We've
lowered our estimate of the marginal cost of domestic natural gas from
$6.50 per thousand cubic feet to $5.40 per mcf, driven primarily by an
updated analytical approach. Because our upstream valuation methodology
incorporates an out-year marginal cost-based view on oil and gas prices,
it follows that a reduction in marginal cost results in a revaluation
of our gas-weighted upstream energy coverage universe. For those firms
most leveraged to gas production, our fair value estimates have
decreased 10%-15%. However, oil and liquids exposure provides insulation
from any meaningful change to fair value estimates for the majority of
our upstream coverage list. Our valuations also reflect our current
midcycle view on oil, incorporating $95 per barrel West Texas
Intermediate and $99 per barrel Brent. In addition, we assume that North
American natural gas liquids composite prices trade between 40% and 50%
of crude oil throughout our forecast period.
We remain bullish
on domestic natural gas and continue to see considerable upside to
current gas prices. Our analysis indicates that Henry Hub gas prices
tend to track marginal cost quite well over longer time intervals,
strongly suggesting a rebound from today's $3.70 per mcf within a few
years. This is reflected in our stock calls, as for the most part our 4-
and 5-star stocks remain just that, even after updating our models with
a lower out-year gas price assumption. We continue to view Ultra
Petroleum UPL and Devon Energy DVN as the most attractive gas-weighted names, Apache APA and Canadian Natural Resources CNQ as the most attractive mixed-oil/gas stocks, and Suncor SU and Occidental Petroleum OXY as the most attractive oil-weighted firms.
Like
its fellow supermajor integrated peers, Chevron is finding it
increasingly difficult to expand production and add reserves in a world
with a shrinking investable resource base. Much of the remaining pools
of cheap, easily accessible resources large enough to interest the
larger players reside in the hands of governments and national oil
companies. Resource-rich nations are bolstering their nationally owned
or controlled energy companies in an attempt to capture more value for
their own countries. While this can create an opportunity for firms that
can offer oil and gas development expertise, it also forces them to
greater lengths to acquire reserves. In Chevron's case, that means
focusing on deep-water exploration.
In recent years, Chevron concentrated its exploration efforts on a
few key areas that have yielded a high level of exploration success.
Discoveries in those key areas of the Gulf of Mexico, West Africa,
northwest Australia, and the Gulf of Thailand have already begun to
contribute production and will serve as the growth engine for Chevron in
the years to come, setting it up for peer-leading growth beginning in
2014-15. Success in each of these regions also demonstrates Chevron's
ability to thrive in a highly competitive environment with limited
access to resources. Exploration and production efforts in West Africa
and the Gulf of Thailand involve numerous partnerships with governments
and national oil companies. In the Gulf of Mexico, Chevron's success
rests on its ability to deliver production from highly technical
projects as it pushes into deeper water to secure resources. In
Australia, Chevron is relying on liquefied natural gas to capture the
value of massive offshore deposits of natural gas.
The two LNG projects in Australia, Gorgon and Wheatstone, will be the
primary drivers of growth in the next few years. Gorgon, slated for
startup in late 2014, will add more than 200 thousand barrels of oil
equivalent per day of production at peak production. Wheatstone,
scheduled for startup in 2016, will add almost another 200 mboe/d. In
addition to the volume growth, we see other benefits. Both projects
allow for future expansion, given the physical space for additional
trains and ongoing discoveries in the region. LNG production, while
primarily gas volumes, has prices indexed to oil, which should allow
Chevron to preserve its peer-leading liquids exposure. Also, projects
like LNG with long-plateau production levels that require little
additional capital expenditure help to reduce decline rates while
generating significant free cash flow to support reinvestment elsewhere
or shareholder returns.
While Chevron's focus on deep water, and by extension larger
projects, brings production growth, it also holds substantial risk.
Since the cost of drilling offshore wells can be more than $100 million,
exploration risks can be quite high. Even after a discovery is made,
Chevron then must confront engineering risk. Deep-water projects are
technically challenging, and they can often incur higher costs and
delays before production comes on line.
Cost inflation in areas with high levels of activity such as Western
Australia can jeopardize the economics of projects if not properly
managed. This is a specific threat to Chevron's two large LNG projects
as other operators in the country have had to revise project budgets
upward based on currency appreciation and materials inflation. However,
we estimate that even if costs for Gorgon's first three trains come in
at $55 billion (compared with $37.5 billion originally), Chevron will
still break even on the project. Also, once operational, the four-train
development will deliver more than $3 billion in free cash flow annually
to Chevron.
Our valuation hinges on Chevron's ability to deliver production from
these deep-water and LNG projects on time and within budget. As recent
events in Brazil and Nigeria illustrate, incidents at deep-water
operations that result in oil spills put the company at risk of negative
headlines at the least and potentially stiff monetary fines or
permanent cessation of operations at worst.
