Big oil's big miss: Here are the options now

Oil falls further into bear market territory

ExxonMobil and Chevron reported results well below expectations, and for a simple reason: oil is not cooperating and they are taking write-downs on the value of their oil holdings.

The narrative for Big Oil has been that earnings bottomed in the first quarter, that the companies will benefit from higher oil prices and lower costs with earnings set to recover in 2016-2017.

Except oil is not cooperating.

Workers on a drill site at the Permian basin outside of Midland, Texas
Brittany Sowacke | Bloomberg | Getty Images

Exxon's report of 41 cents was well below expectations of a gain for 64 cents and even below Q1's 43-cent gain. That 23-cent miss between reported and analyst expectations is enormous when you are dealing with almost $58 billion in sales. The vast majority of the miss was due to the upstream (oil production) business, particularly international.

Without getting into too much detail, Chevron is having the same problem. They reported a loss of $2.4 billion on their upstream operations, but $2.8 billion of that was for a write-down on assets.

"The second quarter results reflected lower oil prices and our ongoing adjustment to a lower oil price world," said Chairman and CEO . "In our upstream business,we recorded impairment and other charges on certain assets where revenue from expected oil and gas production is expected to be insufficient to recover costs."

In other words, they are acknowledging that the value of many of their assets are not what they were and they don't think it will return any time soon. This is "lower for longer" applied to the oil business.

Here's a simple way to understand what a pickle the oil producers are in.

Exxon reported operating cash flow — a key industry metric — of $4.5 billion. That is way below expectations of roughly $6.5 billion expected.

Their capital spending was $5.2 billion. Right off the bat, their capital spending is more than their cash flow.

Then there is that enormous dividend — at $3.1 billion, one of the largest on the street.

Here's the math:

Operating cash flow: $4.5 b

Capital spending: $5.2 b

Dividend: $3.1 b

Funding gap: $3.8 b

Simply put, they are borrowing $3.8 billion to pay for the dividend and the remaining capital spending not covered by cash flow.

Of course, Exxon is one of the most creditworthy companies in the world, and rates are low, so they are having no problem borrowing.

But it's still a bad situation. What to do? You can cut costs, which they are doing. And you can also become a more efficient producer, which they are doing. But cost-cutting is ultimately unsatisfying. You are in a sort of slow-motion liquidation, selling assets and not investing in the future.

What else can they do? They can keep selling assets, which they are doing. They can issue more stock. Many have this year. But dilution is not looked upon with favor by investors.

The preferred option, of course, is for oil prices to go up. But no one has any control over this variable, so the oil companies have very low confidence in their oil price projections — as well they should. All they can control is costs.

Is there any other options? Sure, there are — mergers.

"If nothing happens with oil, M&A is the only thing that can save them," Fadel Gheit, energy analyst at Oppenheimer, told me. "If oil is $40 this time next year, there will be a lot of it. The only answer is higher prices, asset sales, more stock offerings or mergers."

Is there any good news? Well, the dividend is safe, as Exxon reiterated on the conference call: "...we remain resolute in our commitment to pay a reliable and growing dividend."