Chevron Maintains Capital Discipline While Delivering Growth; Increasing Fair Value
Chevron Maintains Capital Discipline While Delivering Growth; Increasing Fair Value Estimate
Business Strategy and Outlook | by Allen Good Updated Mar 20, 2023
We expect Chevron to deliver higher returns and margin expansion thanks to an oil-leveraged portfolio as well as the next phase of growth, which is focused on developing its large, advantaged Permian Basin position.
Its latest capital plan maintains its focus on capital discipline without sacrificing growth. Thanks to improved cost efficiencies and the acquisition of Noble Energy, Chevron plans to grow production to nearly 4.0 million barrels of oil equivalent per day by 2027 from about 3.0 mmboe/d in 2023. New volumes will largely come from new production from its differentiated Permian Basin position (size, quality, and lack of royalties), where it expects to grow volumes to 1.25 mmboe/d by 2027 from about 700 mboe/d in 2022 while delivering returns of nearly 30% and about $5 billion of free cash flow by 2027.
Chevron's Permian growth will be supplemented by expansion projects at Tengiz in Kazakhstan, due to begin producing in mid-2023, new developments in the Gulf of Mexico, and potential new discoveries in Mexico and Brazil. Chevron also now has growth options with offshore gas fields in the Eastern Mediterranean with the Noble acquisition.
Oil and gas prices will dictate Chevron’s earnings and cash flow for the foreseeable future. However, the company is investing in low-carbon businesses to adapt to the energy transition. It recently tripled its investment to $10 billion cumulatively by 2028, with this capital flowing to emerging low-carbon areas that fit with Chevron’s existing value chains and experience. Greenhouse gas reduction projects and carbon capture and offset will enable Chevron to achieve its emission targets while investments in hydrogen and renewable fuels will give it a toehold in emerging businesses that could expand in the future.
Chevron expects the combination of new higher-margin projects along with ongoing cost reductions and operational improvements to drive return on capital employed to above 12% by 2027. Meanwhile, strong free cash flow will go toward steady dividend growth and repurchases, demonstrating management’s ongoing commitment to capital discipline and shareholder returns.
Economic Moat | by Allen Good Updated Mar 20, 2023
Chevron’s returns on capital have suffered from 2015 to 2020 as a period of high investment was followed by one of low commodity prices. Although it was able to reset its cost structure in the wake of the 2015 collapse in prices, it has not been able to do enough to lift returns back to historical levels when oil prices averaged $100 a barrel. However, we continue to rate Chevron as a narrow-moat company as we think during the next 10 years it will be able to deliver excess returns, albeit well below historical levels, on a combination of an improved cost structure and addition of higher-return production volumes. Chevron is only targeting a return on capital employed of at least 12% by 2027, assuming $60/bbl, much lower than the 16% average from 2010-14 but improved from the 3.5% average from 2015-19. We forecast our return on invested capital metric used to evaluate moats to remain above the cost of capital during the next five years and rise to 12% by 2027, compared with our cost of capital assumption of 7.3%, sufficient for it to earn a narrow moat rating.
Although Chevron is an integrated energy company, its narrow economic moat largely rests on the quality of its upstream portfolio. Chevron’s upstream segment holds a low-cost position based on an evaluation of its oil- and gas-producing assets. Its greater exposure to liquids and liquids-linked natural gas production, accounting for over 70% of total volumes, has produced peer-leading cash margins and returns of nearly 20% historically. Since 2015, however, returns have suffered in part as oil prices have fallen, but also due to overinvestment at the peak of the last cycle.
The best examples are Chevron’s LNG projects Gorgon and Wheatstone in Western Australia. Combined the two projects added about 400 mboe/d of production capacity with high margins thanks to contractually set, liquids-based pricing. The projects were already low-return and capital-intensive given the costs associated with timing, location, and complexity, but their returns were depressed further by large cost overruns. As a result, full-cycle returns are likely to be only marginally above the cost of capital, weighing on overall segment and firm returns even as they contribute to higher per-barrel margins.
Overall segment returns should improve, however, thanks to higher oil prices during the next five years and the addition of higher-return projects. Newer projects have superior economics and can earn higher returns at lower oil prices after rounds of cost reductions, re-engineering (standardization and simplification), and service price deflation.
Outside the Permian, growth during the next five years should largely come from the expansion of its Tengiz project in Kazakhstan, which adds high-margin oil volumes at low break-even prices. Also, its past exploration success in the Gulf of Mexico endows it with a large set of brownfield development opportunities that are economical at less than $45/bbl. Beyond the next five years, Chevron also has opportunities for incremental capacity increases at its Australian LNG projects, which should be high return and a new, large resource basin in the Mediterranean natural gas reserves acquired with Noble for development.
