When the Dow Jones Industrial soared over 300 points, Chevron (CVX) shares finished flat because of investor disappointment with their interim report. A month before it releases complete quarterly results, Chevron releases a brief report to refine guidance and provide some details about the operating performance of the first two months of the quarter (you can access the report here). Headlines crossed that CVX anticipated weaker sequential results, weighing down shares. However, that broad generalization misses the underlying positives of the report.
First, the major driver of the sequential decline is foreign currency adjustments with the company expecting a $300 million loss after taking a $300 million gain in the previous quarter. As long-term investors know, foreign currency fluctuations are transitory and should be smoothed out over time. This $600 million swing will make for good headlines but doesn't change the underlying story of CVX.
Second, the refining environment weakened in the 3rd quarter. The WTI-Brent spread tightened significantly, which directly impacts refining margins. Earlier this year, when WTI was trading $10 less than Brent, refineries were printing money at levels not seen in the past 10 years. During the summer, the spread collapsed bringing refining margins closer to historic norms. Margins in the US, for instance, fell roughly 20% from $5.73 to $4.46 per barrel of oil. The drop is steeper when looking at the peak in the fourth quarter of 2012 at $8.85 per barrel. The past 18 months have been extremely good for the refiners, but these earnings were never sustainable. For Chevron and the other majors, the real profits have been in exploration and production with refining a mild add-on. A decline in refining profits has been well-known and is already discounted for 2014.
Importantly, Chevron is seeing improving performance in its production business. As a whole, its upstream business delivered an additional 15 million barrel of oil equivalents a day in the quarter (3% annualized growth). This came even as its U.S. operation saw a mild decline due to planned maintenance activity in the Gulf of Mexico. The major oil companies, especially Exxon Mobil (XOM), have struggled mightily to increase production. This quarter shows Chevron remains on track to do so and remains one of the best run oil companies in the world. I believe CVX will be able to continue to grow production through 2014, which will push up overall earnings even as refining drags.
Even though the company is performing so well, CVX is not trading at a premium to competitors or its historic valuation. At current levels, Chevron trades at 9.4x earnings while Exxon trades at 10.7x and ConocoPhillips 11.7x. With an equally strong balance sheet and better producing properties, CVX should be trading at least at par with Exxon, providing 15% of upside. As you see from the chart below, CVX's P/E, while trending up this year, is well within historic parameters. This stock is not expensive compared to where it has tended to trade.
Chevron has been the ultimate dividend growth stock. In the past 10 years, its payout has nearly tripled from $0.365 to its current $1.00 quarterly payout. With 2014 earnings power of $12.50-$13.00, it maintains a very low payout ratio and will likely increase next year's dividend by at least another 10%. With operating cash flows of $40 billion and a cash pile of $20 billion, the company also has the flexibility to tactically repurchase stock to boost shareholder returns while continuing to invest in production opportunities.
With the stock down 9% from its summer highs, there is a disconnect between the stock and company's performance. This presents a good opportunity for the longer-term dividend growth investor. Trading at $116, the stock now sports a strong 3.4% dividend yield with a path to grow that dividend substantially over the next 5 years, certainly outpacing the gains from the other oil majors. In the immediate term if our politicians scare markets, CVX would not be immune, but its long-run story remains intact. Such a sell-off only presents a better buying opportunity in this fantastic company that is well-positioned to outperform. Contrary to headlines that focused on currency swings and distorted refining comparisons, Chevron continues to expand production. As long as CVX does this, it will provide substantial returns to its investors.