Capital Efficiency

Assessing capital efficiency, along with valuation, is really the second pillar to E&P investing in my opinion.  This may be an unusual concept to investors more familiar with less capital intensive industries.  For instance, when deciding whether to buy Coke or Pepsi, metrics like Return on Capital Employed (ROCE).  The bottom line and the ability to grow the bottom line, are the two key factors for companies in less capital intensive industries, and in many industries these have little relation to the capital efficiency metrics of the company.

With oil companies there is no brand to speak of, and no consumers deciding which type they like best.  What differentiates a successful company vs. an unsuccessful one is their ability to allocate capital in a way that will provide a favorable financial return in the future.  For less capital intensive industries growth in it of itself is usually evidence of good performance, unless the company is buying that growth through acquisitions.  In the E&P business a company that is growing may be paying for that growth by over-investing, and so higher growth is not necessarily evidence of good management.  Because earnings growth is not a reliable metric, we must have other ways to asses management

For very large companies, like the major oil companies, it is difficult to assess the profitability of individual aspects of the business.  The most common measures are ROE and ROCE.  The metric of ROCE is very commonly used, and I believe this was made popular by Exxon in the 1980s or 1990s.  It is calculated by dividing EBIT (operating income) by the total assets minus current liabilities.  A few years ago I was interested in whether the valuation premium of Exxon vs the other oil majors was justified.  Using the Bloomberg “total return” function, which assumes you reinvest dividends in shares, but neglects the effects of taxes, I compared the total compounded annual return of Exxon, Shell, and Chevron since 1990.   Interestingly they were all in the range of 12%.  This was despite the fact that Exxon traded at a significant valuation premium over nearly that entire period.  This indicated that over time, the market was correct in the higher valuation of Exxon vs. the other companies.  The reason for this effect was that Exxon was reliably more efficient with their capital, and earned a better return.  Of course the market was undervaluing oil companies in general in 1990 (which was explicable given the years of low oil prices); the S&P returned a compounded 7.5% over that same period.  Also note that production and refining throughput generally stagnated through this period. The moral of this story is that one company can be trading at 9x earnings, and another can be trading at 12x, and even if both are not growing at all, these relative valuations may be entirely justified.  The less efficient company may have to retain more of the earnings to maintain production, while the more efficient company is free to distribute a higher percentage of earnings through share buybacks and dividends, thus compensating for the higher valuation.

Image from XOM March '14 investor presentation