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Chevron Corporation (CVX)

Chevron (CVX) was founded in 1879 and became a standalone company after the breakup of Standard Oil in 1911. Today Chevron is one of the largest integrated oil companies in the world, with major operations in 31 countries. The business operates across four segments:

  • U.S. Upstream Operations (27% of 2017 operating earnings): exploring for, developing, and producing crude oil and natural gas; processing, liquefaction, transportation, and regasification associated with liquefied natural gas; and transporting crude and natural gas. 

  • International Upstream Operations: 34% of 2017 operating earnings

  • U.S. Downstream Operations (22% of 2017 operating earnings): refining crude oil into petroleum products; marketing of crude and refined products; transporting crude oil and refined products by pipeline, marine vessel, and rail car; and manufacturing and marketing of commodity petrochemicals, plastics, fuel additives, and lubricants. Last year the company refined about 1.7 million barrels per day of oil and sold about 2.7 million barrels per day of refined products through its thousands of branded gas stations around the globe. 

  • International Downstream: 17% of 2017 operating earnings

In 2017, including the effects of asset sales, Chevron's net production increased 5% to 2.7 million barrels per day of oil equivalent. The company expects 2018's production to rise a further 4% to 7%, driven primarily by Australian liquefied natural gas opportunities and the acceleration of development activities in the Permian.

Chevron has significant net proved reserves in its upstream business that should ensure solid production in the future. These net proved reserves totaled an estimated 12.6 billion barrels of oil equivalent (includes natural gas reserves), representing 11.7 years of production at 2017 levels.

This was up 14% thanks to Chevron's 2017 replacement rate (how much new reserves it discovered/how much it produced), which came in at a very strong 155%. Over the last five years, Chevron's replacement ratio has averaged 107%, helping ensure that the company's production growth can continue increasing in the years ahead. 

Chevron's potential reserves (potentially extractable resources) are also about 68 billion barrels of oil equivalent, keeping its longer-term production prospects bright. 

Business Analysis

It's rare for a cyclical oil & gas company to achieve dividend aristocrat status, which requires at least 25 consecutive years of rising payouts. However, Chevron has managed to reward investors with more than 30 consecutive annual dividend increases thanks to several competitive advantages.

These include being extremely large and diversified, with significant operations all over the world. As a result, Chevron can focus on minimizing its production costs, while raising production rates and growing its earnings and cash flow over time.
Source: Chevron Investor Presentation

Chevron's downstream units also help smooth out the inherent ups and downs of the industry's business cycle because refining and petrochemical margins tend to rise when oil prices fall (lower oil prices hurt profits in the upstream business).

Another key to Chevron's long-term success is the high-quality of its management team. Chevron has consistently proven adept at making smart capital allocation decisions, including demonstrating a strong ability to cut costs during downturns and taking a very disciplined approach to dividend growth.

For example, since the oil crash began in late 2014 (when U.S. oil prices peaked at nearly $110 per barrel versus $60 today), the company has managed to slash its exploration, production, and administrative costs by 20% to more than 50%.
Source: Chevron Investor Presentation

In addition, the company has refocused its much smaller capital spending budget on more profitable growth projects, 75% of which are expected to start generating cash flow within two years of construction starting, and 87% of which are focused on upstream production growth. 

Specifically, Chevron has been investing in the Gorgon and Wheatstone LNG (liquefied natural gas) export terminals in Australia, as well as the Permian basin in the U.S.
Source: Chevron Investor Presentation

Demand for liquified natural gas is booming as emerging markets in Asia (such as China and India) struggle with growing their own power generation capacity while decreasing pollution from coal plants. The U.S. also enjoys significantly lower natural gas costs thanks to shale fracking and horizontal drilling techniques, which have sent domestic supply soaring.

Once completed, Chevron's LNG projects feature very low decline rates (essentially zero), and 95% of the production is under long-term (20 to 30-year) contracts. In fact, Chevron expects its massive investments in LNG to lower its overall production decline rate from 2% historically to just 1% going forward.

In other words, LNG represents a highly stable, recurring, and high-margin source of cash flow that should help stabilize the company's ability to pay safe and growing dividends in the future.

The other major area of growth for Chevron is the U.S. Permian basin, which the fracking revolution has turned into a low-cost and prolific source of cash flow growth for the entire industry. For example, analyst firm IHS Markit estimates that the Permian holds 60 billion to 70 billion barrels of oil and oil equivalents (oil, gas, and gas liquids) that can be extracted using today's technology and commodity prices.

Chevron has just over 2 million acres in the Permian (mostly in the Midland and Delaware formations) and expects to add about 115,000 more in 2018. In the fourt quarter of 2017, Chevron's production from the Permian was 205,000 barrels per day, and the company expects this to rise to more than 700,000 barrels per day within the next decade.

When considering that Chevron's total net production around the world was 2.7 million barrels per day of oil equivalent in 2017, the Permian represents meaningful potential.
Source: Chevron Investor Presentation

Thanks to the oil crash forcing shale producers to innovate to maximize production at minimal cost, Chevron's Permian production is capable of generating 30% rates of return at just $50 U.S. oil prices (currently about $60).

Combined with its cost-cutting initiatives elsewhere, Chevron is confident that it can achieve cash flow break-even (after paying dividends) at just $50 per barrel oil. That's even without asset sales, which have averaged $4 billion to $5 billion a year during the oil crash.
Source: Chevron Investor Presentation

In fact, at current oil prices (U.S. oil $60 per barrel and international oil $65 per barrel), Chevron should be able to generate about $5 billion in excess free cash flow which it can use to both continue raising its dividend (4% increase announced for 2018) and paying down debt taken on during the oil crash.