Chevron’s downstream operations consist of its refining and marketing portfolio, and its interest in the Chevron Phillips Chemical joint venture. Compared with peers, its downstream segment is relatively small with only 1.8 mmboe/d of refining capacity and few owned retail sites. We typically do not consider refining to be a business capable of earning a moat, with the exception of some U.S. refineries that hold a feedstock cost advantage. While Chevron does hold some refineries that qualify on the Gulf Coast and in the midcontinent, the bulk of its capacity does not have such an advantage, given that it is located in California. However, in past years it has improved the performance of its operations, divested lower quality assets and improved returns. Meanwhile, the CPChem joint venture is a high-quality chemical manufacturer with low-cost feedstock access in the U.S. and Middle East. While its earnings contribution is small relative to the upstream segment (30% by our forecast in 2030), it generated strong returns on capital of 18% from 2011 to 2019. We forecast at midcycle levels, returns will approach 18%, supporting Chevon’s narrow moat rating.
Chevron is exposed to several environmental, social, and governance-related risks, but these do not imperil its moat, in our view, as most fall outside the 10-year narrow-moat window or are not probable or material enough risk to cause material value destruction. Chevron’s primary ESG risk stems from carbon emissions in its operations and use of its products, emissions, effluents and waste generated in operations such as oil spills and poor community relations.
The risk from carbon emissions is most likely to materialize through a carbon tax, which increases the price of end products to consumers, reducing demand over time and threatening Chevron’s core business. We expect carbon taxes to gain greater adoption over time, but think the impact on hydrocarbon demand remains more than a decade away. Chevron’s upstream greenhouse gas intensity is rather high for its peer group at 29 kilograms CO2e/boe (2021), making it a higher cost producer. However, it is investing efforts to improve its emissions intensity, reduce methane leakage and reduce flaring, but lacks the very long-term targets of some of its peers as well as plans to diversify away from hydrocarbons. It aims to reduce its upstream emissions intensity to 24 kg CO2e/boe by 2028 or about 35% from 2016 levels and be net zero by 2050. That just covers scope 1 and 2 emissions, however; about 90% of emissions from oil and natural gas occur during combustion (scope 3), which the company can do little about.
Chevron recently tripled its low-carbon investment to $10 billion cumulatively by 2028 to fund projects in the areas of greenhouse gas reduction, carbon capture and offset, hydrogen, and renewable fuels. The amount is less than some peers but is more focused on areas that are tangential to Chevron’s core hydrocarbon business or in the value chains it currently participates. Although these areas are still in the early stages and outcomes are uncertain, they hold greater potential for high returns and competitive advantages than more mature areas such as renewable power, where many other integrated oils are investing. Chevron expects these investments to deliver over $1 billion on operating cash flow by 2030, but given their relatively small size and uncertain future, they do not factor into our narrow moat rating.
Oil spills are an ever-present risk for oil companies operating offshore and can be devastating to firm value, as BP’s Macondo incident in the Gulf of Mexico shows. While oil companies regularly cause spills, most are immaterial in size and associated fines and cleanup costs are manageable. Large spills such as Macondo are very rare and do not factor into any of our scenario modeling.
Fair Value and Profit Drivers | by Allen Good Updated Mar 20, 2023
We are increasing our fair value estimate to $161 per share from $149 after incorporating the latest strategic guidance and financial results into our model as well as updated commodity prices. Our fair value estimate implies a forward enterprise value/EBITDA multiple of 6.6 times our 2023 EBITDA forecast of $45.4 billion.
Our fair value estimate is derived using Morningstar's standard three-stage discounted cash flow methodology. With this methodology, a terminal value is derived using our assumptions for long-term earnings growth and return on new invested capital. This valuation methodology also more explicitly incorporates our moat rating, which reflects how long we expect a given firm to deliver excess returns on invested capital from a discounted cash flow analysis.
In our DCF model, we assume U.S. natural gas prices of $3.03 per thousand cubic feet in 2023 and $3.55 in 2024. Our long-term assumption is $3.30 beginning in 2025. For oil, we assume Brent prices of $78 per barrel in 2023 and $73 per barrel in 2024. Our long-term oil price assumption is $60 per barrel. We assume a cost of equity of 7.5% and weighted average cost of capital of 7.3%.
