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Barron's Online: Exxon Mobil returns in full flow

Exxon Mobil returns in full flow

By Dimitra Defotis of barron’s

FOR those stewing about the big profits of the big oil companies, the best revenge may be to invest in them. These companies offer safety for conservative investors, with their combination of refining and exploration businesses. When oil prices fall, they tend to produce more consistent earnings than pure plays on exploration, services or refining.

Several years into this mega-run for energy-related stocks and oil prices, shares in some of the largest integrated oil and gas businesses sport decent valuations. Solid returns on capital employed are especially desirable as the industry faces criticism for hoarding cash in these profitable times. And a winning company is likely to offset exploration with refining and chemicals businesses. Then a drop in energy prices and refining margins won’t hurt as much.

Research by investment bank Friedman, Billings, Ramsey (FBR) shows that some stocks look cheaper, or have heralded managements, but Exxon Mobil, the largest and best-known of them all, is less sensitive than competitors to energy price swings. And Exxon has the juiciest returns.

“Exxon’s returns on capital are over 25% greater than its peer group, which is substantial,” says Frank Holmes, chief investment officer at US Global Investors in San Antonio, Texas. “That tells you that management is better at making economic energy decisions.” Holmes added to his Exxon position in the first quarter, shortly after Exxon’s longtime chairman Lee Raymond retired. Raymond’s handpicked successor, Rex Tillerson, is a Texas native who has been at Exxon for three decades and blazed a trail as an Exxon executive in Russia in the 1990s.

The transition has been seamless, though Tillerson has sidestepped the subjects of global warming and alternative energy that pitted the outspoken Raymond against environmentalists. Tillerson’s diplomatic skills will be key to ventures with state-owned oil companies around the world and to expanding deep-water and liquefied natural-gas (LNG) projects. Already, he has cemented agreements in the United Arab Emirates and Indonesia. Last year,

Exxon’s oil and gas production fell 3.6%. But spending is picking up and new fields under development should boost Exxon’s oil and gas production 13% in 2006 and 2.7% in 2007, according to Tina Vital, a Standard & Poor’s analyst.

Exxon gets about three-quarters of its earnings from its E&P business and about 10% from chemicals, a profitable business many integrated oil companies exited. Most of the rest comes from refining.

Meanwhile, Exxon has an enviable cash position. In the first quarter, Exxon made share repurchases valued at $5bn, more than the combined buybacks of Chevron, Conoco Phillips, Royal Dutch Shell and Total, according to FBR. The buyback and 2% dividend yield should put Exxon shareholders ahead about 8% this year, says Jacques Rousseau, an FBR analyst.

Exxon’s 2006 capital spending budget, excluding acquisitions, is the biggest among the integrated companies at between $18bn and $20bn, according to FBR. Only Royal Dutch Shell’s spending plan rivals that. But what that spending yields is even more important, which is why investors look at return on capital employed (ROCE) to measure profitability. Exxon’s estimated ROCE of 39% for this year trumps its largest peers, which should deliver ROCE of between 21% and 24%, according to FBR.

“Exxon is the largest, most diversified, most operationally efficient . . . using any yardstick . . . they generate the most profit,” says Fadel Gheit, an analyst at Oppenheimer & Co.

And that is one reason Exxon usually trades at a premium to even the biggest integrated oil companies. But Exxon, changing hands at about 11 x 2006 earnings, is trading near the valuation of Royal Dutch and Total shares, and at a discount to BP, according to FBR data.

So what happens if oil prices drop? Shares in Exxon will likely fall as well. And the stock, like other integrated names, is near its 52-week high.

But for every $1 drop in the price of oil, Exxon’s earnings would fall 1.6%, less than four of its five closest integrated competitors, according to FBR.

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