Tuesday, August 5, 2008

Wall Street Not Impressed with Exxon

Exxon has recently reported 2nd Qtr Record Earnings with profit earnings of $11.68 Billion, yet reaction on Wall St. resulted in 4.6% drop in Exxon's stock price.

What's going on here?

The key to this seemingly counter-intuitive reaction from Wall St is understanding what's driving profits.

Profit is influenced by two factors: Revenue and Costs. With the first, there are again two ways to increase Revenue: either by raising the Price or increasing volume.

Increasing price can artificially increase revenue to a limited extent. The reason being that everyone has a price elasticity, so you can only continue to raise price to the point where no one is willing to pay for your product. However, increasing volume represents true potential growth in revenue. Higher revenue driven by increases in volume, as opposed to price increases, demonstrates organic growth, which very often is what the intelligent or rational investor is looking for.

Coming back to what happened with Exxon, Wall St noticed that the profits were primarily driven by higher oil prices, but production of oil volumes were down 10% and 3% for natural gas.

This is an indication that the supply of oil and natural gas is limited, which has a definite dampening factor for future sales - unless the Oil companies can find additional sources of oil. Basically, Wall St. noted that Exxon was not putting capital investment towards increasing oil and natural gas exploration, in addition some of the political instability in regions such as Venezuela and Nigeria where both Exxon and Shell have had sites confiscated by the governments, has also impacted production of oil.

This is why the Oil Companies are pressing for Offshore Drilling. They are looking for additional sites to check for oil reserves. However, there is a catch, there is no guarantee that when they drill, that the oil reserves will produce the expected output. Furthermore, most experts agree that it will take anywhere between 5 to 10 years to get the oil.

If there is no certainty, what's the big pressure to get the leases for additional Offshore Drilling sites?

Quite simply, the Oil Companies know that there is limited time for getting additional OCS leases while Bush remains in office. The likelihood of getting these leases are not as great if there is a Democratic president in office, particularly given how much the Democrats are against releasing protected sites such as ANWR and the Florida Coast. Another driver for getting these leases, is that it can benefit the Oil Companies in the short term - even without drilling! Having analysis or tests to show there are potential oil reserves in their leases, provides "positive" assets that can be considered in the Company's overall financial assets.

While it may seem that profits seem quite excessive, there is a point to keep in mind, Oil Exploration involves high capital costs, so in order to justify investment, there needs to be an appropriate rate of return. What's interesting is that despite the record profits, Exxon made the choice to buy back $8 Billion of shares, as opposed to increasing capital investments for either additional oil exploration on their existing leases or alternative energy sources.

Bottom line, while opening up additional sites for offshore drilling may clearly be in the Oil Company's interest, it is not clear whether America would benefit directly, nor would continually feeding America's addiction be in the best interests of our economy or national security. Yet again, instead of buckling down to address this complex problem, McCain would rather shift the problem off to tomorrow.
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