With recent negative sentiment surrounding Chevron's (NYSE:CVX) costly investments in the Liquefied Natural Gas market, the company has seen a steady decline in the last month; CVX's share price down by almost 2%. Recently, the company also expects Q4 earnings to be lower than expected due to crude oil and gas output quoted as falling short of the 2.585 million barrels reported in the third quarter. The company appears to be at a stage where a high degree of capital investment in its LNG plants worldwide is being accompanied by lags in oil production. In addition, investors are concerned as to whether such LNG plants will in fact provide significant returns in the future. The purpose of this article is to examine the future market for LNG and determine, using a range of scenarios, whether Chevron is in a position to capitalize on this market.
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What is LNG?
Liquefied Natural Gas is a modified form of shale gas that has been cooled to -161°C and has been transformed from a vapor to a liquid. This process of liquefaction allows the volume of natural gas to be reduced by 600 times, making it easier to transport gas reserves across continents. This is done through LNG carriers as opposed to traditional pipelines. The removal of CO2 and other impurities during the liquefaction process makes LNG a cleaner energy source compared to traditional fossil fuels.
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Current Market Trends
- The Asia-Pacific region currently accounts for 71% of the world's LNG imports. Short-term volume demand for LNG is projected to become more attractive due to Asian and South American markets having "proved a willingness to pay for more expensive cargoes above their long-term contracts".
- The U.S. market is set to see a particular surge in LNG export capacity, with reported liquefaction capacity of 250 MTPA (million tons per annum), accounting for just under 40% of the current LNG world receiving capacity of 649 MTPA at the end of 2012.
- While Qatar accounts for the largest share of LNG exports worldwide (77.4% in 2012), the IGU expects this to reverse due to more challenging geological structures, while Australia, East Africa and North America begin to account for the lion's share of production. Following Qatar, Malaysia, Australia and Nigeria are currently the three biggest exporters of LNG worldwide.
- The EIA anticipates that the increased depletion of natural gas reserves from inexpensive areas, increased electricity generation through LNG and projected percentage growth in natural gas demand for vehicles will cause an average 2.4 per cent increase in the Henry Hub natural gas spot price through to 2040.
Chevron's Strategic Position
In the global LNG market, Chevron is focusing heavily on investments in the Australian region, having invested over $54 billion into the Gorgon project, the largest LNG project of its kind in Australia. In Australia alone, gross LNG capacity is estimated to be 25 Million Tons Per Annum (MTPA). Due to expected production capacity, and proximity to the lucrative Asian region, such an investment could prove highly profitable if production continues as expected and demand remains vibrant from Asia. In addition, Chevron's 50% stake in the Canadian Kitimat project allows the company to also benefit from North American LNG production, with export capacity at the plant estimated at 12 MTPA.
Nevertheless, with North American MTPA capacity set to increase and the availability of lower domestic gas prices in that region, doubts are looming as to whether Chevron's large investments in LNG plants outside the North American region can prove profitable. According to the Financial Times, an oil and gas company typically needs to secure 60% of long-term contracts to export LNG in order for the venture to be profitable. Indeed, Chevron has exited certain LNG projects which have proven unprofitable, such as the Olokala project in Nigeria. Cheaper domestic supply in North America has the potential to hinder Chevron's progress in this regard. While Chevron has a presence in the North American LNG market, the lion's share is dominated by competitors such as ConocoPhillips (NYSE:COP) and Exxon Mobil (NYSE:XOM).
- Chevron's LNG portfolio is highly concentrated in the Australian region, and the company could realize a high degree of sunk costs if production and demand fall short of projections.
- It is possible that natural gas prices will not increase as anticipated, leading to high opportunity costs of crude oil production. According to the ratio of crude oil to natural gas prices, the two share an inverse relationship; i.e. if crude oil prices are high, then more companies will produce crude oil as opposed to natural gas, and vice versa. This is especially the case if the industry suffers from overcapacity, where production rates are high but there is not enough global demand to justify a higher price.
Dividend Discount Model
Clearly, attempting to forecast future production levels and prices is a subjective exercise, and one which is prone to a high degree of error. Instead, this article assumes that LNG production and demand rise as anticipated, and Chevron's dividend yield continues to grow as per previous trends. Then, the discount rate is used to assess returns taking into account varying degrees of risk associated with the LNG projects.
- Dividend growth is assumed to continue at 10.04% per annum, in line with the historical average five-year trend from 2009 to 2013.
- The firm's 2013 year-end P/E ratio of 9.85 is multiplied by the discounted terminal Earnings per Share Value of 19.75 in 2017, which is then added to the present value of discounted future cash flow per share values to obtain a projected future price. Outlined in the formula below.
Projected Share Price =
(ds(yr1)/(1+dr)^1) + (ds(yr2)/(1+dr)^2) + (ds(yr3)/(1+dr)^3) + (ds(yr4)/(1+dr)^4) + (ds(yr5)/(1+dr)^5) + (Terminal PE*Terminal EPS)/(1+dr)^5)
where ds = dividends per share; yr = year; dr = discount rate
Using varying discount rates, this particular model shows a price range from $125-$177. Given the high costs and uncertainty of LNG projects, this might suggest that investors will demand a higher rate of return in the coming years to compensate them for the increased risk; in this case we could argue a relatively higher discount rate of 15%. In this instance, assuming that dividend growth is a valid indicator of share price growth, Chevron will need to generate enough cash from the projects to increase its dividend growth rate from its current average rate of 10.04%; or at least convince investors that this will eventually materialize. Failing this, investors are not being adequately compensated for the risk of investing in Chevron, since at a 15% discount rate we are not seeing significant share price appreciation.
Given the above, 2014 will be a significant indicator as to whether Chevron can increase its production significantly to return to a decent degree of earnings growth. It is assumed that this can come from crude oil as well as natural gas sources, since if LNG production fails to materialize, then Chevron is allocating its investments to where it can be most profitable. The concern arises where the costs of LNG investments become so great that they restrict production of crude oil if prices should become attractive.
Chevron's rising cost of upstream exploration and production, coupled with only modest growth in production over the last five years, could become a cause for concern. The above tables show Chevron's production from 2008-2012 (listed from right to left), and upstream costs of production for the same period. Given Chevron's previous production record, a slowdown in production (particularly relative to other competitors) makes LNG production somewhat uncertain, and investors need to weigh whether the risks of the LNG market will be offset by appropriate returns in the future.
Disclosure: I am long CVX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.