Exxon Is Buying Its Way Into the Energy Transition

Analysis by Liam Denning | Bloomberg July 13, 2023

Carbon capture is Exxon Mobil Corp.’s silver linings playbook. The latest chapter, around in draft form for a while, is the $4.9 billion acquisition of Denbury Inc., announced Thursday. Besides Uncle Sam, Wall Street is also doing its bit to help Exxon’s push into the carbon canceling business.

Carbon capture is the centerpiece of Exxon’s climate-related efforts for three big, silver-lined reasons. First, unlike renewable energy, which competes with oil and gas, capturing carbon complements Exxon’s core business and thereby may extend its lifespan. Second, unlike renewable energy, carbon capture hasn’t attracted a flood of investment competing away returns (reminiscent of shale’s boom years). So if it works at scale — a very big if — Exxon’s capital has an edge. Third, the Inflation Reduction Act’s carbon capture credits effectively provide Exxon with extremely patient venture capital to fund development (see this). 

Now there’s a fourth: Apathetic energy investors.

Exxon doesn’t particularly like the ennui that has kept the energy sector’s weighting submerged below 5% of the S&P 500 for much of the past four years. Even 2022’s combination of war, $100 oil and record-breaking free cash flow for Big Oil pushed the sector’s weighting a little above 5% only briefly. Still, in relative terms, Exxon, with a stock that trades higher than it did at the height of last year’s oil-price spike, is doing better than the smaller exploration and production companies. This reflects a fundamental shift in the standing of Big Oil compared with those smaller companies that has been playing out over years but has now reached a moment of truth.

Paul Sankey, an independent, and veteran, analyst of the sector with his own firm, Sankey Research LLC, published a punchy report earlier this week on the forces compelling consolidation among US oil and gas producers. In short, when shale was a growth sector, the smaller frackers traded at a premium to the majors. The model was similar to technology startups, and not only in terms of the minimal focus on profits and rich rewards for executives regardless. As in Silicon Valley, the objective was often to ultimately get acquired by a behemoth. As Sankey writes, the “greater fool” valuation for E&P stocks was that “you grow, you grow, you grow, and then you sell it to Exxon.” XTO Energy Inc. did just that in 2010, and the premium Exxon paid haunted it for years thereafter.

The script began to flip around 2016, as oil prices slumped — partly because of unbridled fracking and OPEC’s response to it — and, as Sankey points out, the growth potential in shale naturally faltered as the best resources were already developed. The frackers’ premium to Big Oil became a discount as investors, no longer dazzled by growth, focused in on poor returns, blitzed balance sheets and bloated costs. As I wrote here, ConocoPhillips, the largest E&P company, produces as much oil and gas as 30 of its smallest competitors but spends only a quarter of their aggregate selling, general and administrative expenses. Or, as Sankey puts it, there are “too many CEOs per barrel of production.”

So while Exxon’s forward Ebitda multiple of about 6 times is hardly racy, it’s higher than the average of about five times for E&P stocks and double what small and mid-cap frackers fetch. This is a buyer’s market. Which explains something important about the Denbury deal.

Denbury is an unusual beast, with a longstanding focus on using carbon dioxide to enhance recovery of oil from wells (by injecting the gas into the reservoir). Decarbonization efforts, exemplified and monetized by the IRA, have recast Denbury as a valuable carbon capture play. In particular, its Green Pipeline, enabling the gas to be shipped from the industrial centers around Houston to caverns in Louisiana, is tailor-made for Exxon’s carbon capture hub and replicating it today would likely cost far more than the $1 billion Denbury spent, and take years to boot.

On top of this impeccable logistical logic, Denbury’s “advisors really worked to find the best way to maximize value,” according to Chief Executive Chris Kendall in an interview with Bloomberg News. And yet, for all that, Denbury is selling itself in an all-stock deal at merely the average price ratio to Exxon’s stock over the past 12 months, providing virtually no premium and at an 18% discount to the consensus analyst price target. How often do you see a company announce it is being acquired and see its stock price actually drop on the news?

One might say that Denbury’s unusual value proposition meant the shortest of shortlists of potential buyers, and earlier rumors of Exxon’s interest had already injected some speculative heat. Yet the mood music is also important. If institutional shareholders are unwilling to pay up for growth, neither will potential acquirers. The market’s ennui, like the IRA, offers a subsidy of sorts for Exxon’s carbon capture ambitions. For the E&P sector, the Denbury deal is not merely an unwelcome portent of a lower-carbon future but also a reminder of their uncomfortable present reality.