Chevron Corporation (NYSE:CVX) has been downgraded by Morgan Stanley as its production level in the second quarter was relatively flat and the company missed analysts' adjusted earnings estimates by 2%. However, the company's target price has recently been raised by almost all the industry analysts indicating that the stock has growth potential.
Chevron's stock closed at $128 up approximately 7% year to date but were considerably lower than the energy sector's approximate gain of 14%. One reason behind the lower gains was the lower volume production in the second quarter. The most recently reported volume was 2.55 million barrels per day down from 2.58 million barrels per day in the second quarter of 2013.
Another reason for the recent decline in share price is the earnings release. Chevron's recently reported earnings comfortably beat the expectations with $5.7 billion ($2.98 per share - diluted) for the second quarter 2014, compared to $5.4 billion ($2.77 per share - diluted) in the second quarter of 2013.However, the numbers don't show a complete story. Earnings were supported by gains in asset sales of about $0.75 billion. By subtracting these gains it becomes evident that earnings fell slightly below expectations thereby disappointing investors. Foreign currency effects also negatively impacted the company and cause earnings to decrease in the second quarter by $232 million compared to an increase of $302 million year over year.
Chevron's sales and other operating revenues in this quarter were relatively flat and missed analysts' estimates. The company has now missed the revenue estimates in five of the last six quarters. The revenues stood at $55.6 billion compared to $55.3 billion in the corresponding period last year.
The drag on the revenues in the company's upstream segment was due to lower worldwide net oil-equivalent production which was 2.5 million barrels per day compared to 2.58 barrels per day in second quarter of 2013.The lower production was offset by higher average prices in this quarter in both the U.S. and International segments.
The company's average sales price per barrel of crude oil and natural gas liquids was $92.44 in the U.S. segment up from the figure of $92.25 last year. The price in the International segment was $101.15 per barrel compared to $93.71 per barrel reported a year ago. Likewise, the prices of natural gas jumped to $4.09 per thousand cubic feet from $3.78 in the U.S. segment and to $5.98 per thousand cubic feet from $5.93 in the international segment.
Source: Company s News Release
Similarly, the revenues from the downstream segment were also mainly affected by lower production. The refinery crude oil production in the U.S. decreased 53,000 barrels per day from the last year's level of 761,000 barrels per day. This occurred due to the planned turnaround at the refinery in El Segundo. The refined product sales in the U.S. downstream segment fell 25,000 barrels per day compared to the figure reported in the second quarter of 2013.
In the international downstream segment, refinery crude oil input of 844,000 barrels per day in the second quarter of 2014 decreased 28,000 barrels per day from last year. The total refined product sales of 1.55 million barrels per day in this segment in the second quarter of 2014 were flat.
Upstream Margins Are Better than Downstream:
The company operates in two segments: Upstream and Downstream. The Upstream segment includes activities such as exploration, development, and production of crude oil and natural gas along with related activities. The Downstream segment engages in refining crude oil into other petroleum products as well as marketing and transporting crude oil and refined products.
Between these operations crude oil and natural gas production is by far the most valuable for Chevron owing to higher profitability margins. This is evident in the fact that the EBITDA margins for crude oil and natural gas liquids (NGL) production were a little over 34% in 2013 compared to only 7.5% for the refined product sales though downstream activities comprised a huge 47% of the company's revenues in 2013 (Trefis).
In the wake of such margins history, Chevron is implementing its previously announced plan to expand and improve its upstream activities at the expense of its downstream operations. This is why the company's international upstream business has performed incredibly well reporting earnings of $4.21 billion reflecting a 9% increase from last year's reported figures. The downstream earnings for the international segment plunged from $628 million to $204 million. Although it might appear to be worsening the impact is actually positive considering the huge difference in their relative margins.
Bottom Line Growth
Unlike revenues, Chevron's bottom line experienced year-over-year growth of 4.72% due to an increase in the upstream segment's earnings. The net earnings in the upstream segment increased 6.36%. However, the earnings growth is mainly attributed to the non-recurring gains that the company achieved from the recent sales of its non-operating interest in seven crude oil producing fields in Chad's Doba Basin along with approximately 21% interest in two affiliates. The higher gains offset the negative effect of additional depreciation, exploration, and operating expenses in the quarter.
The higher depreciation, exploration, and operating expenses were also somehow offset by lower cost of goods sold. The operating margin in the second quarter was relatively flat compared to the operating margin of the second quarter of 2013. The cost of goods sold was lower primarily due to lower crude oil and refined products volume.
Return to Shareholders
The company has been generous in distributing returns to shareholders. Since 2004, the dividend distributed by the company has grown by a compound annual growth rate of greater than 10% and the company has made a cumulative share repurchase of over $40 billion during this period. Over the last 10 years, the company has distributed the highest returns in the form of dividends and stock price appreciation compared to its peers and S&P returns.
Source: Investors Presentation
In the second quarter of this year, the company's board of directors has announced a diluted dividend of $1.07 per share reflecting 7% growth compared to the dividends offered in the same quarter of the previous. The dividends offered in the first six months were $2.07 per share compared to $1.90 per share in the corresponding period last year reflecting YoY growth of 8.95%. During the first half of this year, Chevron repurchased 20.8 million shares for $2.5 billion under its ongoing share buyback program.
