Tuesday, November 26, 2013

Why Warren Buffett purchased Exxon Mobil stock?

I have spent the last year, learning as much as possible about Warren Buffett and his right hand man Charlie Munger. There is plenty of information from both super investors to keep you occupied full-time for months if not years.

The most interesting insight is that if you pay attention to these two investment legends, you can gain a lot of insight about what is going on inside their heads. In addition, by many of their statements, Buffett and Munger can sometimes inadvertently divulge or give away what they think about certain companies, and what they are looking to buy or sell.

For example Charlie discussed US energy independence in a 2013 conference, and some of his statements were widely quoted. While I found his comments to be very weird at the time, I believe Charlie Munger was probably instrumental in the purchase of Exxon Mobil stock in 2013.

Even I succumbed to the frenzy, and dedicated a whole article on the topic. I did not agree with some of his ideas, but concluded that maybe his ideas mean that he is interested in oil as an investment. It seems now that the speech by Munger was definitely inspired by all the research he and Warren had done on the topic of investing in oil. If they spent months researching investments in the oil and gas space, it is not surprise that Munger had oil in his head to talk about. As usual, hindsight is always 20/20 however.

I also previously discussed why the so called peak oil is nonsense. This is because technology is improving, and the ability to discover and tap oil reserves is also improving. Furthermore, as the price of oil and gas increases over time, energy companies would have a higher incentive to explore for energy in areas that are more expensive. In my article I discussed how the estimated reserves of oil and gas left on earth have been increasing over the past several decades.

Another fact that could have shown Berkshire’s intentions that it is researching Exxon Mobil for possible accumulation, is Warren Buffett’s discussion on gold and how he could buy 16 Exxon Mobils and all farmland if he were to own and subsequently sell all the gold in the world. This discussion was listed in the 2011 Letters to Shareholders.

Some of Buffett’s largest buys like Wells Fargo (WFC), Burlington Northern Santa Fe, International Business Machines (IBM), Heinz and now Exxon Mobil (XOM) are truly long-term buy and hold selections. These are core positions, which would likely not be sold for many decades. These are blue chip companies, who will produce an increasing stream of dividends for decades to come to Berkshire Hathaway shareholders. These are the slow and steady type of companies, whose customers repeatedly use their products or services. If you believe the US economy and the World economy are going to be larger 20 -30 years from now, these would be the companies to buy and forget. Once you acquire a shares in a great company at attractive valuations, you can simply afford to sit back and enjoy the dividend checks coming your way for decades. I believe that investing in those companies is one way for Buffett to invest Berkshire’s money for the next generation after him. It is similar to your grandfather leaving his grandson/granddaughter a pile of stock certificates, that would pay for great granddaughters/grandsons college educations. I have analyzed Exxon Mobil before, and have also concluded that it was a sound long-term investment. This is why I have been adding it to my Roth IRA this year.

Essentially, the central idea for buying Exxon Mobil is that oil is a finite resource, which cannot be recovered once it is used up. The easiest oil has already been discovered, leaving oil and gas deposits that are more costly to produce. The world is likely to keep needing carbon energy like oil and gas for several decades, even if renewable energy sources from the sun, wind and water can eventually satisfy worldwide energy demand. This could likely occur in a few decades. Even if that were to happen however, humanity would still need substances like oil, because it is used up in everything that our modern civilization is based upon – plastics, pharmaceuticals, chemicals, etc. Unlike gold however, which is mined and could be reused, once you have used up oil, it is gone forever. You could recycle some of the plastics and other compounds from oil however, but not everything.

Prices for oil and gas will likely increase over time. However, this won’t be a linear and straightforward increase. This would make existing reserves of oil companies like Exxon Mobil more valuable, and its technical know-how of how to successfully explore for and tap reserves, provide it with a competitive advantage in the field. Mostly large companies will be able to succeed in major exploration and production developments in difficult to explore for regions. Their massive scale, access to cheap capital, and experience, will help them overcome the challenges of drilling in inhospitable terrains such as deep seas, and places in the North that have been frozen for millions of years.

