Refining lights the path for Exxon and Chevron

Earnings show why owning downstream assets is a good idea.

By InvestorPlace Feb 4, 2013 3:31PM
 Oil drums copyright Kevin Phillips, Digital Vision, age fotostockBy Aaron Levitt

iplogoThe major integrated energy companies are truly in a league of their own. Among the world's largest corporations, the group holds huge oil and gas reserves and is responsible for the bulk of the planet's energy production. Their massive scale drives industry trends, provides cost savings and other advantages, and allows them to produce profits bigger than the GDP of whole nations.


And perhaps none are more important than the No. 1 and No. 2 producers, Exxon Mobil (XOM) and Chevron (CVX).


Generally, how the pair perform is a good gauge for the rest of the sector and indicative of trends affecting the industry -- and considering what we learned after their fourth-quarter earnings, it looks like the energy sector is in for a very profitable ride.


Refining saves the day

This time last year, poor refining margins or "crack spreads" took the wind out of many of the major's earnings. Higher Brent crude prices coupled with refined-product demand crippled the sector and caused many integrated firms -- like ConocoPhillips (COP) -- to spin off their downstream operations.


What a difference a year makes.


For both Exxon and Chevron, earnings made from their refining and chemical operations drove their near-record profits. The reason has been an ocean of oil that has been unlocked from North America's various shale formations. As E&P firms continue to adopt advanced drilling techniques in areas like the Bakken shale, prices for domestic crude continue to tumble. Currently, WTI benchmark crude oil is trading at about $97 per barrel -- roughly $19 less than the same amount of Brent crude.


By using the cheaper feedstock, both Exxon and Chevron were able to increase margins at their downstream units.


Over the last few years, Exxon's Gulf Coast refineries have more than tripled the amount of cheaper WTI crude they use to produce gasoline, diesel and jet fuel. That helped XOM report downstream earnings of $1.8 billion, or four times the year-ago period. Exxon's chemicals unit saw a doubling of earnings (to $958 million), also based on higher margins. Low natural gas prices have done wonders for ethylene production -- not only as a cheap feedstock, but as an inexpensive power source as well.


Chevron's earnings tell a similar story. Despite a fire that crippled its Richmond, Calif., refinery last August, the integrated giant saw improved refining unit results. Those new delicious margins helped Chevron's downstream unit reverse a $538 million loss a year ago. Downstream earnings closed the fourth quarter at $925 million, and -- like Exxon -- its chemical unit saw the most improvement. The performance of its 50-50 joint venture -- Chevron Phillips Chemicals -- drove the profit growth.


Production's still an issue, though

As we've highlighted here before, dwindling legacy fields and wells have been a big issue at the majors. While XOM and CVX's refining and downstream segments posted great numbers, the duo were plagued by falling production.


Exxon's production slid 5.2% to 4.29 million barrels of oil equivalent (BOE) per day. All three categories of energy -- crude oil, natural gas liquids (NGLs) and natural gas -- saw declines. Natural gas production fell a staggering 8.3% to 12.5 billion cubic feet per day during the quarter. This is now the sixth straight quarter of declines, representing the longest such streak in more than 13 years.


Likewise, lower energy prices also helped reduce profits at Exxon. Profit from exploration and production activities fell 12%, with overseas energy production tumbling by nearly 20%. Exxon did see gains for its North American E&P efforts, however.


Chevron expanded its production by a small amount, by 30,000 barrels per day to 2.67 million -- that comes a year of underperformance and lowered production numbers. Earnings in the sector rose 20% to $6.9 billion.


A very good quarter

All told, Exxon and Chevron each produced strong quarterly earnings and were able to beat Wall Street estimates by a mile. Overall, Exxon made a profit of $9.95 billion for quarter and barely missed a record for full-year earnings at $44.88 billion ($340 million shy of $45.2 billion in 2008, which was itself an all-time record for any publicly traded company). Chevron also reported higher net income at $7.2 billion.


However, the response by shareholders was muted, with XOM roughly flat Friday and CVX up just more than 1%.


At a time when the bulk of the energy industry is re-evaluating the old the integrated model and shedding their refining businesses to focus on higher-margin production operations, the big two of U.S. oil have shown exactly why owning downstream assets as part of your mix is a good idea.


Look at Conoco and its refining spinoff Phillips 66 (PSX) as an example. Conoco has suffered as lower production has hit its earnings. Meanwhile, Phillips has been an earnings darling and is doing better than its former parent. Refining operations aren't sexy, but they are churning out steady cash flows for their owners. Both Exxon and Chevron were "saved" by those operations.


As such, I expect we will see just OK earnings from a variety of E&P names over the next few weeks as relatively lower prices for hydrocarbons still persist.


I also expect some of the other integrated names without much U.S. refinery exposure will report less-than-stellar earnings.


As of this writing, Aaron Levitt did not hold a position in any of the aforementioned securities.


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