Investment thesis: Chevron’s (CVX) American upstream sector saw a surprising convergence in profitability with its international upstream operations in 2021. Recent announcements in regards to Chevron’s increased production goals in the Permian will help the shale industry to produce higher production volumes this year, but it will not necessarily improve Chevron’s profit margins. Higher oil & gas prices will make it possible to increase production & profits, but while revenues will increase significantly, profits will not. The convergence in profitability is mostly the result of an industry-wide trend of rising profits as they massively draw down their DUC Rising costs of shale drilling will limit the gains in profits from higher prices and higher production levels this year and beyond.
Chevron’s US versus international upstream sector shows a significant shrinkage in the gap in asset profitability in 2021.
Chevron’s full-year profits came in at $15.6 billion in 2021. It is a huge improvement on the $5.5 billion net loss it registered in 2020, but it has very little significance given the very extraordinary year that we had in 2020. The US upstream sector contributed $7.32 billion to the overall net earnings, while its international upstream sector produced $8.5 billion in profits. Of note, there seems to be a closing of the profitability gap between its US upstream that is dominated by shale reserves, and its international upstream sector that is dominated by mostly aging or hard to develop conventional or deepwater fields.
As we can see, shale reserves are now a prominent part of Chevron’s overall reserves. It spent $4.7 billion in financial capital on its US upstream, while it spent $4.9 billion on its international upstream operations. In other words, almost half of upstream profits came from the US, with almost half of upstream capital spending also going to its US operations. This is interesting because not long ago, it struggled to squeeze much of any profit out of the US upstream operations, even as it was spending a large portion of its capital budget on US shale.
As we can see, Chevron’s US upstream operations have been far less profitable in the prior years compared with its international upstream results. The results we are seeing for 2021 would suggest that there has been a great deal of improvement in Chevron’s shale operations in the US. A great deal of improvement, probably stem from events that occurred in response to the 2020 oil price slump, which was followed by the recovery in prices that we are currently witnessing. Further consolidation of drilling into the most prolific parts of Chevron’s acreage probably occurred. Furthermore, the entire shale industry has been seeing a major boost to profits in 2021 due to the fact that they have been working down their DUC (drilled but uncompleted wells) stockpile. In other words, companies have been profiting from capital spending they incurred in the previous few years. With DUC levels falling fast, US upstream profit margins will deteriorate and Chevron will be no exception to it, once it runs out of spare DUCs and it has to return to higher drilling spending just to keep current production trends going. If it wants to keep its overall upstream production volumes from falling, it needs to continue growing its shale output.
As we can see, Chevron’s US liquids output will soon converge with its international levels and it will surpass it. In fact, it already may have permanently surpassed it in the fourth quarter of last year. US upstream liquids production averaged 929 thousand barrels of oil equivalent per day, while its international production fell to just 899 thousand barrels per day by the last quarter of 2021. When natural gas volumes are included, Chevron’s international production is still significantly higher with 1.9 mb/d, versus its total US average production in the last quarter of 1.2 mb/d.
When looking at Chevron’s US upstream profits trends, comparing the US versus international results, one would think that there is no problem at first glance related to the fact that it is increasingly becoming reliant on shale production. After all, shale seems to have contributed a great deal to Chevron’s net earnings last year. But when we factor in the fact that Chevron, like much of the rest of the shale industry, have been posting some much-improved upstream financial results, in large part due to the massive draw-down of DUC’s that occurred last year, the outlook is not necessarily as bright as first impressions might suggest.
As I highlighted recently, shale producers such as Continental (CLR), Diamondback (FANG), or EOG (EOG) produced stellar financial results in recent quarters. It should come as no surprise therefore that Chevron also saw a significant improvement in its US upstream financial results. What might come as a surprise for investors is the likelihood that we will see the start of some deterioration in Chevron’s financial results once it starts spending more money on drilling shale wells, once the DUC drawdown will be completed. Higher oil & gas prices may partially or even completely neutralize the negative effects associated with the end of the above-mentioned trend, but it will not help Chevron’s financial results in relation to the results of companies that are less reliant on shale production.
Thanks to higher oil & gas prices, as well as other factors, such as the continued drawdown of DUCs for a little while longer, Chevron is set to see an improvement in financial results compared with 2021. Having said that, the continued decline in its international upstream production, coupled with growing dependence on shale production, which is set to be less profitable going forward, as the DUC drawdown ends, will have a significant negative impact on profit margins. A continued trend of declining quality of drilling locations yet to be drilled will also contribute to lower profits in Chevron’s domestic upstream, in line with industry-wide trends.
There are other major challenges that Chevron along with much of the rest of the Western World-based industry are faced with, which are set to add to the difficulty of carving out a net profit, especially from upstream operations. ESG investment trends are causing oil companies difficulties in regards to attracting capital. Higher oil & gas prices should help them to self-finance most of their operations from internal resources. It does nevertheless put pressure on companies to buy back stock in order to maintain share prices in the face of institutional investors increasingly shunning oil stocks due to their pledge to only invest in higher ESG-rated companies. In other words, the market is set to reward low-carbon industries such as Microsoft (MSFT), even as it intends to punish oil & gas producers and other energy-intensive industries, for the simple reason that they produce the things needed for Microsoft’s products to be relevant, like the lithium found in laptop batteries, or the electricity needed to power that laptop.
In effect, companies like Chevron are set to trade at a much lower P/E than tech companies or companies in other industries that tend to have a much lower emissions profile. Even when factoring in future revenue growth prospects and other factors, which historically tend to act as the main factors that affect P/E ratios, energy companies as well as other energy-intensive industries are set to suffer a great deal of market cap discounting as increasingly aggressive movements to starve these companies of capital will take their toll.
If Chevron intends to borrow money or issue stocks in order to finance a larger project, it will likely find that borrowing costs are on a rising trend, while issuing stocks will have an outsized negative effect on its stock price, which is an industry-wide problem, given the efforts by the environmentalist lobby to starve all industries that have high emissions of needed capital. Chevron’s own efforts to reduce emissions in order to satisfy ESG standards are set to further erode profitability. All these pressures at a time when its upstream segment is already set to face growing pressures on profits due to geological realities, do not bode well for Chevron’s financial outlook going forward. The only thing it does have going for it is the prospect of continued high oil & gas prices boosting revenues, profits, cash flows, while helping it to reduce debt, buy back stocks and so on.
It is difficult to gauge whether higher oil & gas prices will be enough to offset some of the challenges, in part because we do not know just how much higher prices will go in the longer term. It is also hard to tell whether the ESG pressures will intensify. What we do know is that the geological realities that Chevron is faced with are worsening. Its international oil production which historically provided a steady stream of revenues and profits is dwindling. Chevron just recently announced its intention to pick up the pace of drilling and production in the US shale patch, which should help to make up for lost volumes elsewhere, but it is not certain that net earnings will also be bolstered by Chevron’s growing dependence on shale production. The industry-wide boost to profits we saw in 2021, stemming from the massive DUC drawdown may last a few more quarters, after which companies will have to spend far more on drilling services just to stay in place in terms of production volumes. Chevron’s net earnings are likely to start disappointing investors somewhat at that point, even as oil & gas prices are likely to continue their upward surge.