Rising prices will likely result in higher profits over time, which would surely result in higher stock prices and higher dividends per share. The company has proven that it is a steward of shareholder capital, as it has managed to increase dividends for 31 years in a row. Over the past decade, Exxon Mobil has managed to also raise dividends at a rate of 9%/year, while also repurchased one third of outstanding shares. As I have mentioned before, Charlie Munger likes carnivores, which are companies that consistently repurchase their shares. IBM and Exxon Mobil are companies with some of the most consistent share repurchases, which didn't stop even during the financial crisis.

If you compare Exxon to the other major energy companies in the world, it is not the cheapest one on the list.

Currently, Exxon Mobil is trading at 12.40 times earnings and yields 2.60%. It is not the best value, based on this table. However, it is the company with the longest streak of consecutive dividend increases. You can probably look equally as well with any of the companies listed above. I am going to speculate why he didn't buy each company, based on information I have gathered from Buffett over the past decade. The likes of Total have withholding taxes, and some uncertainty over increasing taxes for French companies. BP was probably excluded, because of the negative environmental effects of the 2010 oil spill. Buffett probably doesn't want to be associated with this. I am not sure why Royal Dutch was excluded, although it could be due to a scandal a few years ago that had to do with the company overstating reserves. We all know that Buffett wants to deal with able and honest management, and therefore a history of mismanagement of such proportions could be a red flag. This could be a red flag, even if the company has gotten rid of all the people responsible for inflating the company's oil and gas reserves. I would say that Lukoil looks the cheapest, and probably has more room to grow. However, Russia has an image of a very corrupt country, with memories of the government expropriation and bankrupting of Yukos in the mid 2000's still fresh in many investor's memories. For example, during the 2004 Berkshire meeting, Buffett discussed that he had to decide between buying shares of Yukos or Petrochina (PTR). Ultimately, he purchased shares of Petrochina, because he thought that the risk there was lower. I didn't list Petrochina in the table, but with a P/E of 10.37 and yield of 3.90%, although I would not be surprised if Buffett revisits this trade as well.

Interestingly enough, I sold Exxon in late 2012 and replaced it with ConocoPhillips (COP). I guess COP does not have the scale of Exxon, and does not have any Refining & Marketing operations, which were spun-off in 2012. However, it seems to have a very shareholder friendly management, despite the fact that it doesn't have a lengthy history of dividend increases like Exxon.

As for Chevron, it is one of my largest portfolio positions ( top 3), and I am not sure why Buffett would pick Exxon over it. However, I realize that I am biased on that issue. It could be due to the trial in Ecuador, where Chevron has been ordered to pay billions of dollars in fines for damages. However, I have some doubts about the integrity of the trial against Chevron. Check my analysis of Chevron.

I think Buffett likes the valuation, the economics of the business, and the massive scale of the company. In addition, he likes the high amount of cash flows generated, which allow it to return so much in the form of dividends and share buybacks to shareholders. Furthermore, the company is one of the largest in the world, and therefore, further buying by the Oracle of Omaha is not going to materially impact the stock price. The company is also US based, and therefore all earnings and dividends are not going to be subject to foreign withholding taxes, or add increased uncertainty over foreign governments. Last but not least, the company has proven that it can boost dividends to shareholders, consistently buy back stock, and also effectively deploy cash to replace reserves used. With a shareholder friendly management culture like that, it is no wonder the Oracle of Omaha chose the stock.

Full Disclosure: Long XOM, IBM, WFC, CVX, BP, RDS.B, COP

Relevant Articles:

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Dividends versus Share Buybacks/Stock repurchases
Warren Buffett Investing Resource Page
Charles Munger: A Lesson on Elementary, Worldly Wisdom as it Relates to Investment Management and Business
How to Generate Energy Dividends Despite the Peak Oil Non Sense

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