With Oil Well Above $80,

Dawn over petroleum pump

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Steep market declines have spooked investors and resulted in significant capital being pulled to the sidelines. While it is prudent to reevaluate one’s portfolio, it is important not to miss out on opportunities during times of heightened market volatility. One such company that should be on investors’ radars is Chevron (CVX). Chevron is well positioned to continue to profit from oil’s heightened price levels. Adding in the rising geopolitical tensions with Russia and Ukraine, and oil prices could rise sharply in the near term. Lastly, with the company reporting earnings this Friday, now might be the ideal time to add Chevron to one’s portfolio.

Introduction

Global stock markets are off to their worst start in years due to a litany of concerns facing investors. In times like these, it is often difficult to discern which companies are positioned for continued strength and which will be challenged over the medium term or worse. One area of favor that investors should consider is the Energy Sector. Unlike most other sectors of the markets, these companies are generating record levels of profits and are benefitting tremendously from the supply chain disruptions as the global economy returns to normal.

One of the top stocks to capture this opportunity is Chevron Corp. Chevron is uniquely positioned to continue to profit from rising oil prices thanks to their vast operations. More importantly, while the company has done well in recent years it continues to be cheap compared to pre-Pandemic levels. Adding in the rising geopolitical concerns, and Chevron could be a great addition to one’s portfolio.

Why Chevron Today?

Chevron has been nothing short of a great driver of returns for investors over the past year (46%+ for 2021) and even year-to-date (8%+ vs. S&P 500 down 7%+). While oil prices have been one of the main drivers of these impressive returns, it is really the combination of impressive financial performance and the possibly of a demand surge in the near-term that have further propelled returns for investors.

Chevron’s Strong Outperformance Thus Far in 2022

Chart
Data by YCharts

On the financial performance front, the company has been successfully growing EPS since their fiscal fourth quarter of 2020. This has led to larger and larger earnings beats over the past two quarters. With Chevron reporting earnings this Friday, another resounding earnings beat could push the stock significantly higher.

Chevron’s Recent Strong Earnings Performance

Chevron

Chevron’s Recent Strong Earnings Performance

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Separately, the escalation between Russia and the Ukraine has the potential to send oil prices dramatically higher in the near term. While Russia’s stance has been intimidating to Ukraine, they have not chosen to invade the country. Many European countries and the United States have been vocal against any further action Russia may take against the country as it progresses towards joining NATO. Politics aside, Russia is a major player in the energy markets. For 2020, Russia was the third largest producer of oil (behind Saudi Arabia and the United States) and second largest producer of dry natural gas (behind the United States). With oil prices at levels not seen in years, Russia is uniquely positioned to cut off supply to other countries if they don’t support Russia in the escalating conflict with Ukraine. This, in turn, could be the catalyst for a major spike in oil prices in the near term – something that should generate outsized profits for Chevron.

With these two major factors developing over the coming days (earnings) and weeks (Russia and Ukraine) as well as the strong demand for oil around the globe, Chevron is poised to deliver another year of impressive gains for investors.

The Pandemic Pivot Was Essential

To fully understand Chevron’s current record levels of profitability, it is important to review the changes management made during the Pandemic. The beginning of the Pandemic was a tough one for all Energy companies. To brace for the potential prolonged period of low oil prices, many Energy companies sharpened their pencils to enhance margins and cash flows. During this time Chevron made deep cuts to their operations to remain profitable if oil prices stayed over the long term. This included:

  1. Capital Expenditures: First, they reduced their Capital and Exploratory Budgets through 2025. In 2021 alone, the budget has been cut to $14 billion and will be $14 billion to $16 billion through 2025. This change was based on a prioritization and ranking of each project by its expected return on investment. Only projects with the highest ROIs have been kept in the plans over the medium term.
  2. Operating Expenses: Secondly, management scrutinized the operating expenses in great detail for areas to reduce overhead costs. This included both looking at costs, as well as reducing personnel in redundant and unnecessary positions.
  3. Shareholder Distributions: Lastly, management opted to suspend the company’s share repurchase program, which was nearly $3 billion in 2019 and almost $1.6 billion for the first quarter of 2020. This action was taken to further bolster capital for the company. Fortunately, for income-oriented investors, they only opted to suspend growth of the company’s dividend and not cut dividend distributions.

