Chevron: A Big Value in Big Oil
Chevron (CVX) is the third-largest integrated oil company in the U.S. and the fifth-largest in the world—as well as the fifth-largest natural gas producer in North America. The company has a strong global presence in refining, marketing and transportation—with retail marketing under the Chevron, Texaco, and Caltex brands.
While the company's exploration and production earnings have been from hurt by the sharp drop in crude oil and natural gas prices, as well as reduced production rates reflecting damage from September 2008, Gulf of Mexico hurricanes, its diversification into downstream businesses has helped offset these losses, and lower crude oil feedstock costs have benefited its refining and marketing businesses.
We believe Chevron will benefit from improved industry fundamentals and higher commodity prices through its exploration and production activities. With Gulf of Mexico oil and gas production being restored, and several upstream projects slated to start up, we expect Chevron's oil and gas production will increase about 4% in 2009, and we look for annual production growth of 2% to 3% between 2007 and 2012. We believe the drop in oil prices over the past month(s) to the low $30-per-barrel range was excessive, and expect West Texas Intermediate (WTI) oil prices will average around $40 in 2009, and trend even higher in 2010 and beyond—averaging above $90 per barrel in 2014 and thereafter.
The stock recently traded at 65. A blend of our direct and relative valuation methods leads us to our 12-month target price for Chevron's shares of 95. The value represents potential appreciation of about 45% from current price levels, and an expected enterprise value of 7.5 times our 2009 earnings before interest, taxes, depreciation, and amortization (EBITDA) estimate, a discount to Chevron's U.S. supermajor oil peers. We believe that the company's high degree of earnings and dividend growth and stability (it has an A- ranking under the S&P Quality Ranking system) justifies a higher multiple than Chevron's stock currently receives in the market and that its shares are undervalued reflecting weakness in its upstream business. In addition, the shares recently had a dividend yield of about 4.0%.
The stock carries Standard & Poor's highest investment recommendation of 5 STARS (strong buy).
Our fundamental outlook for the Integrated Oil & Gas subindustry for the next 12 months is positive, as we see reduced upstream earnings being offset by increased downstream results. While we expect the profits of the U.S.-based integrated oils will drop more than 50% in 2009, we look for a rebound of over 50% in 2010 on higher projected pricing amid an improved economic outlook and continued upstream volume growth.
With the effects of the credit crisis spreading, impacts across the energy sector have intensified. Budgets are being cut, and it is difficult to expand oil and gas production. We are pessimistic about future supply trends, which we expect will put upward pressure on oil prices when demand rebounds. In the meantime, we think the slippage in supply is not enough to offset reduced global demand—focusing attention on OPEC compliance.
The current global economic slowdown has led to further reductions in global energy demand and energy prices. As of February 2009, IHS Global Insight, an economic and financial analysis firm, estimated that reduced consumption in the Organization for Economic Cooperation & Development (OECD) nations would lead global oil demand down by 0.84 million barrels per day (b/d), to 84.87 million b/d in 2009, and that OPEC cuts would lead global oil supply down by 1.67 million b/d, to 84.93 million b/d, in 2009.
As of Feb. 10, using a blend of data from the U.S. Energy Information Administration and IHS Global Insight, we estimate that WTI spot oil prices will average about $40 per barrel in 2009, $53 in 2010, and $61 in 2011. Risks to our forecasts to the downside include an extended worldwide economic downturn and limited OPEC output cuts. However, upward pressure on prices may occur if the world economy recovers sooner than anticipated, a major supply disruption occurs, or if OPEC aggressively cuts output.
While oil and gas prices continued to pressure earnings for energy companies, as of February 2009, Energy was one of the most attractively valued sectors within the S&P 500 index, in our view, with a forward price-earnings ratio of 11.3 times, vs. a multiple for the overall index of 12.2 times. Year to date through Feb. 13, the S&P Integrated Oil & Gas subindustry index declined 6.3%, outperforming an 8.4% drop for the S&P 1500 Composite index. In 2008, the subindustry index also outperformed, decreasing 23.5%, vs. a 38.2% fall for the S&P 1500.
In October 2001, Chevron and Texaco merged, creating the second-largest U.S.-based oil company at the time, ChevronTexaco. As separate companies, we believe Chevron and Texaco had positive future prospects, but as a combined entity, it was positioned for even stronger returns. In May 2005, the company changed its name to Chevron.
In August 2005, Chevron completed its merger with Unocal in a deal valued near $17.3 billion, and the company became one of the largest resource holders in Asia and the largest producer in the Caspian, with stronger positions in the Gulf of Mexico and mid-continent U.S. The combination also made the company one of the largest renewable energy producers in the world, and we believe Chevron will benefit from increased interest and funding for alternative and renewable energy projects.
Chevron separately manages its exploration and production (26% of 2007 revenues; 79% of 2007 segment income); refining, marketing and transportation (72%; 19%); chemicals (1%; 2%); and other businesses, which includes its mining operations of coal and other minerals, power generation, insurance and real estate operations, and technical companies.
