Chevron's Still Our Favorite Integrated Oil Major

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Following similar reductions from ExxonMobil XOM, Chevron cut capital spending guidance for 2017 and 2018 to $17 billion-$22 billion from the $20 billion-$24 billion guidance given earlier this year during the fourth-quarter earnings announcement. Guidance of $26.6 billion for 2016 is unchanged but could ultimately be lower as management continues to seek out reduction opportunities while oil prices remain low. While requiring additional debt this year to fund capital expenditures and cover the dividend, Chevron anticipates being cash flow break-even at around $50 a barrel in 2017 on a combination of higher production, reduced capital spending, lower operating expense, and asset sales. We anticipate that break-even levels could fall further in 2018, depending on capital spending, as higher production and improved margins lift cash flow, keeping the dividend safe. The increases in production, earnings, and cash flow should also allow for increases in the dividend.

Previous production guidance of 2.9-3.0 million barrels of oil equivalent per day in 2017 remains intact, as key contributors to growth are already well under construction and slated for startup in the next several years. As a result, Chevron maintains the greatest growth profile of its peer group. The completion of many of these major capital projects is the primary driver in the reduction in capital spending. Chevron is not risking future growth for the sake of the dividend, although it does plan to proceed with fewer major capital projects. Outside of the Tengiz expansion slated to reach the final investment decision by mid-2016, most major capital projects in Chevron's queue appear to be on hold. Future investment will increasingly go toward expansion of its existing base business and developing its high-quality unconventional portfolio (Permian, Duvernay in Canada, and Vaca Muerta in Argentina), which represent short-cycle investments compared with the longer duration of its large liquefied natural gas and offshore projects. As a result, nonproductive capital should fall from about 50% of capital employed today to 25% by 2018, contributing to improved returns.

We've previously highlighted Chevron's large Permian position as a competitive advantage, given the basin's high returns and low break-even levels relative to other unconventional plays. Despite a slow start, Chevron has closed much of the operating gap between it and smaller peers, and it can now begin to exploit its royalty advantage (around 85% of acreage is no or low royalty). It estimates 1,300 of its drilling locations (about seven years' worth of inventory at current activity levels) are break-even at less than $40 a barrel, but this figure represents only 30% of its operated acreage, implying greater potential. It expects to add a minimum of 100 mb/d of production from the Permian by 2020, with the potential for 200 mb/d, assuming greater activity in an environment of higher oil prices. The size and quality of its Permian position provide Chevron a flexible option on high-return future production growth that many of its peers do not have.

New Production Will Be the Growth Engine In recent years, Chevron's oil portfolio has led to peer-leading margins and returns on capital. New production from the Permian Basin, Gulf of Mexico, West Africa, Western Australia, and the Gulf of Thailand will preserve its liquids price exposure and serve as the growth engine for Chevron in years to come, setting it up for peer-leading growth through 2018.

Two liquefied natural gas projects in Australia, Gorgon and Wheatstone, will be the primary drivers of growth in the next few years. Gorgon, slated to start in 2016, will add more than 200,000 barrels of oil equivalent per day of production at peak levels. Wheatstone, scheduled for startup in mid-2017, will add almost 200 mboed.

The investment in 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 expenditures, help reduce decline rates while generating significant free cash flow to support reinvestment elsewhere or shareholder returns.

However, to achieve its growth, Chevron has spent more on a per-barrel basis than peers, while at the same time experiencing budget overruns on the Gorgon project. As a result, we expect returns to be lower in the coming years on a combination of lower earnings and increased capital employed.

That said, we expect cash flow to rise during the next five years thanks to improving oil prices, cost-cutting, and increased production. Free cash flow should increase as capital spending declines due to Chevron investing in shorter-cycle, less capital-intensive projects like unconventional production in the Permian Basin and brownfield expansions of existing projects, which will also deliver the next stage of production growth.

Upstream Makes the Moat Though an integrated energy company, Chevron has a narrow economic moat that relies for the most part on its upstream operations. We generally regard refining operations as having no moat, as refiners produce a commodity product in a highly competitive market. In addition, refiners have no pricing power over either their input or output. However, integrated firms can usually add value to refining operations through integration where independent refiners cannot. Compared with other supermajor firms, Chevron has a small refining footprint. In recent years, its lower exposure to refining has proved beneficial as margins fell.

On the upstream side, Chevron benefits from skills and expertise developed through years of successful deep-water exploration in its core areas, which it can export to other parts of the world. Not only will the experience probably make Chevron more attractive to foreign governments in future bids for production-sharing opportunities, but it will also increasingly add value as more resources become available in deep-water locations. Chevron's expertise should open opportunities in deep-water areas where its peers and rivals may not have the qualifications necessary to operate. It also holds expertise in sour gas processing and heavy oil recovery, which it has leveraged to secure projects in Kazakhstan and the Middle East.

As part of its deep-water exploration, Chevron is building out LNG infrastructure to capture value in its offshore gas reservoirs, which are capital-intensive and require years to develop. With its size and financial strength, Chevron is typically able to maintain the capital spending through commodity price cycles necessary for these types of projects. Smaller rivals may not be able to do so. Chevron's strength can be seen in its massive Gorgon LNG project, where it has continued to advance the project through the commodity price volatility of the past year. As a result, Chevron was able to sanction the project and secure resources before rivals.

Energy Prices a Constant Risk 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 are also 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.

Chevron built cash as oil prices rose in anticipation of higher levels of future spending, but the fall in oil prices has created the need to increase debt. That said, Chevron still carries very little debt and holds a significant cash balance (net debt/capital of 14%).

The company makes dividend growth a priority, which is evident in its higher dividend yield relative to Exxon. Even with a pause in dividend growth this year, we expect growth to resume during the next few years as free cash flow rises.

Though debt has risen, we still think Chevron has the capacity to execute on acquisitions. The company's small debt balance also allows for the potential to increase leverage if necessary. Alternatively, it could use proceeds from a targeted $10 billion in asset sales to fund any transaction. Chevron also holds a large balance of unretired treasury shares that could be deployed toward an acquisition.

Stewardship Is Exemplary We give CEO and chairman John Watson high marks for his leadership to date, despite some negative headlines over the past couple of years. He faces his greatest challenges now as Chevron completes its multi-billion-dollar LNG projects and continues to invest at a high level in the face of falling oil prices. We think the actions taken to date, including slashing future capital spending to ensure the dividend, are prudent given the likelihood of low prices persisting for several years.

We also like Chevron's measured approach to acquiring U.S. unconventional assets and the fact that 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 in past years. Also, the firm remains focused on cash returns to shareholders. Its preferred method is through dividends, which it has historically steadily increased.