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Executive summary:

  • Weak production figures and rising costs have hurt Chevron shares.
  • The cap-ex budget is starting to decline, which is supportive of free cash flow.
  • While near-term production is disappointing, growth should pick up in 2015.
  • At 10x earnings with a 3.5% dividend yield, CVX is an attractive long-term investment.

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Chevron (CVX) shares have started 2014 on a pretty weak footing and are down by roughly 10%. The company reported disappointing quarterly results with production missing estimates (press release available here), and Friday's 10-K release has also illuminated some other concerns about production costs. While Chevron's execution over the past six months has left something to be desired, CVX is better positioned than peers like Exxon Mobil (XOM) and shares do offer a compelling value for long-term investors thanks to a low P/E multiple and 3.55% dividend yield.

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Chevron has been aggressively spending on expansion projects in boom U.S. areas, offshore internationally, and in Australia to grow production. In fact, the company spent $41.9 billion on cap-ex in 2013. Even with this spending, production growth has been slow to materialize. 2013 production was down 0.5%, and fourth-quarter production was exceptionally weak with the U.S. down 4% and international down 3%. For perspective, CVX had been hoping to grow production in the 1-3% range. 2014 will be another lost year with management guiding for flat daily production in 2014 on the most recent conference call (transcript available here).

Now, cap-ex spending takes some time to materialize into actual production. For instance, Chevron has spent billions on the Gorgon gas project in Australia, which should come on-line by 2015 and help production in that year. Due to cap-ex timing, Chevron has said production growth will accelerate in 2015 to 3-5%. I am hopeful Chevron can deliver on this guidance, though given recent production figures, I expect Chevron to deliver production growth towards the low-end of range.

Investors can also take some relief in the fact Chevron's cap-ex budget has likely peaked in the near term. Now, that is not to say Chevron is spending little cap-ex going forward. The 2014 budget is $39.8 billion, down about 5% year over year. To build a company that can grow production, Chevron has been spending more on cap-ex than the cash its operations generate. With the cap-ex budget, dividend, and buyback, Chevron added $13 billion in net debt in 2013. Importantly, Chevron is certainly not over-levered with a debt to equity ratio of only 13.5%. Investors should expect Chevron to borrow another $5-8 billion in 2014 and hopefully reverse the trend in 2015.

Now, some investors have raised a red flag over Chevron's rising cost of production. Chevron's cost of producing a barrel of equivalents was $17.10, which was up 10.6% year over year and 56% over three years. While production costs are rising, they are far from prohibitive with crude prices trading around $100. While investors should continue to watch costs, Chevron continues to be immensely profitable, and costs are far from a point where they will be problematic.

For several years, low domestic natural gas prices have provided an earnings headwind, but we have seen a dramatic increase in pricing with natural gas now trading at $6. This rise has been driven by an unusually cold winter that has impacted most of the United States and will likely prove unsustainable. While another coming cold front should support prices in the near term, longer-term contracts suggest natural gas prices will fall back below $5. The recent spike should help first quarter earnings slightly, but the increase will be short-lived. Natural gas is an important fuel of the future, which is great for Chevron, but the current price should not be seen as the new normal.

With flat production, higher costs, higher end-prices, and some share buybacks, earnings should come in around $10.90-$11.40 in 2014. Earnings growth will be relatively flat compared to last year's $11.09. At current prices, Chevron is trading at roughly 10x earnings. While there are near-term headwinds, this is a compelling valuation, especially when compared to Exxon which trades 12x earnings despite a weaker production profile. Chevron's cap-ex budget should start to slowly decline in 2015 when production starts to grow again. These trends suggests long-term earnings growth will be solid while free cash flow improves dramatically, allowing greater capital returns. After the drop year to date, CVX shares are a compelling value. With earnings growth poised to return in 2015, 10x earnings is very attractive. While weak production numbers cap near-term upside, long-term investors will be glad if they buy shares at current levels.

Source: Chevron: Compelling Long-Term Value