Once upon a time – the 1990s if you are interested — there was a wondrous oil company called Exxon. It was run by a clever wizard and his acolytes who believed that it was probably the best oil company in the kingdom. It was certainly the largest in the United States!
The reason Exxon believed it was the best in the magical oil kingdom was that its chief wizard had discovered a secret. He didn’t set out to make Exxon the biggest oil company in the world – even though it was. He wanted to make it the lowest cost company in the world. He told his acolytes “Don’t worry about the oil price, worry about the cost base! Everything else will follow.”
His assistants listened carefully and followed this rule. He kept saying: “Keeping costs low keeps risk low. Keeping costs low also boosts margins. Higher margins mean higher returns. And higher returns mean a higher stock price. A higher stock price means more gold coins for everyone!”
The wizard’s magic formula meant that Exxon’s financial returns were higher than that of the whole market. And even better, it carried lower risk. The grand viziers of the stock market said that consistently achieving high returns with low risk is impossible. Exxon’s followers knew better – their magic formula did just that.
When the viziers of the market saw that the impossible was possible, they were willing to pay higher and higher prices for Exxon’s wonderful, so-called “impossible” shares. Exxon had discovered the goose that laid golden eggs. For doing this, the market viziers gave Exxon’s head wizard a beautiful new robe with the words “Premium rating” on it. And, all the market players in the kingdom cheered.
The wizard and his acolytes liked the new robe because the “premium rating” meant that they received more gold coins and were able to buy their own fine robes as well as beautiful, expensive castles in the sky, and fine elixirs. Once the head wizard saw that everything was wonderful, he decided to retire in 2005. Sadly, that’s when things started to unravel.
As time moved on, the acolytes began to forget the old wizard’s wise words about low costs and began to believe that they could forecast the oil price. They no longer kept costs low and began to worship the God of growth. They believed that they could start developing higher cost assets such as tar sands and heavy oil. This meant that the cost of replacing the magical oil and gas fields more than doubled between when the wise wizard retired and 2013. Because the oil price didn’t stay as high as the acolytes hoped, higher costs meant lower margins and lower returns from projects. Even worse, these new barrels were not only high cost, they were high carbon! Exactly the wrong barrels to develop for an energy transition!
It also meant that by the middle of the current decade, Exxon’s magical returns had faded and its beautiful robe did the same, becoming thinner and plainer. Its project returns (ROCE) had halved. Exxon’s magical rating gradually faded as well (The acolytes decided to keep the robe even though the premium rating had gone). Re-embroidering it so that it said “Not quite the best oil company in the world” didn’t seem like a good idea to them.
Anyway, the acolytes decided that the growth strategy should continue despite all the problems. They believed that, like all fairy stories, it would all work out alright in the end. (Hint: It didn’t). This was a shame as they could have listened to the advice of Carbon Tracker. On March 13 2014, they published a pamphlet titled “Response to Exxon: An Analytical Perspective”. It pointed out that “Continuing to invest in high cost, high carbon investments could pressure future returns and – just as important – increase Exxon’s operational gearing to the potential consequences of action on carbon, including higher environmental costs and downward pressure on oil prices. Maybe it is time to consider a “shrink-to-grow” strategy?”
But the powers that be didn’t even read the report as they liked their comforting story of business as usual. They seemed not to notice their fading returns, their rising costs and the erosion of their premium rating. Indeed, over the past five years, the grand viziers of the market who invested in Exxon’s magic shares were horrified to see that they lost money! If they had invested in the wider market, they would have gained over 10% a year! (That’s a lot of gold coins to forgo).
It got so bad that even Exxon’s book of gold coins (2019 executive compensation overview), which determines how much management should get paid, had to admit that 2018 wasn’t a particularly great year for the former best oil company in the world! Over ten years, its shareholder returns were the lowest of all the other large oil companies in the kingdom. And in 2018, shareholders lost 15%!
Source: page 7, 2019 Exxon Executive compensation overview.
Ignominy followed! Exxon was thrown out of the magic circle of the ten largest companies in the S&P 500 Index in August 2019! The market had realised at last that Exxon’s new robes were now totally transparent!
Investors were no longer happy. They had seen what was really underneath the robes – rising costs and lower returns. The golden goose that had delivered superior returns with lower risk was dying. Perhaps if they had remembered the wise wizard’s words of “low cost and high returns”, things would have been a lot different.
But the good news is that it’s not too late. As Carbon Tracker pointed out: “A strategy focusing on lower cost projects, stricter capital discipline and increased distribution to shareholders may boost group returns and lower risk.” If the acolytes at Exxon were willing to change from a growth agenda to one of low cost and high returns, they might be able to rekindle the old magic – and get the dazzling robe back.
Author: Paul Spedding