Reflecting what we view as a solid queue of upstream growth projects, capital spending totaled $22.8 billion in 2008; Chevron has budgeted about $22.8 billion (77% for exploration and production) for 2009.
We expect aftertax operating earnings will drop 38% in 2009 on lower projected oil and gas prices before rising about 5% in 2010 on our higher price forecast and an improved economic outlook.
Exploration & Production
We have a positive outlook for Chevron's upstream business based on our view of its strong array of exploration and development projects, contributions from its 2005 acquisition of Unocal, and its "Big Five" upstream development projects in Angola, Kazakhstan, Nigeria, the Gulf of Mexico, and Australia. The company is also expanding into non-conventional oil production from Canadian oil sands to global liquefied natural gas (LNG) projects.
Further, improved technology (such as 3-D seismic, directional drilling, and artificial lift) has enabled the company to discover and develop plays in the Lower Tertiary trend in the deepwater Gulf of Mexico, such as the Jack and Saint Malo plays. Early indications are that these plays may be the largest North American finds since Prudhoe Bay, and there are more Lower Tertiary prospects being studied.
Chevron is developing more than 40 projects with net capital investment of over $1 billion or more each. Of these projects, three (Blind Faith in the Gulf of Mexico, the Sour Gas Injection/Second Generation Plant in Kazakhstan, and Agbami in Nigeria) increased capacity in 2008. In 2009, Tombua Landana in Angola, Frade in Brazil, and Tahiti in the Gulf of Mexico are expected to come on line.
Net production of crude oil, natural gas liquids (NGLs) and natural gas rose 1.3%, to 3.272 million barrel-oil equivalent (boe) per day (68% liquids), including equity share in affiliates, in 2007. Net proved oil and gas reserves, excluding equity share in affiliates, declined 8.8%, to 7.86 million boe (59% liquids, 64% developed), as of Dec. 31, 2007. Using data from John S. Herold, an independent petroleum research and consulting firm, we estimate Chevron's three-year (2005-07) reserve replacement rate at 105%, below the peer average; its three-year finding and development costs at $48.45 per boe, above the peer average; its three-year proved acquisition costs at $6.91 per boe, above the peer average; and its reserve replacement costs at $19.00 per boe, above the peer average. In January 2009, Chevron estimated its 2008 overall reserve replacement rate at 146% (80% organic), including year-end pricing effects.
Refining, Marketing & Transportation
As of Dec. 31, 2007, Chevron owned 10 refineries and two asphalt plants, and had interests in 12 international refineries, for a total production refining capacity of 2.115 million b/d (50% North America). As of yearend 2007, it had a network of 25,082 retail sites (including equity affiliates) worldwide.
About three-fourths of Chevron's refining capacity is located in areas of the world that are expected to account for about half of the world's growth in energy demand. Many of its refineries are complex, and capable of converting significant volumes of lower-quality heavy and sour crude into a variety of low-sulfur, higher-value, refined petroleum products.
In 2000, Chevron and Phillips Petroleum (Conoco and Phillips Petroleum merged in 2002) combined their chemical operations into a 50/50 joint venture, called Chevron Phillips Chemical (CPChem). By the end of 2007, CPChem owned or had joint ventures in 30 manufacturing facilities and six research and technical centers in Belgium, China, Puerto Rico, Qatar, Saudi Arabia, Singapore, South Korea, and the U.S.
Other businesses include the company's U.S.-based mining company and its power generation business. Chevron has major geothermal operations in Indonesia and the Philippines and is investigating several advanced solar technologies.
Chevron Energy Solutions (CES) provides public institutions and businesses with projects designed to increase energy efficiency and reliability, reduce energy costs, and utilize renewable and alternative power technologies.
Our 12-month target price of 95 per share is derived by blending our net asset valuation into our more heavily weighted discounted cash flow and relative multiple valuations reflecting overall equity market conditions. The result represents an expected enterprise value of 7.5 times our 2009 EBITDA estimate, a discount to Chevron's U.S. supermajor peers, ExxonMobil (XOM) and ConocoPhillips (COP).
We believe Chevron's corporate governance practices are sound, and above average for companies within the S&P 500 and S&P Energy sector. Its board of directors is controlled by a supermajority of independent outsiders (independent outsiders are greater than 75% of the board).
In addition, the nominating and compensation committees are made up solely of independent outside directors; the company has a committee that oversees governance issues, and the committee met in the past year; the full board is elected annually; the CEO serves on the boards of two or fewer other companies; no former CEO of the company serves on the board; the company has governance guidelines that have been publicly disclosed on the company's Web site; the performance of the board is reviewed annually; outside directors meet without the CEO present, and the number of meetings of the outside directors is specified; a board-approved CEO succession plan is in place; and the company conducts performance reviews of individual directors.
However, shareholders do not have cumulative voting rights in director elections, the positions of chairman and CEO are combined, and the board is authorized to increase or decrease the size of the board without shareholder approval.
Risks to our recommendation and target price include geopolitical risk associated with the company's international operations and interests, changes in economic and industry conditions (including commodity price and refining margin volatility), an inability to achieve upstream production growth and cost targets (including the company's success at replacing its reserves through the drill bit), and operational risk from several large development projects.