Is Integration Still Best for ExxonMobil and Chevron?


Reporting season continues to have lots of life left in it, in the form of companies awaiting their turn to tell us about their quarterly results. Nevertheless, it's already provided a host of information about the benefits or drawbacks of maintaining upstream and downstream operations in a single oil and gas company.

It's possible to form an opinion on that somewhat newly contentious subject by examining the results already posted by the two remaining major U.S.-based integrated majors, ExxonMobil and Chevron . At the same time, I'd remain cognizant of the fate ofConocoPhillips -- now the biggest of the independent producers, following a previous life as No. 3 in the integrated group.

Tough rowing upstream
You probably recall that Conoco kicked off earnings season for the bigger producers with per-share results that were more than 40% lower than those it chalked up a year ago. In addition to putting a passel of its upstream properties on the block, the company has spun off its downstream operations, which became the basis forPhillips 66 . Since it figuratively was granted its adulthood on May 1, Phillips, which consists of 15 refineries, about 10,000 retail outlets, and 15,000 miles of pipeline, has seen its shares nearly double in value.

With the success of ConocoPhillips' spinoff -- along withMarathon Oil , the downstream offspring of Marathon Petroleum , having turned its year-ago $75 million loss into $755 million in profits -- more than a few observers have wondered why Exxon and Chevron haven't yet gifted their shareholders with separate downstream operations. One of the key reasons is that the tables can be turned year over year or even sequentially, such that upstream and downstream sectors swap sides, with one period's financial engine becoming the next quarter's laggard, or vice versa.

For instance, in the December 2012 quarter, ExxonMobil's $1.34 billion year-over-year boost in downstream profits were sufficient to overcome a $1.07 million dip upstream. But one quarter, or even a year, doesn't constitute a trend. A year earlier, the winds for the company blew in the opposite direction. For the fourth quarter of 2011, the company's GAAP upstream earnings were nearly 14% higher than in its latest quarter, while the contribution from the downstream segment was fully 75% lower.

And while Chevron managed to increase its exploration and production earnings year over year, its downstream results swung from a $61 million loss a year ago to a $925 million gain. That, despite a major fire in August at its Richmond, Calif., refinery.

The latter segment benefited from higher refinery margins, of "crack spreads." That simply means that input costs for crude oil, natural gas, and natural gas liquids all slid to one degree or another, while prices for refined products and chemicals headed higher.

Is last year's hot idea now an absurdity?
A year ago, with Marathon's refinery divestiture still fresh in analysts' and investors' minds, and with ConocoPhillips about to bid adieu to its own downstream operations, there was a push by Wall Streeters at an ExxonMobil meeting for the company to follow suit and spin off its own downstream units. However, CEO Rex Tillerson would hear none of it, maintaining that the integrated model permits the company to obtain the "highest value for each molecule." And he added, "There's no doubt in my mind that the integrated model adds incremental value to everything we do."

Tillerson was clearly referring to the natural hedge that results from housing upstream and downstream efforts under one corporate umbrella. A key result is less variance and increased predictability in a company's cash flows.

None of this is to imply that the two biggest U.S. producers aren't striving constantly to upgrade their downstream assets and to enhance the cross-pollination between their segments. For instance, in the past few years, Exxon has pushed successfully to expand the amount of cheaper West Texas Intermediate crude it uses as a feedstock in its Gulf Coast refineries. And as Chevron CEO John Watson noted as part of his company's quarterly release, "In the downstream business, we completed a multiyear plan to streamline the asset portfolio."

Other benefits
To my way of thinking, there are other benefits to integration as practiced by Exxon and Chevron. Essentially, combined upstream and downstream operations imply greater critical mass than occurs in companies where the operations are separate. An important result, which is likely to increase in importance over time, is a heightened ability to deal with obstreperous national oil companies bent on using sharp elbows in the practice of resource nationalism.

At the same time, the geographic spread that the integrated operators typically achieve can provide a buffer against slowdowns in specific regions. Despite being the biggest U.S. natural gas producer, Exxon has, for instance, weathered the slowdown in onshore U.S. activity far more adroitly than has the more one-dimensionalChesapeake Energy .

Foolish takeaway
I'm hardly arguing that energy-investing Fools should ignore independent producers in favor of our two biggest remaining integrated companies. Indeed, I continue to be a major fan of, for instance, EOG Resources , a successful Houston-based independent that is highly liquids-centric. Rather, my point is simply that the two majors are nicely structured just the way they are, and that Fools would be well advised to consider one or both for the energy portions of their portfolios.

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Fool contributor David Lee Smith has no position in any stocks mentioned. The Motley Fool recommends Chevron and has options on Chesapeake Energy. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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