From the end of 1998 until the summer of 2008, ExxonMobil reported annual earnings per share growth of 21%. Chevron reported earnings per share growth of 26%. When oil prices rose substantially, the profits of the two American supermajors grew at a pace we typically associate with a tech startup—not a stodgy oil company that is supposed to be all about the dividends and moderate profit growth. And of course, both Exxon and Chevron were delightful investments over this time frame. Exxon returned 14% annually from the start of 1998 until the peak of oil prices in 2008, and Chevron returned 12.5% over that same time frame.
But here is what I find personally interesting: the price of oil was unusually low throughout extended periods in the 1980s and 1990s, and these two oil stocks did especially well during this drought. In fact, it was a golden age of sorts. Look it up—Exxon delivered 21% annual returns from 1982 through 1998, and Chevron returned 16% annually from 1982 through 1998. Oil was at $30 per barrel in 1982, went down to $13 in 1987-1989, played between the $10 and $20 range for most of the 1990s, and then went down to $8 in 1998. Summing it all up, the measuring period from 1982 through 1998 saw the price of a barrel of oil go down from $30 to $8, and yet Exxon returned 21% and Chevron returned 16% over this time frame. It’s worth investigating why a crash in commodity prices corresponded with such significant wealth creation for the owners of both Exxon and Chevron.
It takes a while for this principle to set in, but it’s always worth remembering that there are three primary ways you can create wealth: (1) you can sell more of a good, (2) the price of the good can increase faster than inflation, or (3) you can buy an asset that is trading below its long-term earnings power, and enjoy the ride up as the price dislocation vanishes.
Operationally speaking, companies like Exxon and Chevron have a long-term track record of excelling at item #3. There are dozens of smallish (companies valued $400 million to $5 billion) exploration and production companies (commonly called upstream companies) that carry large debt burdens and are highly sensitive to changes in the price of oil. The upstream sector is the high risk/high reward part of the oil world where you can get rich overnight or lose it just as fast because the balanced sheets are typically leveraged as the result of high capital costs, and oil price collapses lead to an immediate loss of profitability which is especially problematic when you’re mired in debt.
Because debt + no more profits is a formula for bankruptcy over a long enough time period, companies like Exxon and Chevron have a rich history of stepping in to buy these companies on the cheap—$2 billion of debt is crippling for a $500 million oil company that can’t eke out a profit, but it’s a shrewd addition for a $385 billion company like Exxon that still generates $20 billion in profits because it relies on midstream, downstream, and chemical operations that are less sensitive to declines in the price of oil (I actually expect Chevron to lead the acquisition front over Exxon because it is sitting on 4x as much cash; on the other hand, a little known fact about Exxon is that when it does its share buyback the company doesn’t actually destroy the stock but rather keeps it “hidden” in the treasury to bring out to issue as a currency during an acquisition so it wouldn’t be surprising to see Exxon take the lead either).
The acquisition of cheap assets takes a few years to look shrewd, as the acquisitions sit like a coiled spring until oil prices recover (think about how quickly Exxon’s profits went from $20 billion in 2007 to $35 billion in 2008, now back to the $20 billion range amidst this latest decline).
And, of course, the other reason why Exxon and Chevron do so well is the result of dividend reinvestment at low prices. Oil prices are cut in half and Exxon still makes around $20 billion per year in profit. This is not the image of a sky falling; this is value investing during some down point in the business cycle (whether it’s the bottom or the midway of the down cycle I do not know). Chevron’s dividend yield is now 4.07%. Reinvesting a 4% starting dividend yield at a low price, that is back by over $15 billion in annual profits and a three-decade track record of dividend growth, is how long-term wealth gets created.
How long will this last? I don’t have a prediction on that either, other than to observe that typically, excess supply takes about three years to work itself out as banks become more selective with their lending practices to small oil companies and oil executives become more selective with their future project investments in light of lower oil prices. Given that investing in rigs and bringing them to production is a multi-year project, it usually takes around 30 months for a full cycle of projects to reflect the latest reality (of course, there is no rule that oil prices can’t recover quickly in response to some supply cutoff event, or linger lower for an extended period of time than typical).
I feel bad for the good-hearted people who have owned Exxon and Chevron and decide to sell simply because they have seen Exxon go from $105 to $90 and Chevron go from $135 to $104 in less than a year. It is a rare temperament that can be at ease with such a quick paper loss. Yet, for someone who is truly in it for the long-haul (rather than just paying lip service to the practice) and can thoroughly understand business to the point where he can see that Exxon and Chevron still make $15-$20 billion in profit per year, this is a time where wealth gets created as dividends reinvested at lower prices will eventually turbo charge returns and crude oil in the $45-$55 range for an extended period of time permits Exxon and Chevron to acquire overleveraged companies with nice reserves and real assets at a substantial discount to what they will be worth in a world of higher oil prices.
C.S. Lewis once said, “Experience: That most brutal of teachers. But you learn, my God do you learn.” I would imagine that if someone owned Exxon and Chevron until the last oil price decline (2008-2009) and sold low, they would be frustrated by the experience as they saw production grow, commodity prices rise, and dividends pile up for shareholders in the coming years. Hopefully, that experience of loss led to a desire to not repeat this scene as it unfolds again. Fluctuating is what oil does, and Exxon and Chevron both have excellent records of laying the seeds for long-term wealth creation when prices are low, both through steady dividend payouts and shrewd acquisitions that are possible on account of their immense financial strength.