As Chevron's operating and free cash flows are growing at a good pace we can expect that the company would remain generous in the future as well. Since 2010, Chevron has been generating the highest per share cash flow compared to its industry rivals. In the first six months of this year, the cash flow from operations jumped to $16.3 billion compared to $14.2 billion last year. Per share cash flow was $8.62 compared to $7.38 per share in the first half of 2013.The free cash flow in this period stood at $17 billion compared to $16.7 billion in 2013.
Going forward, I share most analysts' expectation that downstream margins will remain under pressure (at around 3% - 4%) due to overcapacity in the global refining markets, declining demand for gasoline in developed markets, and higher, on average, crude oil prices.
Also, there is mild concern rising in the investment community concerning upstream activities since according to an analysis by Cambridge Energy Research Associates (CERA), the costs associated with constructing new oil and gas upstream facilities have reached an all-time record high value. According to the analysis, costs related to the extraction of oil and gas have more than doubled since 2005.For instance, Chevron's US operations faced an earnings decrease of $29 million falling to $1.05 billion despite an 8,000 barrels increase in production to 667 thousand barrels per day. Higher exploration and operating expenses were to blame for declining earnings. The main reason for this increase is the growing complexity of upstream projects. Thus the shrinking of EBITDA margins is expected for upstream activities in the future but the increase in these margins will still be higher than the decrease caused by reducing downstream operation seven after setting off the price hike in exploration and extraction processes.- Thus the company is getting a better trade-off in this deal.
Chevron intends to use the most capital expenditure on its LNG segment, spending billions of dollars in the construction of around 25 million tons per annum LNG capacity in Australia and another 15 million tons per annum in Canada and Australia. Over the next two years, the company would be spending 22% of its total spending on LNG projects. As the trade for LNG is poised to grow due to its increasing usage in electricity generation, industrial operations, and transportation so this spending would result in the reaping of good profits for Chevron in the coming years. The global natural gas demand is projected to grow by 64% from 113 trillion cubic feet in 2010 to 185 trillion cubic feet in 2040.
The company has started commercial production at its new premium base oil plant which will add 25,000 barrels per day of premium base oil, meeting increasing strict regulatory requirements and high performance standards for lubricants around the world. This year Chevron also acquired shallow water acreage offshore Myanmar which would expand its leading position in Asia and complement its portfolio of exploration opportunities.
These expenditures would undoubtedly bring huge revenue generating opportunities for the company but at the same time these are increasing the downside risks for Chevron as the global supply of oil has been running ahead of demand; this has also pushed down its prices. However, now oil rebounded to more than $105 per barrel bouncing back from its lowest close in nine months. So it can be expected that the price level will be sustained in the coming period and will help Chevron to grow its revenues.
A Better Future Ahead:
"It's been a mediocre quarter for Chevron", said Brian Young berg of Edward Jones noting most of Chevron's asset sales were involved in production operations in Chad and Cameroon. He also said that 2014 is a transition year for the company as it looks for growth in 2015.
John Watson, the CEO of the company, announced that significant progress on major capital projects is being carried out and the company is expected to yield a 20 percent increase in production by 2017. The company is confident that this will lead to a considerable growth in its cash flows. In my opinion, the company is correct to expect its future production to increase. For example, there are a number of projects going on at present such as in the Gulf of Mexico where the company expects to improve production from the beginning of the Jack/St. Malo Project later this year and the Big Foot Project in 2015. Also, in Australia, the Grogan and Wheatstone LNG projects continue to reach important interim milestones. Gorgan is expected to begin its operations in 2015.The company is advancing the development of its liquid-rich properties in Canada, the U.S. and Argentina.
Finally, the U.S. shale boom has caused a reduction in the company's growth trend. Despite that the company reported a modest 1% increase in the second quarter compared to a year ago. More importantly, the company is working on benefiting from the same technology. Jeff Gustavson, Chevron's general manager from investor-relation department, said that the company is also increasing production from shale deposits in the Permian Basin in Texas. He pointed out that the company now has 27 active rigs in that region and has begun horizontal drilling in the Wolfcamp area. Thus, the future prospects in this technology also look promising.
Chevron could not meet the expectations in this quarter due to lower production in both its upstream and downstream segments. However, there are some factors that still make its stock attractive. They include the company's spending in LNG and oil projects that will add more capacity and rectify the problem of lower production in the future. The rebound in oil prices would also help the company to add growth to its top line. Moreover, the company is excellent in generating cash flows and distributing returns to the shareholders compared to its peers in the industry. However, it needs to pay attention to its increasing operating expenses which could deteriorate its margins in the future.
Therefore, like the industry experts, I would also suggest investing in Chevron's stock as there is upside potential.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: The article has been written by APEX Financial Consultants. This article was written by one of our research analysts. APEX Financial Consultants is not receiving compensation for this article (other than from Seeking Alpha). APEX Financial Consultants has no business relationship with any company whose stock is mentioned in this article.