Chevron's Turnaround Is Not As Far Away As You Might Think

  • Chevron has been struggling with massive cash flow deficits in the downturn.
  • But recent reports from S&P Global Platts, IEA and US EIA point towards improvements in the global oil market.
  • Chevron could turn around sooner than you’d expect.

Crude’s slide has hurt all oil producers and Chevron (NYSE:CVX), the second largest US-based energy company, is no exception. Chevron hasn’t been able to fully fund its capital expenditure and dividends from internally generated cash flows.

In the previous quarter, for instance, it posted a massive cash flow deficit of around $6.5 billion (based on my rough calculation) which was funded from asset sales and borrowings. Chevron has been living beyond its means by outspending cash flows for the last three years. But this can’t go on forever. If oil prices, which have gained by roughly a third from an average of $34 per barrel in the first quarter of 2016 to current level of $48 a barrel, fall back to $30s, then Chevron could be forced to make a tough decision around dividends. But based on recently released reports from S&P Global Platts, International Energy Agency and US Energy Information Administration, chances are, Chevron won’t have to.

On Wednesday, the S&P Global Platts released a report, based on survey of OPEC members, industry officials and analysts, in which it saw OPEC’s monthly output climbing by 140,000 barrels a day from the previous month to 32.52 million barrels per day in April, thanks to 150,000 barrels per day increase in production from Iraq and Iran.

At first sight, the report looks disappointing since it shows that OPEC continues to pump additional quantities of crude in an already oversupplied market. This can’t be good for oil prices. But a closer look reveals several silver linings. First, Iran’s output has now climbed 490,000 barrels per day since December to 3.38 million barrels per day in April. This shows that Iran has almost achieved its target of increasing production by 500,000 barrels per day as soon as the sanctions are lifted.

According to data from Bloomberg, the US and European sanctions crippled Iran’s crude oil output, but it has recovered completely.  The Persian Gulf nation is pumping more oil now than four years ago when the sanctions were imposed. I believe this has increased the chances of Iran joining hands with other major oil-producing nations when they discuss the possibility of freezing output during OPEC’s next meeting in June.

Second, the report has also pointed towards some major supply disruptions experienced by OPEC members. Kuwait’s output, which has been hit by labor strikes and protests, fell by 100,000 barrels per day from March to 2.68 million barrels per day in April. Nigeria’s oil production plunged to 1.67 million barrels per day, the lowest since 1994, due to militant attacks on major oil facilities. In Venezuela, oil production has come under pressure due to severe power outages.

The Latin American country, which holds the world’s largest oil reserves and was already struggling with an economic recession, is experiencing four-hour blackouts on a daily basis. Ecuador’s oil production, on the other hand, has been hit by a deadly earthquake. Outside of OPEC, the wildfires in Canada have knocked out a million barrels a day of oil production and there’s no telling when the supply might resume. I believe these supply disruptions can accelerate oil’s recovery.

Third, the report should also serve as a reminder that most of the world’s oil demand is met by non-OPEC producers. According to International Energy Agency’s oil market report, the average demand for oil and liquid fuels could be around 96 million barrels per day in 2016. OPEC’s crude and liquids production meets just 40% of that demand. The rest comes from major non-OPEC suppliers such as Russia and the US. Since these countries command a greater share of the global oil space, they can play a bigger role in rebalancing the market. Some of these countries, including the US, have been reporting declining production. With persistent weakness in energy prices, other major non-OPEC producers could also be forced to cut output. This can offset the impact of increase in OPEC production, leading to higher oil prices in the future.

According to this week’s report from US Energy Information Administration, the price of the international benchmark Brent crude, which averaged $52.32 per barrel last year, could drop to $40.52 this year but climb back to $50.65 in 2017. This shows a big change from a few weeks ago when US EIA predicted Brent averaging in the mid-$30s in 2016 and low-$40s in 2017. It seems that the supply side issues and declining production from major non-OPEC producers is having a bigger impact on the oil market than the government agency initially expected. That’s great for all oil producers in general and Chevron in particular.

That’s because the oil giant, which has been struggling with large cash flow deficits, is well positioned to significantly narrow the shortfall in a $50 oil price environment. The improvement in oil prices will change the fortunes of Chevron’s beleaguered exploration and production business which has been losing more than $1.4 billion in each quarter since last year, with the exception of the third quarter of 2015 in which it managed to eke out a modest profit of $59 million. The company’s cash inflows will receive a boost.

That’s going to come at a time when Chevron’s major capital projects – such as Gorgon and Wheatstone LNG projects in Australia – are starting up. These projects, most of which will be operational by the end of next year, will not only boost Chevron’s operating cash flows, but also lower the company’s capital expenditure requirement. The capex is projected to fall from $34 billion last year to $26.6 billion in 2016 and as low as $20 billion per year over the next two years. The increase in cash inflows from higher oil prices with decrease in outflows due to decline in capital spending should have a positive effect on Chevron’s cash flow deficit. The company expects to hit cash flow neutrality with Brent at $52 a barrel. This means that at $50, it will still have a cash flow deficit, but it’s going to be significantly smaller than what we’ve seen in the previous quarters.

Conclusion

Chevron has been struggling with cash flow deficits in the downturn. But oil price environment could improve moving forward. The OPEC members, with support from Iran, could come to an agreement on freezing output. The supply disruptions and declining production from major non-OPEC producers could play a major role in solving the supply problem. These factors could push oil to $50 in 2017. At $50 oil, Chevron’s cash flow deficit will shrink significantly and at $52, it could disappear. That would be a big turnaround for the oil producer that has been reporting large cash flow deficits for the last three years.

Although Chevron stock has underperformed as compared to the S&P-500 and Dow Jones over the last 52-weeks, I believe investors should continue to hold this stock and watch its gradual recovery towards cash flow neutrality unfold.

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