Like all oil companies, Chevron had to borrow heavily ($23 billion) during the oil crash, when oil prices plunged as much as 76%, to fund its continued investments and dividends. In 2017, Chevron paid down $7.3 billion in debt (16% of its total) and has a long-term plan to maintain a very conservative debt to capital ratio of 20% to 25%.

Management's debt plan is meant to preserve Chevron's AA- credit rating, which allows it to borrow cheaply and maintain the financial flexibility to pay and grow its dividend during both industry booms and busts. Importantly, the company is able to do all of this while still investing in future production growth and growing its long-term reserves by maintaining a reserve replacement ratio above 100%.

Simply put, Chevron's experienced management team has managed to allocate capital in a very efficient manner over the long term. This has allowed the company to generate about 20% average returns on capital over the past five years, and analysts expect Chevron to generate industry-leading $30 per barrel profits over the coming years.

As a result, Chevron should likely provide an increasingly safe dividend, backed by one of the strongest balance sheets in the industry, and could potentially be a reasonable choice for high-yield investors who can tolerate some of the energy sector's volatility.

Key Risks

While Chevron has certainly proven itself to be one of the best run and most shareholder-friendly oil companies in the world, there are still various risks that all oil companies face. 

First and foremost is the fact that their ultimate products - oil, gas, refined products, and petrochemicals - are all commodities. This means their prices are set in international markets, so any oil company's revenue, earnings, and cash flow are ultimately at the mercy of highly volatile commodity cycles that management has essentially no control over. 

Fortunately, the Organization of the Petroleum Exporting Countries (14 nations known as OPEC) and Russia have done a remarkable job of cutting production (about 10%) and actually getting its members to adhere to these cuts (90% or so compliance rate). When combined with an accelerating global economy, global oil supply has now fallen beneath demand and brought down global oil inventories to close to historical levels. 

This is largely why U.S. and international crude prices have recovered so strongly in the past year, greatly benefiting Chevron's cash flows and making its dividend appear more sustainable once again. However, keep in mind that this situation could change relatively quickly in the future, from any one of several potential scenarios including: 

  • A global recession (demand falls below current supply)
  • U.S. shale producers ramp up production too quickly (there are about 7,900 drilled but uncompleted wells that could send production soaring and U.S. rig counts are rising rapidly)
  • OPEC and Russian agreement on lower production (valid through end of 2018) could break down

While Chevron did an admirable job of slashing costs and was able to borrow to maintain its dividend throughout the latest downturn, the company is now potentially more at risk should another industry downturn strike soon.

That's because Chevron has already cut costs to the bone, and there is only so much efficiency that it can achieve. In order to keep growing for the long term, the company will likely have to raise its spending going forward, potentially limiting how much its cash flow can grow.

In addition, Chevron took on a lot of debt during the oil crash and will need to devote a lot of its excess cash flow to paying that down ahead of the next inevitable industry downturn. This is especially true now that interest rates are rising, which increases the cost of refinancing existing debt when it matures. 

Therefore, at least for the next few years, Chevron investors shouldn't necessarily expect to see anything close to the company's long-term (10-year average) dividend growth rate of 7%.

In addition to the inherent volatility of oil earnings and cash flow, there's the fact that Chevron faces numerous operational risks. For example, major oil & gas projects can be extremely complex, meaning that bringing them in on time and on budget can be challenging.

For example, Australian LNG projects, which are a major cornerstone of Chevron's long-term production growth plan, have generated over $50 billion in cost overruns in the past decade.
Source: Financial Times

Add to this the potential risks of operating in politically unstable countries (like Venezuela), industrial accidents, and storms (hurricanes) temporarily disrupting production, and it's not hard to see why these ambitious growth projects could unexpectedly lower earnings and cash flow, at least over the short term. 

Finally, a very long-term risk to consider is the world's increasing shift away from fossil fuels and towards renewable energy. Now given the world's dependence on oil & gas, this risk is likely to take decades before having a material impact on the company, but the trend seems to be clear. 

For example, according to a recent report from analyst firm McKinsey, between 2017 and 2050: 

  • Solar and wind will account for 80% of new energy capacity.
  • Gas demand will grow at 1.4% per year and oil at 0.4% annually through 2050, but overall fossil fuel market share will fall from 82% of all energy use today to 74%.
  • Petrochemical industry will account for 70% of oil demand growth.
  • By 2030, 50% of new cars sold in China, the European Union, and the United States could be partially or fully electric (30% worldwide).
  • Overall global oil demand could peak in 2030.

No single analyst report can be taken as an accurate representation of the future, as they are all educated guesstimates. However, McKinsey's forecasts are far less optimistic than Chevron's growth projections, which call for annual long-term demand growth rates of 2% and 0.7% in gas and oil, respectively. 

The bottom line is that major oil companies have to make large and potentially risky investment decisions years out, but if their projections prove incorrect, then their shareholders (and dividends) could potentially suffer. 

Closing Thoughts on Chevron

The oil & gas industry, especially the upstream component, is hardly conducive to strong, steady, and reliable dividend growth. The highly capital-intensive nature of the business and the inherent volatility of commodity prices make it difficult for most energy companies to be able to commit to a consistent and growing dividend. 

That being said, Chevron has managed to prove itself extremely capable of navigating this industry's booms and busts, helped by its conservative management team, scale advantages (break-even point for cash flow after dividends is just $50 per barrel), and integrated business model. These factors have allowed it to become one of just three dividend aristocrats in the energy sector (ExxonMobil and Helmerich & Payne are the others). 

However, because of the inherent ups and downs built into the business model, oil companies are generally more appropriate for risk tolerant investors since they tend to have very volatile share prices. Furthermore, any investor considering energy companies needs to be mindful about when to purchase shares, with a preference toward investing during an industry downturn (not necessarily after oil prices have recovered meaningfully from their lows).

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