How To Generate A 10% Yield On Chevron Stock

  • Oil prices have rallied hard since mid-February. Chevron's stock has also rallied meaningfully.
  • Fundamentals are very strong. One more year of borrowings is required to fund the dividend but this should stop in 2017.
  • Technicals are overbought. Income investors should consider long-term or "leap" covered calls in 2017.

The price of crude oil has been on a tear recently with a barrel of crude almost topping $40 in recent days. We may have had a temporary top at this point though (with a barrel of crude resting at $37.75) but I still maintain we printed a firm bottom at under $28 a barrel last month. Why? Well, a common hallmark of permanent intermediate bottoms is the rally after the potential bottom has formed. The chart below shows the violent rally the energy sector has had since the 10th of February (up almost $10 a barrel) which makes me believe it is very unlikely that we will see break through the lows once more.

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So in terms of investing in the energy sector at present and if one were bullish on oil prices, one could invest in a strict upstream company like Hess (NYSE:HES) which is up more than 32% in the above mentioned time-frame. However in this article, I want to discuss the income investor or the yield hunter whose fixed income returns have been obliterated over the past few years by central bank interventions.

Europe and Japan are now supporting negative interest rates and many analysts are now stating that the US will not be able to raise interest rates four times in 2016 as was originally predicted. Fixed income investors are being forced to turn to equities and Chevron (NYSE:CVX) is a good pick for a 10%+ yield in less than 12 months. In fact, we are going to more than double the prevailing dividend rate (which is 4.52%) by selling an out of the money covered call which will expire 10 months from now.

However let's first go through why I feel Chevron is a worthwhile candidate. The company recently held its annual analyst day which many investors were watching with keen interest, especially on matters concerning the dividend. Here is the crux of the problem. In 2015, Chevron reported net income earnings of $4.59 billion which pales in significance to the company's 2011 figure of $26.9 billion. Furthermore, the dividend has gone the other direction with payouts soaring from $6.14 billion in 2011 to almost $8 billion last year.

The shortfall in cash flow has meant the company has had to sell assets aggressively ($15 billion over the last 2 years), cut capex budgets and lower operating costs all in an attempt to safeguard the dividend. Well, I believe Chevron is over the worst of its cash flow crisis as recent guidance illustrated that 2017 capex is to be reduced to between $17 and $22 billion.

This is good news as 2017 had been previously earmarked as the year in which Chevron would be cash flow neutral (meaning no borrowings would be necessary to fund operations and the dividend). The reason why capex is expected to decline substantially after 2016 is because once projects are up and running, very little capex is needed. Gorgon is now almost shipping cargo and we will see the double benefit (of substantially increasing cash flow through robust production and massive lay-offs) reflected in Chevron's earnings in upcoming quarters

The best way to combat low oil prices and increase cash flow is to increase production and Chevron managed to increase its output by 2% in its latest fiscal year. I expect production to surprise on the upside as major capital projects such as Tubular Bells, Bibiyana & Jack/St. Malo are predicted to increase output in the near term. This is bullish as Chevron is less integrated than its peers Exxon Mobil (NYSE:XOM) in the respect that its upstream division is far larger than its downstream counterpart. We have seen evidence of this already over the last 30 days or so with Chevron vastly outperforming Exxon Mobil since oil bottomed on the 10th of February.

In saying this, Chevron technicals are definitely over bought and if crude oil struggles to piece through $40, it is more likely that Chevron will fall from these levels (presently at $94.58) than rise. The 5 day RSI and the weekly stochastics are both illustrating that the stock is currently overbought (see chart). This is why a long term covered call trade would suit yield hunters as long as the investor is willing to give up his or her shares at a higher price.

For example, the January-2017-$97.50 calls are selling for $635 per contract (1 contract = 100 shares of stock). If the investor was to buy 100 shares today and sell the above-mentioned call and hold until expiration, the yield would be $635 + 3 dividend payments of $107 which is $321 combined which totals $956 which based on the investor's original investment is a 10%+ yield in just over 10 months.

The above hypothesis will play out if Chevron stock trades under $97.50 throughout the 10 month period. However if the stock goes "in the money" which is above $97.50, the call buyer (the person on the other side of the trade) may at any time exercise his right to take ownership of 100 shares of Chevron (highly unlikely) which would mean you would offload your shares to him at a price of $97.50. This would give you almost a $300 capital gain on your shares plus any dividends you would have collected plus the initial option premium.

Either way, the investor should generate a good yeild on Chevron over the next 10 months irrespective of where the share price will trade at until expiration. The takeaway here is that the investor must be comfortable with holding the shares for the duration of the contract. This is why fundamental analysis is key and my research shows Chevron will rally meaningfully if oil prices continue to increase.

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To sum up, Chevron's analyst day has made me more bullish on the stock. Capex is set to fall after 2016, Gorgon celebrated its first shipment to Asia recently and production elsewhere will continue to increase. All these initiatives will boost cash flows and earnings substantially which we should see reflected in the company's next set of earnings. However due to the recent run-up in the share price the January-2017 calls look enticing for income investors who want to boost their yields this year. The options market will pay you for the right to "call" away your shares at a higher price and technicals are indicating that now may be a good time to adopt this strategy.

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Author's Disclosures & Disclaimers:
  • I do not hold any positions in the stocks mentioned in this post and don't intend to initiate a position in the next 72 hours
  • I am not an investment advisor, and my opinion should not be treated as investment advice.
  • I am not being compensated for this post (except possibly by Amigobulls).
  • I do not have any business relationship with the companies mentioned in this post.
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Comments on this article and CVX stock

PaulPasternack
neutral
The media seems to be the only thing moving oil prices at the moment, any look at the data confirms that the fundamentals are still hugely disconnected from the markets. The oil prices have not bottomed out as the IEA suggests and prices will continue to decline in the $20's.
http://oilprice.com/Energy/Energy-Genera...
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kenfwaldron
neutral
When you try to get others to sell long term calls on good quality dividend stocks you are just hurting the amount of premium I and others that have been doing this for years can collect when we sell our covered calls. I think you should keep your comments to yourself!!
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