Surprisingly, the long period of oil prices never materialized. Instead, the price of oil recovered from its collapse during the Pandemic and then set new multi-year highs. For Chevron and its peers, this led to record levels of profits.

Crude Oil Futures (CL1): Past Five Years

Crude Oil Futures (CL1): Past Five Years

Crude Oil Futures (CL1): Past Five Years

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Why Oil Prices Matter

Understandably, energy companies saw their share prices decimated as the Global Pandemic heavily curtailed oil demand. This drop in demand had a major impact on the cash flows for all energy companies. In response, many energy companies shifted their priorities and preserved capital. For the fortunate ones, this generally meant rationalizing planned capital expenditures, reductions in personnel, and reduced dividends to shareholders. For the unfortunate ones, the decline in cash flows was so severe that they were forced to declare bankruptcy.

What is important for investors to note, especially during this challenging time, is that historically the demand for oil, as well as the impact it has on oil prices, is fairly dramatic. Unlike most other commodities, a small change in the supply/demand relationship will have a large impact on the price of oil. This bodes well for energy companies that survived the collapse of oil prices in 2020. Using 2019 and 2020 as indicators of the magnitude oil prices can move in one year, 2021 is poised for outsized growth:

  • In 2019, oil started the year at $45 per barrel and rose to $61 per barrel by the end of December. This increase was in large part due to consumption outpacing supply by roughly 500 thousand barrels per day. The magnitude of this shift is surprising, considering that total world production for 2019 averaged 100.65 million barrels of oil per day. This means that a supply shortage of less than 1% was able to drive prices more than 35% higher.
  • Similarly, in 2020 demand for oil dropped precipitously. The average demand for oil was nearly 2 million barrels per day less than supply over the course of the year. This led to oil prices dropping from $61 per barrel down to $40 per barrel by the end of the year. Even more dramatically, the price of oil dropped to a low of $11.26 per barrel in the depths of the pandemic.

While supply and demand were estimated to reach equilibrium in 2021 by the U.S. Energy Information Administration, this clearly did not happen as oil prices continued to surge throughout the year. Although 2022 could be the year that equilibrium is once again established, the continued rise of oil prices show that this goal is still far off.

Crude Oil Futures (CL1): One Year Chart

Crude Oil Futures (CL1): One Year Chart

Crude Oil Futures (CL1): One Year Chart

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To us, this means that any surprise to the demand side could drive oil prices notably higher. Considering that oil is currently above $80 per barrel as the world is in the midst of grappling with Omicron and a potential conflict between Russia and Ukraine, there is still more room for oil prices to run from here. Additionally, if there is a surprise increase in demand or the conflict in between Russia and Ukraine lead to a disruption in oil supplies, we may even see oil prices temporarily approach $100 per barrel.

Chevron is Poised for Large Gains

Chevron is uniquely positioned to benefit from continued higher oil prices thanks to its vast operations. The company operates in more than 180 countries and is involved in most aspects of the oil and gas industry. To manage these vast and complex operations, the company is divided into three main segments:

  • Upstream: Includes exploring for, developing, and producing crude oil and natural gas. Additionally, this segment includes the company’s extensive operations around liquefied natural gas. Lastly, this segment includes some of the transporting, storage, and marketing for both oil and gas.
  • Downstream: Consists primarily of refining crude oil and marketing of both crude oil and refined products. Additionally, the segment also handles some of the company’s transportation for crude oil and refined products.
  • All Other: While technically not a third division, the company does see this as a distinct entity in its reports. This “segment” includes the company’s global cash management and financing activities, administrative functions, insurance and real estate. Additionally, this “segment” also includes Chevron’s technology companies.

With this vast and diverse business, it is no wonder that investors in Chevron benefitted from a nearly 60% return from the end of 2015 through 2019. This period started with a major challenge for oil and gas companies as the price of oil collapsed at the beginning of 2016. Fortunately, since the company had a strong balance sheet and a well-diversified business, they were able to navigate through this rough patch better than most of their peers.

Impressively, Chevron has been able to grow both their revenues and operating income since the first quarter of 2016. This speaks volumes about the management team’s ability to make the right decisions under immense pressure that will benefit shareholders in the long run. Additionally, these changes have made the company more efficient and capable of operating at fairly low-price levels for oil.

