Warren Buffett is loading up on shares of Exxon Mobil (NYSE: XOM). But is that a good reason to buy this oil giant?

Let’s start by understanding what’s happening with Berkshire Hathaway’s investments in big oil. I’ll then present Buffett’s “bullish case” for buying Exxon Mobil shares. And I’ll share a more pessimistic view from one of the most respected short-sellers.

Earlier this month, Berkshire Hathaway (NYSE: BRK-B) reported in a SEC filing that it bought $3.8 billion of Exxon Mobil shares. That makes Exxon the seventh largest public stock investment of Berkshire. With the investment, Warren Buffett’s holding company owns nearly 1% of Exxon.

[ad#Google Adsense 336×280-IA]In the same filing with the SEC, Berkshire announced that it had reduced its position in ConocoPhillips (NYSE: COP) by 44%.

With only $985 million now invested in ConocoPhillips, Buffett clearly sees more upside potential in Exxon.

Everyone knows Exxon Mobil.

It’s the world’s largest oil company and the second most valuable company in the world with a market capitalization of $415 billion.

Its global presence includes onshore and offshore oil wells, refining facilities, and gas stations.

The Bullish Case for Exxon Mobil Shares

With shares trading at around $95, Exxon is valued at 11.9-times next year’s earnings. That gives Exxon shares a 20% discount to the valuation of the S&P 500 index.

In addition to the cheaper valuation, Exxon pays a 2.7% dividend. That compares favorably to the 2% yield from the average stock in the S&P 500 index. In addition to the dividend, Exxon is boosting earnings by repurchasing about $5 billion of its stock every quarter.

In spite of those bullish signs, Exxon stock has been a poor performer. This year, the stock has gained just 7% compared with a 24% return for the S&P 500. Meanwhile, Conoco has gained 25%. Contrarian investors will argue that this poor share price performance means that Exxon shares could be due for a recovery.

Buffett is buying Exxon Mobil shares because it’s a cheap stock that has considerably lagged the market. He clearly thinks that Exxon shares deserve a market-correct multiple. Assuming that he’s right, Exxon shares could be worth about 15 times earnings. That would price shares at $120 or a 25% premium to the recent price.

The Bearish Case for Exxon Mobil Shares

Buffett may be the best investor in the world. I’m a devout follower, and a Berkshire Hathaway shareholder. But I’m not particularly optimistic about the long-term prospects for Exxon.

The bearish case for Exxon has been highlighted in recent years by Jim Chanos. He became one of the most well known short-sellers after publicly calling Enron a fraud. His hedge fund reaped huge profits by shorting the stock. While Chanos doesn’t view Exxon as a fraud, he believes that the business of big oil is in decline.

The reason is that new oil and gas discoveries are harder to find. This makes it more expensive to replace dwindling oil reserves.

The deteriorating economics of the big oil business is becoming more evident. One way to measure this is by looking at Exxon’s return on capital. This measures the investment returns from capital for growth projects. At Exxon, the return on capital has dropped from 27% in 2008 to 18.7% last year.

It also appears that Exxon is living beyond its financial means. For example, last year Exxon spent nearly $31 billion on dividends and the stock buyback program. But the free cash flow was just $22 billion. Some simple subtraction shows us that there is a $9 billion gap.

Exxon has plenty of cash and access to the debt markets to fund this gap. But over the long term, I’m skeptical of a business where expenses exceed the cash flow. Sooner or later the cash flow must fund the dividend and buyback program.

I won’t be buying Exxon Mobil shares in my investment portfolio. But Berkshire Hathaway remains one of my top value stocks. And I’ll continue to own the stock despite my views on Exxon.

Income investors who are excited about the American energy boom would be better off looking at Master Limited Partnerships (MLPs). Companies like Kinder Morgan Energy Partners (NYSE: KMP) with a 6.6% yield or Williams Companies (NYSE: WMB) with a 4.3% yield look far more attractive.

— Ian Wyatt


Source: Wyatt Investment Research