pandemic. This poses very important questions regarding how their future path will unfold and the implications for their cherished dividends. Whilst some investors may hope that oil will essentially become the new tobacco, sadly its characteristics mean it will be more like thermal coal rather than tobacco.
The Potential Future Oil Path
When deciding whether oil will take a path more like thermal coal or tobacco, try asking whether the oil market is very competitive? Yes, definitely. Do oil companies control their sales price? No, not apart from small margins above or below benchmark prices for different grades. Are people addicted to oil in a similar way as tobacco? Once again, certainly not because its use is solely to serve a purpose and not provide any personal recreational enjoyment, unlike tobacco. This important end usage means that whilst tobacco sees inelastic demand, if an oil company tries to increase its oil price then buyers will simply turn to one of their many competitors.
It now starts becoming clear that the underlying characteristics of oil are much more similar to that of thermal coal rather than tobacco. The one benefit for oil versus the bleak thermal coal is its breadth of uses that unlike the latter that is solely used for electricity, sees use across land, air, and sea transportation as well as feedstock for a range of important chemicals, thereby easing a degree of the pain but not eliminating the core issues.
Unlike tobacco that has proven extremely stable, this means that oil will likely increase even higher in volatility as the balance between supply and demand fluctuates wildly from markets constantly adjusting. There is no realistic way that a very competitive industry could see its stability increase as a result of demand shrinking. This does not mean that they will not have good years, it more so means that the difference between the good and bad years will become more noticeable. Whilst the focus has been on the future path of oil, they also produce other commodities such as natural gas and chemicals but these too are facing similar long-term threats to their demand, and given they are also commodities, they will likely fare similarly.
Implications For Exxon Mobil & Their Dividends
Since the future path for oil appears more similar to that of thermal coal rather than tobacco, oil prices would likely see their averages trend lower despite the heightened volatility as the secular declining demand would provide weak fundamentals. Whilst the transition towards clean energy is beneficial from a societal perspective, it poses headaches for income investors with their dividends more likely to take a path similar to that of Alliance Resource Partners rather than Altria, as the graph included below displays.
It would reasonable to expect further oil industry consolidation in the future but given the spread between state-controlled national oil companies, this alone could never reach the levels of the tobacco industry and would still not resolve the lack of price elasticity. This means that they may one day no longer be the great dividend investment they have been since the end of World War II when their dividend streak started and thus investors should temper their expectations, especially since they have never covered their dividend payments with free cash flow since 2011, as the graph included below displays.
Since the intrinsic value of investments extends past the short-term, this situation could spell the beginning of a new era of pain and disappointment once oil demand has peaked in the coming decade and their dividends become risky. Whilst they could diversify away into other fields, this will obviously require a massive investment that itself will hinder their dividend prospects. Thankfully there should still be several years before oil demand falls at a materially fast rate even in the more aggressive scenarios and thus investors still have time to adjust their portfolios.
Conclusion
Whilst their dividends are not at risk at the moment with oil prices around $80 per barrel, their future will be more like thermal coal rather than tobacco. Given this sobering outlook, this could very easily change one day in the future after oil demand begins fading in the final innings of the oil age and thus I believe that only a neutral rating is appropriate given their contrasting short and long-term appeals.