Chevron’s Revenues and Operating Income – Past Five Years

Chart
Data by YCharts

What excites us today is that this skilled management team is finally operating in an environment of high oil prices. Considering that the average price of Crude Oil was above $70 per barrel for 2021 and could be even higher for 2022, this should lead to historic profits for Chevron. Additionally, with the U.S. Energy Administration’s (EIA) forecast for oil prices to average above $60 per barrel for the foreseeable future, these elevated profits should be here for quite some time.

Ultimately, we expect a record level of profits and a strong outlook from management should fuel the next leg up for Chevron’s stock.

How High Can Chevron’s Stock Go?

With crude oil well above $80 per barrel, the price of oil has risen more than 35% from its end of 2019 level. Considering that Chevron has generated barely half those returns over this period of time, we would have expected the company’s stock to at least keep pace with the recovery in oil prices. Adding in the enhanced margins that the company now produces due to the changes mentioned above, and the company should have posted stronger gains than the price of oil.

Chevron’s Total Returns Since the End of 2019.

Chart
Data by YCharts

One of the main reasons for this “lag” between the rise of oil prices and Chevron’s stock could be a result of views on oil prices. Since the rapid rise in oil prices was not expected this soon, there could also be little confidence that they will stay at these levels. If the view is that $80+ oil is more of an inflationary shock due to unexpected demand, rather than a shift in consumption, then one could argue that oil prices may decline over the medium term. While this could be a fair outlook, the elevated levels for crude for the majority of 2021 and the gradual further rise of prices for nearly all raw goods (due to inflation) point to a more permanent trend.

Our base case is more focused on the probability that heightened demand will be in place for the near to medium term for Chevron’s products. Essentially, with major supply chain issues continuing to be a problem around the global economy, we expect these heightened levels of demand to persist for quite some time. As each bottleneck in the supply chain is resolved, there will be an accompanying heightened demand to quickly move these products to the next stage in the supply chain. This, in turn, will keep the prices of oil elevated and should yield continued record profits for Chevron and further stock price growth for shareholders.

Steady Stream of Dividend Income

In addition to the company’s unique positioning to benefit from continued inflation in the supply chain, their focus on the dividend is also important to note. During the depths of the Pandemic, management had been in strong support of the current dividend levels, despite the collapse in oil prices. This is not terribly surprising as Chevron has been a popular holding amongst dividend-focused investors for decades. Chevron did make a tough decision in 2020 to maintain their dividend while other oil majors opted to cut dividends to preserve cash flows. This decision to maintain the dividend during such a challenging period gave investors confidence of the company’s stability in this and future crises.

In addition to not cutting the dividend, the company’s yield of 4.2% is highly attractive in today’s market where the S&P 500 yields only 1.3% and most bond portfolios yield little more than 2%. Adding in the company’s focus on continuing to grow their dividend, and income-oriented investors should find Chevron an attractive position for their portfolio.

This phenomenon occurred a little more than a decade ago during the Financial Crisis. As a result of the Federal Reserve’s actions to bolster the economy, interest rates fell to historically low levels. At the time, income-oriented investors were faced with the same challenge as today. Their solution to this challenge was to invest in high-quality dividend stocks to replace lost income. This translated into strong investor demand for high dividend stocks as rates remained low. Additionally, as rates rose, investors continued to flock to dividend stocks as their dividends continued to grow while the values of bond funds declined.

Risks

Investing in energy companies at this stage certainly comes with a number of risks.

  • The primary risk is that demand does not continue to recover and may drop if another wave of the pandemic forces the global economy to shut down again. This would have a knock-on effect for these companies to make further cuts to operations and selling off assets to maintain the core businesses.
  • Another major risk is the potential for a dividend cut. While the recovery in oil prices makes this less of a likelihood, each company currently has an extremely attractive dividend yield compared to many other income stocks. If management needed to redirect capital, they could potentially reduce their dividend and still maintain an attractive yield compared to other income investments.
  • Lastly, another potential major risk is for a fire at a primary facility. Working with hydrocarbons is ultimately a dangerous business as they tend to be highly flammable. Historically, fires have been known to shut down operations for extended periods of time and it can be very expensive for companies to clean up.

Conclusion

In conclusion, Chevron is well positioned to generate outsized returns for investors as the price of oil climbs. Even if oil prices moderate, Chevron’s stock has plenty of room to run before it reaches “fair value”. This creates a potentially great opportunity for investors to add an attractive energy company to their portfolio during this time of market uncertainty. Adding in the company’s upcoming earnings release at the end of this week, and now could be a great time to own Chevron.

Source

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