Oil majors’ misery shows what the market is worried about
A 'capital light' recovery has left the US economy with a backlog of capital spending; companies now have to play catch up
The worst performer on the Dow-Jones Average at close on Monday was Exxon Mobil, which already had taken a beating last week after it reported disappointing earnings. Today’s price decline of 5.69% brings the three-day decline in the stock to more than 10%. Exxon isn’t the only disappointing performer, to be sure, but it’s a poster child for market fears.
Exxon cut its capital spending from about $35 billion during 2011-2014 to barely $15 billion in 2016 after the oil price collapse. Correspondingly, oilfield equipment manufacturers and oil service companies have been underperformers.
There’s no real sign of a recovery in the overall volume of oilfield investment. As of the most recent data, orders for oilfield equipment are still running at only $1 billion a month, about a third the level during the oil boom. Construction equipment orders, which also reflect oil investment, are also well below peak.
There’s no indication that the oilfield equipment producers are making much money, either. The iShares ETF for oil equipment manufacturers and service companies (ticker IEZ) hasn’t risen along with oil prices.
The forward price-earnings ratio for this ETF is over 140, which means that investors are betting on an big bounce in orders. That hasn’t materialized.
The most likely explanation for Exxon’s disappointing performance is that the energy giant, formerly America’s largest company by market capitalization, cut corners in capital investment and failed to meet its production targets. We don’t know this for sure, but the evidence points towards this conclusion.
Capital investment during the Obama recovery never came close to the previous peaks. The chart below shows nondefense capital goods orders, a proxy for capital investment, adjusted for the private capital goods deflator. In real terms capital spending by this gauge is still 25% below the 1999 peak and 15% below the 2007 peak.
The “capital light” recovery has left large parts of the US economy with a backlog of capital spending. This causes execution problems, for example Chevron’s and Exxon’s unexpectedly low output of oil. It also requires catch-up spending, as UPS admitted in a market-moving announcement on Thursday.
The US economy, in short, has run into selective capacity constraints that make future earnings growth dicier. With the S&P trading at 18 times forward earnings, uncertainty about earnings is a big negative for equity prices.