There's a list of four or five excellent companies that I do not currently own, but I probably should. Chevron (CVX) is one such company. Some of my hesitancy to purchase shares has been due to modest market timing. I have been hoping that if an adverse liability about the legacy pollution allegations in connection with Texaco's (now part of Chevron) conduct in 1990s Ecuador materialized, the price of the stock might take an unjustified hit (think Johnson & Johnson after recalls, or Wal-Mart after the Mexican bribery scandal), potentially creating fertile ground for investors with a ten-year time horizon to initiate a position.
Absent that, I have been hoping that Chevron shares might trade at a discount due to the company's short-term difficulties in finding cheap oil. For the past decade or so, it has become clear that Chevron cannot find oil as cheap as Exxon Mobil (XOM), the old ConocoPhillips (COP) before the split, and in some years, even the sprawling empire at Royal Dutch Shell (RDS.B). Over the past five years, it has cost Chevron $5.38 in total finding costs for each barrel, compared to the industry average of $3.78. For the most part, this concern about finding costs has been extremely petty because the big-picture is that the company has 24% operating margins and generates $21 billion in annual profits and has a cool $18.3 billion in cash on hand.
But I think we are starting to see some indication that Chevron's short-term difficulty in finding cheap oil is turning into more of medium-term concern. The production expenses for Chevron are on the rise because Chevron has to keep travelling farther and father to find oil; while the company spent $22 billion in research projects last year, that figure is up to $29 billion this year. The deep research projects have served the company well as Chevron now has over $172 billion in proven reserves (calculated by using end-of-November pricing), but the replacement rate has fallen to 94%, compared to Exxon which is actually managing to replace its reserves at a nearly 110% rate.
Despite these concerns, Chevron has many good things that are sure to make shareholders much richer fifteen years from now than they are today.
First, Chevron is continuing to shift from the owner to the lease model at its over 4,000 gas stations (over 85% of which are in the U.S.). Generally speaking, gas stations are a low-margin proposition that tie up a lot of capital. By continuing to shift towards leases, Chevron is able to free up cash and operate on the "toll booth" model as the new gas station owners send Chevron regular streams of cash in an arrangement that is quite similar to an annuity that gives Chevron easy to cash to invest in the business, buy back stock, and send dividends to its shareholders.
Secondly, Chevron has been ahead of the game regarding the declines in profitability among the refiners. Chevron has been gradually selling off its refining assets, choosing instead to bolster its exploration and production efforts. This has been a timely maneuver. As peers like BP (BP) are now contending with third-quarter losses at their U.S. refining operations, Chevron has been able to reduce the size and scope of its refining operations to the point where it only contributes about $1 billion or so in total profits to the company (obviously, this figure fluctuates year to year, due to the nature of commodities investing).
Right now, Chevron's dividend takes up a very low percentage of the cash flow that is being generated by each share of the stock. The $4.00 annual dividend is only 21.6% of the expected $18.50 cash flow per share that Chevron should create by year end. Chevron's dividend payout ratio could generally be summed up as this: when energy prices are either normalized or rising, the payout ratio tends to march upward from 20% to 40%. When energy prices fall, Chevron's payout ratio tends to become around 60-70% of profits and the dividend increases tend to become of a more token size.
In the case of Chevron, it appears that shareholders are currently positioned for 8-10% dividend growth moving forward (unless oil prices fall by 25% or more in the ensuing five years, in which case I would need to admit my mistake, and revise my figures downward). The assumption is that shareholders will get 5-7% organic growth from the operations themselves, as large projects in Australia come to fruition in the next 2-3 years. Another 1% or so will be due to the freed up funds courtesy of a modestly declining share count going forward (as the company takes about 50 million shares off the market each year). And then another 2-3% will be due to increases in the payout ratio, as Chevron's dividend is currently at one of the lower points in the cycle during times of normal commodity pricing. Although Chevron's shares are not currently on sale, the company may be a good candidate for "growth at a reasonable price" investing given the promising growth in the dividend going forward.