Exxon Mobil (NYSE:XOM) had a tough 2013, as its earnings declined by ~24% y-o-y due to the declining upstream production, lower divestment gains and thinner refining margins. Like its peers amid industry-wide weakness in the downstream business, the company’s stock underperformed the S&P 500, which grew by more than 25% last year. Almost all the integrated oil and gas companies, including Shell (NYSE:RDS), BP (NYSE:BP) and Chevron (NYSE:CVX), suffered from thinner downstream operating margins last year because of industry overcapacity. Additionally, lower commodity prices and rising production costs also put pressure on upstream earnings.
We believe that this is going to be another lackluster year for Exxon Mobil marked with flat upstream production and thinner downstream margins. However, improving volume-mix and lower capital expenditures could potentially boost its return on capital employed (ROCE). We currently have a $92 price estimate for Exxon Mobil, which values it at around 12x our 2014 GAAP EPS estimate of $7.68, and is almost in line with its current market price.
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Flat Upstream Production
Exxon’s upstream production has been relatively flat over the past decade. It actually declined slightly from over 4.21 million barrels of oil equivalent per day (MMBOED) in 2004 to 4.17 MMBOED in 2013.  This has also been a case with most of the other large integrated oil and gas players, as they have been unable to add enough new production to more than offset natural field declines. This could partly be attributed to the shear size of these firms, and also fact finding and developing large hydrocarbon reserves is getting more and more difficult.
However, Exxon expects to ramp up its upstream production to ~4.5 MMBOED by 2017 as it progresses on its plan to add 1 MMBOED of new production between 2012 and 2017. The company is banking on a number of new project start-ups to achieve this target. As many as ten of these projects are scheduled to start-up this year itself, including the liquefied natural gas (LNG) project in Papua New Guinea, first oil from the Arkutun-Dagi field offshore Russia’s Sakhalin island and the Cold Lake Nabiye expansion project in Canada. However, Exxon expects its net hydrocarbon production to remain relatively flat this year, as these new project are not expected to ramp-up substantially until next year. Beyond 2014, the company expects its upstream production to grow at 2-3% CAGR till 2017. 
Exxon’s total hydrocarbon production can be broadly split into two categories – liquids, which include crude oil, natural gas liquids, bitumen and synthetic oil, and natural gas. Liquids made up more than 60% of Exxon’s total hydrocarbon production in 2009. However, their percentage contribution reduced significantly after the company acquired XTO for $41 billion in 2010, which increased its natural gas production by 31% y-o-y that year.  More importantly, most of the increase came from the U.S., where natural gas prices have been significantly depressed by international standards due to a sharp rise in production from unconventional sources. (See: Key Trends Impacting Natural Gas Prices In The U.S.)
Liquids have generally become more profitable to produce than natural gas because of higher price realizations. Last year, Exxon sold liquids at an average price of around $95 per barrel, compared to just around $41 realized per barrel of oil equivalent (BOE) of natural gas. This is the reason why the company has been trying to improve the proportion of liquids in its production mix over the last couple of years. In 2013, liquids made up 52.7% of Exxon’s total hydrocarbon production, up from 51.5% in 2012.  This year, the company plans to boost it further as it expects liquids production to grow by ~2% y-o-y and natural gas production to decline by around 2%. 
Thinner Downstream Margins
Thinner downstream margins weighed heavily on Exxon’s 2013 results. Almost 80% of the total year-on-year decline in its full-year operating earnings (earnings adjusted for divestment gains in 2012) could be attributed to thinner downstream margins. This was primarily due to industry overcapacity amid sluggish demand and higher crude oil prices. There were certain bright spots as well, such as refineries in the Midwest U.S. that gained from lower crude oil prices due to the fast-growing supply from unconventional plays in the U.S. and a lack of midstream infrastructure. However, the sharp decline in international crack spreads more than offset this advantage for Exxon.
Going forward, we expect global refining margins to continue to remain under pressure in the short to medium term due to industry overcapacity, which stems from the fact that governments in different parts of the world are willing to run uncompetitive crude refineries at very low or no returns to sustain employment and reduce their reliance on imported fuels. (See: Key Trends Impacting Global Refining Margins)
Lower Capital Expenditures
While Exxon’s total hydrocarbon production has remained relatively flat over the last decade, its capital expenditures have soared from around $18 billion in 2005 to over $42 billion in 2013. This is a clear indication of how difficult the oil drilling business has become over the years. However, the company believes that 2013 was a peak year of capital expenditures and it would not spend more than $40 billion on leasing rigs, floating oil platforms, installing pipelines and repairing oil-refineries this year. 
Beyond 2014, Exxon expects its capital expenditures to decline further to an average of less than $37 billion annually. We believe that it would not be an easy task for the company amid growing pressures to increase its production, as hydrocarbon finding and development costs continue to swell. However, if the company is able to successfully achieve this target through efficient capital allocation, it could provide a much-needed boost to its declining ROCE, which stood at just around 17% last year. Notes: