Monday, April 23, 2007

Exxon = oil, g*dammit!
Unlike its rivals, Exxon Mobil doesn't much care about alternative fuels and doesn't try to please the greens. Is CEO Rex Tillerson nuts - or shrewd?
By Geoff Colvin, Fortune senior editor-at-large
April 23 2007: 6:36 AM EDT

(Fortune Magazine) -- Rex Tillerson is way out of line, and he knows it. "They want us to join the parade," he says, referring to assorted environmentalists, scientists, politicians, investors and others who've been lambasting him and the company he heads, Exxon Mobil. He knows what they're saying about him, and he repeats it: "Get in line. You're outta line right now - get in line."

Why Tillerson refuses to run Exxon (Charts, Fortune 500) the way other CEOs are running other giant oil companies is for many people the most baffling and even infuriating question about the world's most profitable corporation.

The basic model for managing an oil company in this eco-conscious age became clear a few years ago when Britain's BP (Charts) loudly declared itself to be "beyond petroleum." The other supermajors are all proclaiming their greenness and investing in biofuels, wind power and solar power. Exxon isn't. It only recently acknowledged publicly that - brace yourself - the world is warming. Beyond petroleum? At Exxon it's all petroleum.

It does seem strange that such a high-profile corporation could be so egregiously not with the program. The pressure to conform arguably increases because Exxon is doing so well. In 2006 it earned higher profits than any company in history: $39.5 billion. That's more than the GDP of Yemen and Bahrain combined.

A year to remember in financial terms, but in other ways Exxon had to endure some truly miserable moments. Reports of former CEO Lee Raymond's exit package, worth some $400 million, stoked outrage across the political spectrum. Senators Jay Rockefeller (D-West Virginia) and Olympia Snowe (R-Maine) sent Tillerson a long letter berating the company for funding groups dubious of global warming. (The irony of a Rockefeller attacking Exxon ensured extra attention for the story: Exxon is a descendant of Standard Oil, source of the Rockefeller family fortune.) Legislators in Washington, D.C., and several states proposed windfall-profit taxes on oil companies; the notion stood little chance of becoming law but signaled powerful hostility. Through it all, Tillerson remained defiantly, even proudly, out of line.

And maybe he's not nuts.

His company is shaped above all by a rigorous analytical culture. "Exxon Mobil is not a fun place to work," says Fadel Gheit, the Oppenheimer & Co. oil industry analyst widely considered Wall Street's best. "They're not in the fun business," he explains. "They're in the profit business."

Remember that. It means that Exxon understands the essence of capitalism: earning a return on capital that exceeds the cost of that capital. At this supremely important job, it is a world champion. All the major oil companies bear about the same capital cost, just over 6%. But Exxon earns a return that trounces its competitors.

The reasons are many. Partly it's the portfolio of locations - some acquired in the Middle East decades ago - at which Exxon can pump oil for less than $1 a barrel. Partly it's wise business bets on building refineries and petrochemical plants as vast single units that achieve tremendous efficiencies; most other big oil companies separate refineries from chemical plants. Partly it's that intensely focused corporate culture.

Gheit, who worked for Mobil long before the companies merged, recalls being mystified by Exxon's X factor. "We [Mobil] could be pumping oil from the same platform, and they'd make more money on it than us," he says. "It was like taking the same train to work, but they got to the office first."

Exxon not only earns better returns on capital than its competitors, but also deploys more capital than any of them (although Royal Dutch Shell (Charts) is close). That combination - higher returns on more capital - yields Exxon way more money than its competitors that it can use to invest in future projects or reward shareholders directly by paying dividends and buying back stock. And it is why Exxon has become the most valuable company on earth, with a current market cap of about $440 billion.

As a financial picture, it's a thing of beauty. Alas, it is one that needs constant attention: Investors expect Exxon to keep performing at that level. The price of any stock is based on an evaluation of the future. Exxon's high price (about $77, up almost 30% in the past year) means the market is counting on it to continue its run. If Exxon even hints that it might stumble, the stock could collapse. As Tillerson says during an interview in his Houston office, "We're only going to invest our shareholders' money where we think they can get the kind of returns they expected when they invested their money with Exxon Mobil."

Which brings us to the biggest beef Exxon's critics have: Why isn't the company investing in less polluting energy sources like biofuels, wind, and solar? Remembering that Exxon is above all in the profit business, we know where to look for the answer. As a place to earn knockout returns on capital, alternative energy looks wobbly. For example, the darling of the moment, ethanol, is nowhere near economically competitive with gasoline (and may not be better environmentally, because it is fuel- and land-intensive to produce). Take out the 51-cents-a-gallon federal subsidy, and the true cost of U.S.-produced ethanol is equivalent to paying $6 a gallon for the same energy as gasoline, calculates Michael B. McElroy, Harvard professor of environmental studies. Even subsidies granted for national security reasons can come and go. To a disciplined investor, such a product is not especially attractive. "I don't have a lot of technology to add to moonshine," says Tillerson of ethanol.

It's a similar story for alternative fuels for power generation. Solar-generated electricity is still way costlier than juice from traditional coal- and gas-fueled plants. Wind power is narrowing the gap but is difficult to scale up. Hydro and biomass are clean and fully competitive on cost - but Exxon just doesn't know much about building dams or burning agricultural waste. Its expertise is in oil and gas, as exemplified by its world-class Upstream Research Center in Houston; the company is happy to leave the alternative stuff to others.

"What are we going to bring to this area to create value for our shareholders that's differentiating?" asks Tillerson. "Because to just go in and invest like everybody else - well, why would a shareholder want to own Exxon Mobil?"

At least one group of investors thinks Tillerson is missing the bigger picture. By not investing in new energy technologies, Exxon "lags far behind its competitors in developing a strategy to plan for and manage" the potential impact of climate change, argued a group of pension fund chiefs in a letter to the board. If governments around the world begin to bear down on Exxon's oil-based business - through heavier regulation or taxation - then the company's return-on-investment calculations get turned upside down. Its whole future would be in jeopardy.

That will not happen, says Exxon, because it cannot happen. Exxon is certain that oil, gas and coal will remain the world's dominant energy sources for decades to come.

That belief drives the company's critics crazy. But Exxon's projections are not radical. A forthcoming report from the U.S. Climate Change Science Program cites three of the most widely used models for climate change analysis: one from MIT, another developed jointly by the Pacific Northwest National Laboratory and the University of Maryland, and a third created by Stanford University and the Electric Power Research Institute. The studies do not agree on everything but they do agree on this: Fossil fuels will remain the planet's No. 1 energy source through the 21st century, supplying 70% to 80% of the total by 2100, vs. about 90% today. Exxon forecasts only as far as 2030; in that year, it projects, primary energy sources such as coal, oil and gas will account for 81% of global demand.

That's another reason Exxon isn't investing in alternative energy sources: They don't look big enough. For a company Exxon's size - No. 2 on the Fortune 500 - businesses of less than mammoth scale don't merit troubling with because they can't nudge the bottom line.

It's worth noting that the company carries no genetic hatred of alternative energy. In the wake of the 1970s oil shocks, it conducted major research in solar energy, and it holds dozens of patents in the field. But it couldn't see how to earn a profit, and shut the program down. That experience also thickened the company's skin. While greens today vilify Exxon for not investing in solar power, back then they attacked the company for investing in it. The theory was that oil companies would monopolize solar and then withhold its benefits from the public to sell more oil.

Exxon avoids investment in alternative energy sources for yet another reason, one that reaches deep into the company's experience: Much depends on the future price of oil, and no one knows what it will be. Consider two scenarios. If oil dropped to $25 a barrel - about what it was (in today's dollars) just before 9/11 - alternative energy would look even less attractive economically. Exxon's decision not to invest would look all the wiser, but its oil-related profits would shrink. Conversely, if oil rose to $100, its profits would rise but many alternative energy sources would become economically viable - and Exxon wouldn't be able to capitalize on them.

The company considers low-price oil the greater risk. Experience has shown that when oil prices rise, customers are slow to cut back. Alternative energy may sell better in a high-oil-price world, but Exxon wouldn't care, since it believes those sources are destined to be small-scale - and it would be making huge profits in its traditional business.

Of course, no one knows the future price of oil. Says Tillerson: "We tell the organization, 'Folks, we really don't have a clue what the price of oil is going to be, and so given that, how should we run this business?' "

The answer is spelled out in a recent SEC filing: "Investment opportunities are tested against a variety of market conditions, including low-price scenarios. As a result, investments that would succeed only in highly favorable price environments are screened out of the investment plan." Alternative energy sources are precisely such investments.

Exxon does have a strategy for a carbon-constrained world; it just has nothing to do with alternative energy. The company's scientists are researching how to reduce CO2 emissions from oil and gas, and working with auto companies to make engines more efficient. Unlike, say, biomass or windmills, those are fields in which Exxon commands formidable expertise.

The whole process of Exxon's investment choices - the extraordinary returns on capital, the disciplined analysis, the spurning of alternative energy, the focus on the core business - hasn't changed in 20 years. One important thing, however, has changed: Exxon's public stance on global warming. Substantively, that's nothing compared with how the company directs its $20 billion of annual investment, and it doesn't make it one bit greener. But the company clearly realizes that it took a shellacking for no good reason and is trying, in its unique, Exxonish way, to do something about it.

