Chevron: Sweating It Out In Canada

| About: Chevron Corporation (CVX)

Chevron (CVX) has oil and natural gas assets in Canada like the Horn River Basin, Liard Basin, and the Duvernay shale formation. The development of these assets plays a major role in terms of the company's growth in Canada. It plans to export the natural gas extracted from the Horn River and Liard Basin through Chevron's Kitimat LNG project to different nations where demand for energy resources is rising. In addition to these developments, Chevron is also developing the Duvernay shale formation, which is still in the initial phase of development.

Growing need for natural gas

Chevron is turning its focus to the development of the Kitimat LNG project, where it has a 50% share. The Kitimat project is located in British Columbia, Canada. The Kitimat project will receive a supply of natural gas from the Horn River and Liard Basin. The Horn River Basin has an approximate total reserve of 250 trillion cubic feet, or tcf, of natural gas, out of which around 10% to 20% is recoverable. The Kitimat LNG project has a capacity to supply 5 million tons per annum, or mtpa, with an additional expansion capacity of more than 10 mtpa. The Kitimat LNG project is a major project for Chevron to become a leading supplier of LNG to different countries across the world. According to Chevron, the demand of LNG is going to rise and is shown in the chart below:

(Click to enlarge)

While there is a future demand for LNG, Chevron is still searching for buyers of LNG from its Kitimat project. One of the uncertainties in the project is that the company might rethink the final investment decision, if it doesn't have buyers for 60% of the LNG produced from the Kitimat project. According to the updates provided in its third quarter results, Chevron is moving ahead with the construction phase of the project site. Additionally, the company is targeting around 70% of the LNG output from this project under long-term sales contract to go ahead with the final investment decision. Long-term sale contracts are essential for the Kitimat LNG project to determine the economic viability, as the total project cost is estimated to be around $4.5 billion.

Is pricing tending to be more market oriented?

One of the obstacles in the marketing of the Kitimat project is the price formulation of LNG. While Chevron is offering LNG at oil indexed prices, Asian countries are demanding a price based on the spot market price of natural gas. In the case of oil indexation, the Japanese Crude Cocktail, or JCC, determines the natural gas prices. The JCC is the custom cleared price of oil imported into Japan. In the case of spot market price, the price of natural gas is determined by supply and demand and supply.

Chevron is offering oil indexed prices, but price determination of natural gas is shifting more towards spot market determined prices. In the U.S., the natural gas prices are determined by the spot market prices prevailing at Henry Hub. Similarly, in the European markets spot market prices from 2005 to 2010 increased from 15% to 42%. During this year, the amount of natural gas sold in the European markets based on spot market prices is estimated to be above 50%. So, we feel the pricing of natural gas for the Asian markets might transition towards the spot market price compared to oil indexed pricing.

The major natural gas resources available in British Columbia, Canada have attracted another major player, Royal Dutch Shell (RDS.A) (RDS.B). LNG Canada was formed last year as a joint venture with Shell Canada, Korea Gas, Mitsubishi Corporation (OTC:MBGCF), and PetroChina (OTCPK:PCCYF). In February this year, LNG Canada received an approval from the National Energy Board, or NEB, to export 24 million tons per annum, or mtpa, of liquefied natural gas, or LNG, for 25 years. Compared to Chevron, Royal Dutch Shell is in an beneficial position by being in the joint venture, because the co-developers of the project are also importers of the LNG produced from the project. Thus, Royal Dutch Shell has been able to remove the uncertainty surrounding the takers of the LNG produced from this project. In a recent development, KoreaGas is contemplating to trim a part of its 20% stake in the project as part of its business structuring to sell non-core assets.

Experiencing success in the Duvernay

Chevron has concluded the initial phase of its 12 well exploration program in the Duvernay shale formation located in west-central Alberta, Canada. Chevron has around 325,000 net acres in the Duvernay shale play. Among the 12 wells, five wells are complete and beginning the production phase. The amount of liquid produced by the completed well ranges from 30% to 70% of the total well production. The liquid production consists of oil and natural gas liquids. The initial production from the wells reached around 7.5 million cubic feet per day, or mcfpd, of natural gas and 1,300 barrels per day, or bpd, of condensate. Condensate are petroleum products that remain in liquid form under normal temperature and pressure. Initial production is a metric that helps estimate the amount of petroleum deposits that can be extracted from a well. A study by ERCB/AGS estimates that the potential reserve in the Duvernay play to be around 61.7 billion barrels, or bbl, of oil, 443 tcf of gas in place, and 11.3 bbl of natural gas liquids in place. This huge reserve in the area gives Chevron significant room for exploration and could increase the production output from the region.

There is huge deposit present in the Duvernay formation and drilling out this petroleum requires a significant capital outlay for well drilling. The cost of drilling wells in Duvernay shale ranges between $8 million to around $10 million with some reaching as high as $15 million. Though the cost of drilling wells is high in the Duvernay play, significant cost reduction could be achieved as the development continues. According to Rystad energy, the cost of wells could come down by around $3 million, or 20% of the initial cost. The lowering of well costs as the play develops will result in a significant increase in Chevron's operating margin.

One of the major players in the Duvernay play is Talisman Energy (TLM) with an acreage position of around 347,000 on the Duvernay shale formation. The company is planning to develop its acreage with a 50-50 joint venture partner. Talisman plans to drill four to five pilot wells in the region this year. With the huge potential of the Duvernay formation and major players like Chevron focusing on exploration and production, we expect other companies will follow suit.

Not letting it go in Canada

The worldwide demand for natural gas clearly shows that the natural gas from the Kitimat project might find ready buyers. As discussed, the pricing strategy requires a solution, which could be win-win for both the buyer and seller. We found that spot market oriented pricing is gaining acceptability across the world. Once Chevron resolves this pricing issue, the Kitimat LNG project has real potential to provide multi-year revenue.

In addition to the Kitimat project, the Duvernay play is expected to become a high growth area for Chevron as the development progresses in the coming quarters. Currently, the stock of Chevron trades at a price-to-sales, or P/S, of 1.07. With these projects coming into operation in Canada, we expect the P/S ratio should reduce further. The two projects in Canada hold immense potential for growth of the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: Fusion Research is a team of equity analysts. This article was written by Madhu Dube, one of our research analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.