Warren Buffett, one of the world's most successful investors, has revealed his latest big buy.
Buffett's investment vehicle, Berkshire Hathaway [NYSE: BRK] has bought shares in oil giant Exxon Mobil [NYSE: XOM] worth $3.45bn. Berkshire now owns 0.9% of Exxon.
Buffett's move has triggered a fair bit of excitement about Exxon. The bulls have highlighted the fact that the company trades on a price/earnings multiple of just 11.8 times next year's earnings. It's also paying a 2.7% dividend, well ahead of the average for the S&P 500 index.
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It looks cheap, and Buffett is buying. Those are two good reasons to get excited about any stock.
But I don't think you should follow Buffett's lead. Here's why
Some of Exxon's biggest businesses are struggling
Refining is the worst of the three. Profit margins are thin and look set to stay that way. There is simply too much refining capacity around the world. Things are so bad in this sector that Exxon's refining profits have slumped 81% over the last year.
On the exploration side, oil exploration is also a tough business. Most of the low-hanging fruit was found long ago. If you want to find new oil reserves these days, you have two options.
You can explore in remote locations such as the Arctic or Kazakhstan. Or you can find ways of obtaining oil from fields where extraction was previously considered too difficult.
In fairness to Exxon, it's following both of these approaches. It's exploring in the Arctic as part of a joint venture with Russia's Rosneft, while it's extracting oil from oil sands (an unconventional source of oil) in the Kearl sands project in Canada.
The trouble is, these projects are expensive. Even if a project does eventually strike oil, it can be a long time before the exploration costs are paid off. For example, with its Kashagan project in Kazakhstan, Exxon doesn't expect a decent return until 2040, even although production has already commenced.
Remember also that some oil-producing countries have been keen to develop their own national oil companies. That's made it harder for the likes of Exxon to access fresh oil fields.
Production is the jewel in Exxon's crown but it's still a tough business
But that production can only be sustained if the exploration continues to be successful, and that's a huge challenge. Indeed, production has fallen over the last two years. That decline has only been arrested by production starting at Kearl sands.
So you can't assume for a moment that Exxon is a one-way bet that will carry on producing oil at current levels for generations to come.
And this is all before you throw in the wild card of climate change. It's tough to make any firm predictions here. But there has to be at least a chance that governments will eventually decide to aggressively clamp down on carbon dioxide emissions. One way or another, that won't be good news for any oil company.
I suspect that you might by now be wondering: "But what about shale oil? Hasn't that transformed the energy industry?"
And you're right. The boom in shale oil is a major change and has dramatically increased oil production in the US. Trouble is, Exxon doesn't have a big presence in shale oil, so shareholders can't rely on that, even if Exxon has a stronger position in shale gas.
Exxon might make sense for Buffett but you and I have better options
And with Exxon, he's got a large company, trading on a low rating, which also delivers an excellent 25% return on capital.
But as I'm much poorer than Buffett, I can choose from a much larger universe of potential investments. Given all the things to worry about with Exxon especially its growing costs of production I'd rather put my money in some smaller companies where I think the risks are lower. Over the long-term, I think they'll probably do better.
I mentioned some of the small companies I'm investigating in a recent Money Morning. And if you're interested in playing the shale revolution, my colleague David Stevenson over at the Fleet Street Letter has put together a report on the prospects for fracking in Britain you can read it here.
The Fleet Street Letter is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. 0207 633 3600.
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