The most important change is simply admitting the world is heating up. Ken Cohen, the company's communications chief, insists there is nothing new here: "Lee Raymond has said for many years that this is a serious issue." But Raymond never said, as far as we can tell, the simple words Rex Tillerson uttered at an energy conference in February: "We know our climate is changing, the average temperature of the earth is rising, and greenhouse-gas emissions are increasing."

That sentence would be a great big "duh" coming from anyone but the CEO of Exxon. For him, it signals a new corporate public relations strategy: The reality of warming is no longer debatable, and it's time to move on. That's a significant change.

Exxon's most stinging critics, such as Greenpeace and the Union of Concerned Scientists, have charged for years that the company has funded a range of global-warming doubters and deniers, and it's true. Public documents show that Exxon has long given money to organizations that publish papers, run websites, and write letters contending that global warming isn't happening, or isn't proven, or isn't connected to human activity. The company recently stopped funding some of those outfits - "about a half-dozen," says Cohen - though it may still be financing others. (Disclosure filings for 2006 are not available yet.) But at least publicly, Exxon accepts that the risk that human activity is warming the earth is great enough to warrant a response.

Exxon officials who once wouldn't acknowledge warming now publicly discuss the merits of, say, a carbon-cap-and-trade system vs. a carbon tax (they seem to favor the latter). They are even initiating meeting with critics they once shunned, including environmentalists and religious investors. Cohen has held a number of conference calls with bloggers on energy and climate. "I'm still fairly dubious," wrote blogger Stuart Staniford of the Oil Drum in a typical response, "but I also appreciate that they have been courteous and willing to sit through a couple of very frank exchanges of views."

Not that any of this has quieted Exxon's many critics. "I'm not sure I know what we're ever going to do that's going to cause them to have a different opinion about us," says Tillerson. "We may serve some other useful purpose." But Greenpeace research director Kert Davies says his organization doesn't need Exxon as an evil opponent. "I would love nothing more than for them to change their position and help us fix global warming," he says.

An alliance with Greenpeace is hardly imminent, but relations are more likely to warm under Tillerson than under his predecessor, the notoriously grumpy Lee Raymond. Tillerson, a native Texan and Exxon lifer who made his mark managing successful production deals in Yemen and Russia, has a softer edge. He often lets a grin break through his sober engineer's demeanor. If not exactly a barrel of laughs, Tillerson is much more likely to make friends. "He can disagree with you, but he does it with a smile," says Oppenheimer's Gheit. "He can tell you you're an idiot, but he doesn't make you feel like an idiot. That's the difference from Raymond."

Exxon's new attitude, though, still doesn't feel like much. With environmental news making headlines daily, with major competitors celebrating their work on alternative fuels, and with government leaders banging the green drum, Exxon's public stance seems somewhat oblivious. In truth, the company could say much more.

It could, for example, play up its $100 million in funding, over ten years, of Stanford's Global Climate and Energy Project, which conducts research into alternative fuels, including cellulosic ethanol. Or talk about its carbon-capture research with the EU. Or brag about how its operational improvements have reduced emissions. Or publish splashy ads, with lots of green ink, about its research into emissions-cutting technology and fuel efficiency. Why not out-BP BP - particularly since BP's image is looking rather frayed, given its now well-known operational issues?

Rex Tillerson answers before the question is even finished. "Intellectually, it's just not us," he says. "It's just not me, it's not Exxon Mobil. It's not the people of Exxon Mobil. We just don't take a view that we should try to paint a picture of something other than what we are." In other words, we're comfortable with ourselves and our actions, and you may make of us what you like.

Risky business
Thus, Exxon steams serenely forward on a course all its own, maddening critics, puzzling competitors, and gratifying investors. To adversaries like shareholder advocate Robert Monks, that's a sign of its arrogance and unmatched power. "Exxon is the single enterprise least accountable in any effective way to anybody outside itself," he says. "Vladimir Putin has more accountability than they do." To admirers like Fadel Gheit, it's a mark of Exxon's rigorous culture and a key to its success. "Exxon Mobil is not like other companies," he says. "They never take a day off." Both men have a point.

Maybe Tillerson will be proved wrong. Maybe wind or solar or "moonshine" will turn into huge businesses in which Exxon will lag far behind. Maybe retail customers will abandon its products out of irritation. But Tillerson is convinced that his judgments, which may seem out of line today, are not risky at all. And when you do the analysis from the perspective of a company in the profit business, it's hard to say he's wrong.