On the downstream front, Chevron is well positioned for the future
with highly complex facilities that serve key developing markets. Not
only are its facilities capable of producing lower-quality crudes, but
many also have the flexibility to produce highly valued diesel. Diesel
consumption is likely to drive future refined product demand growth,
particularly in the United States.
However, Chevron has a measured view of the long-term economics of
the refining business. As a result, over the past two years, Chevron has
restructured its downstream operations and shed assets, which should
lead to improved returns. Also, returns should improve as it shifts
downstream capital to its higher-return chemical operations to fund
projects designed to take advantage of low-cost feedstock in the Middle
East and North America.
We
are maintaining our fair value estimate of $125 per share after
lowering our long-term natural gas price assumption from $6.50 per
thousand cubic feet to $5.40/mcf. The lower natural gas prices reduce
our fair value estimate by $5 per share, all else equal. However, the
reduction is largely offset by the rise in short-term oil prices since
our last update.
Our fair value estimate is approximately 3.9 times our 2013 EBITDA
forecast of $60 billion. We expect natural gas to contribute a greater
share of production, about 36%, by 2016 compared with 31% in 2011.
However, a significant portion of these volumes will be LNG, whose
pricing is linked to oil. Also, close to 75% of Chevron's oil production
comes from international assets and is tied to higher Brent prices.
In our discounted cash flow model, our benchmark oil and gas prices
are based on Nymex futures contracts for 2012-14. For natural gas, we
use $2.87 per thousand cubic feet in 2012, $4.08 in 2013, and $4.31 in
2014. Our long-term natural gas price assumptions for 2015 and 2016 are
$5.40. For oil, we use Brent pricing of $112 per barrel in 2012, $108 in
2013, and $104 in 2014. Our long-term oil price assumptions for 2015
and 2016 are $99 and $102, respectively.
In our forecast for the next few years, we expect Chevron to see
little production growth. Also, rising oil prices will probably mean
Chevron's production-sharing contracts yield lower oil volumes.
Production growth should increase to 4%-5% by the end of our forecast
period as large LNG projects start up. In the downstream segment, we
expect profitability to improve in the coming years as a result of
improved refining margins, stronger chemical results, and the benefit of
recent restructuring.
Chevron's
profits and cash flow are largely tied to oil and gas production and
could suffer as a result of a significant fall in prices. Additionally,
long-term price depreciation would expose the company to overinvestment
risk as current projects would see returns languish with weaker
economics. Regardless of commodity prices, these projects also are
subject to cost overruns or completion delays. Many of the company's new
investments are in politically challenging areas that sometimes have
fickle leaders and populations hostile to outside firms. With
significant exposure to the Gulf Coast, extended delays in permitting
could result in higher costs and delayed production volumes.
Management & Stewardship
John
Watson assumed the CEO and chairman position in 2010
after serving as vice chairman. He joined Chevron in 1980 and has
held several different senior management roles, including president
of international exploration and production and CFO. We like that Watson
has a mix of financial and operational experience that should lead to
better capital allocation decisions, in our opinion. We also like that
other senior executives have significant operating experience in various
parts of Chevron's business throughout the world.
We give Watson high marks for his leadership to date, despite the
stream of negative headlines. His greatest challenges may be yet to come
as Chevron develops its multi-billion-dollar LNG projects and fights an
ongoing legal battle over environmental damages in Ecuador. Positive
outcomes on both fronts would speak volumes about current leadership.
We also like Chevron's measured approach to acquiring U.S.
unconventional assets and the fact it stayed out of places like southern
Iraq where the returns are questionable. We think this speaks to
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. We think this is wise,
given the increasingly competitive environment for resources and the
willingness of some international competitors to pay for access. As a
direct result, Chevron's upstream segment's returns have outperformed
peers of late. Also, the firm remains focused on cash returns to
shareholders. Its preferred method is through dividends, which it has
historically steadily increased. Given these factors, we think Chevron
earns an exemplary stewardship grade.
Overview
Chevron has one of the strongest balance sheets and lowest debt/capital
ratios among its peer group. Strong cash flow from
operations should be sufficient to fund investments and pay the
dividend; however, if oil prices retreat significantly, the company may need to
increase its debt load.
Profile:
Chevron is an integrated energy company with exploration,
production, and refining operations worldwide. With production of
2.67 million of barrels of oil equivalent a day (69% oil), Chevron
is the second-largest oil company in the U.S. Refineries are
located in the United States, South Africa, and Asia for total
refining capacity of almost 2 million barrels of oil a day.
Proven reserves at year-end 2011 stood at 11.2 billion barrels of
oil equivalent (58% liquids).
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