Chevron Stock Remains A Speculative Investment

  • Chevron topped estimates on earnings and sales.
  • However, the on-going risks to the investor thesis makes it less compelling.
  • Furthermore, commentary from investment banks coming out of the quarter wasn’t as reassuring.

Chevron (NYSE:CVX) remains a speculative investment upon the recovery in oil prices, and while I’m somewhat bullish on oil fundamentals, there’s still enough incremental capacity regarding wells with spuds so that if the prices were to recover, the amount of supply would likely match the demand in North America. Furthermore, there have been issues on the geopolitical front as Saudi Arabia fired its oil minister, and it’s not yet clear if it was in response to the minister being unable to ink a deal at the Doha Convention, or if it was because the minister was unable to secure a deal with Iran. Moreover, if Iran doesn’t agree to production cuts, it’s dubious as to whether Saudis will jump on board either. That being the case, the recent strength in oil prices is due to certain OPEC members cutting production, and falling production in North America across unconventional resources.

There are also promising seasonal trends in demand, and resurgence in demand for larger vehicles, which could sway consumption growth estimates in CY’16 for oil resources. As such, the mix of positives/negatives is what’s keeping crude below $50/bbl, and unless the middle east cuts production (like in prior cycles), a sustained recovery to $60-$70/bbl is dubious/unlikely.

It’s unlikely that Chevron is your best play on oil, and here’s why:

  • While the company delivered above consensus estimates, there’s no denying that Chevron was free cash flow negative to the tune of $1.45 billion in Q1’16.
  • Chevron plans to utilize more leverage to either return capital to shareholders in the form of dividends or sustain development in oil projects across North American unconventional resources.
  • Chevron’s break-even point is a lot higher when compared to some of its other mega-cap peers, which puts pressure on margins if oil prices don’t recover.
  • Investors have already priced in oil prices of $60/bbl into the stock price.

Assuming the oil market doesn’t recover as significantly in prior cycles, Chevron will likely exhibit higher beta volatility than some of its other mega cap counterparts.

5-10-16 CVX pic 1

Source: Bank of America Merrill Lynch

As it currently stands, the weakness in oil prices translates to heightened investment yields for investment-grade/non-investment grade debt securities. Given Chevron’s credit rating of AA, I don’t anticipate the company’s cost of capital to worsen too significantly given 7-year duration corporate Chevron bonds trade at $100.24/2.32% currently. However, if the company were to leverage its balance sheet even further as mentioned on the earnings conference call, I could imagine Chevron’s credit rating declining modestly. Hence, income-oriented investors should buy the stock as it pays a 4.2% yield, which compares to Exxon’s dividend yield of 3.39%.

Notwithstanding the attractive yield profile, I still view Chevron as being riskier when compared to its peer's given recent commentary from its earnings conference call:

The way I look at this, and the way we look at this, really is that obviously when you're at the peak of a price cycle that is when you want to have restored your balance sheet, have an ultraconservative balance sheet and that allows you to come through a price downturn. Right now we are sitting at a 22% debt ratio. We showed a slide at the security analyst meeting that said we could take somewhere between $25 billion to $30 billion of incremental debt. That would take us up to about a 30% debt ratio. There is nothing necessarily magic about the 30%. It was just an indicative place to do a measurement ourselves versus peers.

The company could lever up to complete some projects, but will likely reach a debt ratio of 30%. If the current cycle of low oil prices were to continue for the next couple of years, the balance sheet would weaken albeit modestly.

The company reported revenue of $23.553 billion and EPS of $(.11), which compared to consensus estimates of $21.434 billion and $(.20) respectively. The commentary out of the quarter from analysts was modestly upbeat, but weakness in free cash flow metrics and commentary of inflection to positive free cash flow seems like a 2H’16 story.

Here are some of the most pertinent commentary coming out of the earnings report:

1Q was a messy quarter, with pre-working capital FCF that was well below our model, and several one-time factors called out. Capital spending came in below and is trending toward the full year guidance. Bigger picture, nothing has materially changed with the FCF inflection story, with 1Q likely representing the trough on all fronts. However, execution needs to pick up as the year progresses to drive idiosyncratic upside, in our view. We remain OW with a price target of $113/share, up from $98/share, which represents an increase in our price deck to $55/bbl in 2018+. – Phil Gresh from J.P. Morgan

We stay Neutral on Chevron (CVX) following relatively in-line 1Q2016 results, after adjusting for one-time items. We update our 2016-2018E EPS from $0.31/$5.46/$6.96 to $0.64/$5.40/$6.91 to reflect: (1) slightly higher international E&P production and (2) revised corporate/interest expenses. We raise our 2017E EV/DACF (7.5x), P/E (17.0x) and dividend-yield (3.75%) based 12-month price target from $101 to $102. Our target increases on a slightly lower dividend yield assumption (from 4.0% to 3.75%) to reflect the lower interest rate environment. – Neil Mehta from Goldman Sachs

Continued expansion of the balance sheet and cash outflow remind us how much remains to be delivered. CVX is heading in the right direction. Once Megaprojects are on stream, long duration cash flows will be higher (higher multiple), and a shift to shorter cycle shale and brownfield expansion around the large existing hubs will be more capital efficient (higher returns). Business structures and costs are being streamlined to lower costs. However, at $65/bbl medium term, we find the shares fully valued and look for a better entry point for this improving business. We raise our Target Price to $100/sh on higher Debt Adjusted Cashflow. Following better than expected Downstream earnings, 2016 EPS increases to $0.64/sh (from $0.30). – Edward Westlake from Credit Suisse

While I don’t believe the dividend yield is at risk, the company isn’t as well positioned when compared to some of its peers. While the company has worked to reduce costs, the lead time to positive FCF metrics and on-going leveraging of the balance sheet makes it less attractive. Furthermore, there’s a lot of uncertainty in oil price fundamentals, which should be concerning given Chevron’s heavier concentration into its upstream oil business as opposed to downstream. Efforts to free up cash could bear fruit due to asset divestitures/sales worth appx. $5 billion to $10 billion in FY’16, which will free up the working capital for some of its major capital projects without increasing debt too significantly. However, even with asset sales, the net effect of weaker margins, higher oil price dependency, and low likelihood of a dividend increase makes the investment less compelling when compared to some of its more well-managed peers.

As such, I continue to reiterate my hold recommendation.

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