FORTUNE 500 2007  
FORTUNE 500    

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

(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.