Big oil companies could unlock big value for shareholders. But to do so they need to slaughter an industry sacred cow: the integration of the exploration and production business with refining and other activities. This model worked for decades but today accords a conglomerate discount to the likes of Exxon Mobil, Shell and BP. Splitting up, as the smaller Marathon is doing, could add tens of billions of dollars to shareholders’ portfolios.
A Marathon Oil refinery. The company plans to spin off the refining business.
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As United States members of the group prepare to report earnings starting this week, the world’s big oil companies know they have a problem. Whereas a decade ago their shares fetched price-to-earnings multiples in the high teens, today they languish on valuations ranging from around seven times earnings for BP to 12 times for Exxon, despite the tripling of oil prices over the period. With the majors increasingly locked out of oil-rich nations, the difficulty of ramping up production bears much of the blame.
But so, too, does a growing distaste for complexity among investors. Largely for historical reasons, today’s oil giants are ungainly combinations of higher growth exploration businesses shackled to sluggish refining and marketing operations.
Observable valuation measures hint at a shareholder preference for simplicity. While the integrated majors as a group trade at around nine times 2011 earnings, pure exploration companies in the United States command multiples closer to 20 times, with independent refiners at about 14 times. Even allowing for the swifter growth of these smaller companies, investors are penalizing big oil companies.
Oppenheimer researchers contend the United States majors could raise their valuations 20 percent by spinning off their refining and marketing operations. By this calculus, a partition would add $15 to Exxon’s $79 share price — or $80 billion to its nearly $400 billion market capitalization. Slower-growing leviathans don’t deserve the racier values accorded to the independents. Yet even a modest increase in price-to-earnings multiples could be a boon for investors.
For instance, valuing Exxon’s exploration and production business at 13 times expected 2011 earnings — far less than independents command — would yield a stand-alone value of $382 billion, according to research from Madison Williams. Assuming a conservative multiple of 10 times for Exxon’s downstream, or refinery, businesses makes them worth $78 billion, Madison Williams calculates. Combined, that’s a 15 percent higher value than Exxon at present.
That kind of illustration makes justifications for integration seem increasingly threadbare. Executives argue that lumping refiners and explorers together offers a natural hedge. In theory, when falling crude prices hurt production, the refining business gets relief from lower input costs. Exxon, for example, fared relatively well during the slide in oil prices of 2008, when its shares fell a mere 15 percent.
Still, it seems Exxon was shielded more by its size and a lack of debt, rather than integration. The much smaller rival Marathon, for example, fell 55 percent over the year. In reality, oil prices and refining margins are frequently correlated, since both are led by fuel demand and economic growth.
Big oil companies also claim that technology developed in one part of the business can be used in another. Yet with the possible exception of liquefying natural gas, energy experts struggle to think what these supposed synergies may be. Besides, technology can be easily bought or hired: none of the majors seem to have objected to relying on oil services companies like Schlumberger for technology and Transocean for rigs.
Finally, energy majors contend that refining expertise helps clinch access to reserves in oil-rich nations. A company that knows refining, they say, is more likely to be granted exploration rights. This may have been true decades ago when large national oil companies were less sophisticated. Now they are more than capable of developing their own refining operations or signing joint ventures.
So the benefits of integration are hard to pin down. By contrast, splitting up would make oil companies far easier for investors to value. It would surely sharpen management focus, since different skills are required to run exploration and refining operations.
There is no reason to fear that oil giants would have to give up the scale needed to compete. Newly liberated exploration and production companies could simply hook up. Most of the smaller integrated oil companies, like Marathon and Murphy Oil, have already reached these conclusions. It may not be long before the majors do too. CHRISTOPHER SWANN
For more independent financial commentary and analysis, visit www.breakingviews.com.
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