Chevron's latest plans call for production of nearly 4.0 mmboe/d in 2027 due to completion of the Tengiz expansion and Permian growth to 1.25 mmboe/d. We model a gradual return to normalized downstream earnings by 2025.
Risk and Uncertainty | by Allen Good Updated Mar 20, 2023
Chevron holds a High Morningstar Uncertainty Rating based on fundamental exposure to commodity prices, evaluation of ESG risks, and the range of return outcomes used by our star rating system.
Chevron's main risk is the level of oil and natural gas prices which are the primary determinant in cash flow and valuation. Chevron faces the risk global oil demand falls quickly, leaving it unable to fully develop its reserves. Our research suggests oil demand will not decline materially for several more decades, implying more supply will be needed and the risk of stranded assets for Chevron is low. However, greater adoption of electric vehicles in the U.S., specifically California, could reduce demand for refined products, impairing the value of Chevron’s refineries.
For a company with global operations, geopolitical risk is always an issue. Past events in Nigeria and Venezuela underscore the risk associated with doing business in those countries. By investing in large, capital-intensive projects, such as LNG liquefaction, Chevron also runs the risk that commodity prices will decrease dramatically or it will exceed budgets, making those projects no longer economical.
Chevron also holds several ESG-related risks, but based on our framework they are not collectively material enough to alter our scenario analysis-determined uncertainty rating. ESG-related risks include changes in policy related to climate change such as a carbon tax that could result in higher costs, reduced demand, or stranded resources. Operating in offshore environments exposes Chevron to the risk of large oil spills that could result in material losses through lost revenue, fines or penalties, or loss of license to operate. Finally, as a large chemical producer whose products are key components of plastics, Chevron faces the risk environmental concerns result in bans or usage reduction that reduces demand for its products or higher costs related to reuse or recycling.
Capital Allocation | by Allen Good Updated Mar 20, 2023
Based on our capital allocation framework, which evaluates soundness of the balance sheet, investment strategy, and appropriateness of shareholder distributions, Chevron earns an Exemplary rating.
Although Chevron’s business has a high amount of operating leverage as well as revenue cyclicality, management typically operates with relatively low levels of debt to retain flexibility in times of market weakness. This is evident in its ability to raise debt during the recent downturn, combined with capital expenditure reductions, in order to protect the dividend and still keep net debt to capital under 25%. Given cost reductions, lower spending, and improved market conditions, we expect some deleveraging during the next couple of years. All of this amounts to a sound balance sheet in our framework.
Chevron also scores an exceptional rating for its investment strategy. In the past, Chevron has demonstrated a measured approach to acquiring U.S. unconventional assets and stayed out of places such as southern Iraq, where the returns are questionable. We think this indicates Chevron's overall emphasis on returns over growth and is reflected in its returns on capital, which rate near the highest in the sector. Unlike other majors, Chevron has been reluctant to rush into acquisitions or add projects in foreign countries where it cannot add value for the host countries or shareholders. Chevron CEO Michael Wirth seems to be maintaining these policies by not entering a bidding war after making an initial offer for Anadarko and instead turning to a more accretive deal for Noble.
The company remains focused on capital discipline with a cap on capital spending and the bulk of growth capital going toward the Permian, where it holds a low-cost position, supporting its moat. Furthermore, it can flex investment levels there based on oil prices, which should preserve returns. Unlike many peers it is avoiding investment in renewable power generation where it lacks expertise and it is difficult to carve out a competitive advantage. Instead, it is investing in carbon abatement to reduce operating emissions (scope 1 and 2) while investing in renewable fuels where it already participates in value chains. It expects to spend $10 billion by 2028 on these initiatives.
We rate Chevron’s shareholder distribution policy as appropriate. Although it required debt to pay the dividend in 2020, it had ample capacity to borrow without straining the balance sheet. Furthermore, it has reduced its break-even to below $50/bbl and can easily afford it at our midcycle price at $60/bbl. As such we view its current dividend levels as appropriate and leave room for growth. At $50/bbl oil it expects to generate excess cash, which it will direct toward repurchases. Repurchases afford flexibility and are prudent given the volatility of commodity prices. Historically, Chevron has had a similar policy, but its record on repurchases is mixed as it often repurchased more shares at higher prices. However, all of its repurchases during the last 10 years occurred at prices below our fair value estimate at the time. In order to avoid repeating the mistake of buying the most amount of shares when oil prices and share prices are high, Chevron has reintroduced a repurchase program it believes can be maintained through the cycle and is willing to rely on the balance sheet in times of low prices to do so. As a result, it should be continually buying shares through the cycle, maximizing the potential for value creation.
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