By Matthew Smith
As global concern grows over an impending Chinese economic slowdown, we are seeing commodity prices fall, which is having a direct impact on the price of resource stocks. However, it is my opinion that this is creating many investment opportunities for astute investors in the resources sector, and in particular, the oil and gas sector. I believe that an economic slowdown in China can't last forever, and over the long-term, we will continue to see both commodities, especially oil, rise in value. One particular company that comes to mind, due to the latest adverse publicity for the industry, is Chevron (CVX), the fifth largest publicly traded global energy company. Since hitting a 2012 high of $111.19 in mid March, Chevron has dropped by 4% to $107, which I believe represents a buying opportunity. Below, I will explain why.
Chevron's financial results for the fourth quarter 2011 were disappointing, with the company reporting a 5% drop in revenue to $56.4 billion and a 35% drop in net income to $5 billion. In addition, for the same period its balance sheet weakened, with cash and cash equivalents falling 1% to $20 billion and long-term debt rising by 3% to $9.8 billion. Yet despite the disappointing fourth quarter results, Chevron reported strong full year 2011 results, with revenue rising by 25% to $236.5 billion, and net income rising 41% rise to $27 billion.
There were also a number of positive indicators that bode well for the growth of Chevron's future earnings in its fourth quarter 2011 report, including:
- The company added 1.67 billion barrels of net oil-equivalent reserves in 2011.
- It increased its penetration of the Brazilian market in 2011 with a 9% increase in sales when compared to 2010.
- The average sale price for crude oil in the fourth quarter 2011 was $101, which is a 28% increase from the same period in 2010.
- The average price of natural gas in the fourth quarter was $5.55 per thousand cubic feet, which is a 15% increase from the same period in 2010.
However, when Chevron's key performance indicators are compared to its competitors, the company is lagging behind its competitors in almost all of them as the table below shows.
Debt to Equity Ratio
Based on the PEG ratio, Chevron does not appear to have strong growth prospects and appears expensive in comparison to Ecopetrol with a PEG of 0.87. However, this is similar to BP's and Exxon's. The company's profit margin, while quite respectable at 24%, is less than half of Ecopetrol's but superior to BP's and Exxon's. Chevron is also delivering a solid return on equity, though it is lower than Ecopetrol's, BP's and Exxon's. However, with a return on equity of 24% in conjunction with a double digit profit margin and extremely low debt, it does bode well for increased profitability. This extremely conservative debt to equity ratio is also a good indicator of the low degree of investment risk an investor accepts when investing in Chevron.
While these indicators give us a snapshot of the performance of the company, especially in comparison to its competitors, investors need to recognize that except for the PEG, the other indicators are lagging indicators and only show us how the company has performed. Therefore, to get a solid feel for whether the company is cheap in comparison to its competitors, it is important to get a feel for its future valuation and determine whether at current prices, combined with consensus future earnings, it is expensive in comparison to its competitors.
Chevron, has 2012 consensus EPS of $12.98, which with a current trading price of around $108, gives it a forward PE of 8. The consensus forecast is that Chevron will see a 23% increase in revenues to $290 billion for 2012. Ecopetrol is trading at around $62 with consensus 2012 EPS of $4.60, giving it a forward PE of 13, as well as a consensus forecast of a 7% fall in 2012 revenues to $34.7 billion. This makes Ecopetrol appear expensive in comparison to Chevron. BP, which by market cap is the fourth largest company in the integrated oil and gas industry, has a consensus forecast 2012 EPS of $6.60, which with a current trading price of around $46, gives it a forward PE of 7. Analysts have also forecast a 1% drop in 2012 revenues to $372 billion.
Then there is the world's largest publicly traded oil company Exxon, which is trading at around $86, with a 2012 consensus EPS forecast of $8.24, giving it a forward PE of 10. The consensus forecast is that Exxon will see a 13% drop in revenues during 2012 to $492 billion. Overall, Chevron appears cheap in comparison to Ecopetrol and Exxon and around the same value as BP. It is also the only company of the five to have a consensus forecast predicting a rise in revenues during 2012.
I like Chevron's dividend yield of 3%, which is a solid yield for an oil and gas producer, though it is lower than BP's 4% and Ecopetrol's 3.5%, but higher than Exxon's 2%. Furthermore, it has an extremely low payout ratio of 23%, which as a quick and dirty measure of dividend stability indicates that Chevron is capable of sustaining this yield.
It is also important to get a feel for Chevron's cost of production as this will have an impact on future net income. For 2011 Chevron reported a cost of goods sold (COGS) of $163.5 billion, which is 69% of total revenue. This is higher than Ecopetrol's 2011 COGS of $20.8 billion, which is 56% of total revenue, but superior to BP's COGS of $318 billion, which is 84% of total revenue and Exxon's COGS of $304 billion, which is 70% of total revenue. Overall from a cost perspective Chevron is a more cost effective producer than BP or Exxon but is trailing behind Ecopetrol.
There is significant concern regarding a slowdown of the Chinese economy and the impact this will have on the global economy, particularly as China is the second largest economy in the world, with a share of global GDP reaching almost 15% (on a PPP basis) in 2011. Accordingly, the IMF estimates that the impact of Chinese demand on the world's largest economies has more than doubled over the past decade. Therefore, any slowdown in the Chinese economy will have a significant impact on resource prices, accordingly affecting the earnings of resource companies worldwide.
However, I am of the opinion that despite negative implications for iron ore and base metal mining companies such as Vale (VALE), BHP Billiton (BHP), Rio Tinto (RIO) and Cliff Resources (CLF), it will not have a significant impact on oil prices. In fact, despite signs of a slowing Chinese economy for over a year, the price of Brent Crude has risen by 13.6% since October 2011 to be trading, at the time of writing, at $124.38 per barrel, as the table below shows.
Table 1: Brent Crude per barrel
*As at the 26th March 2012
I believe that oil will not be subject to the same price pressure as other commodities from a slowing of a Chinese economy because there are signs of significant supply-side constraints, which I believe will support the price for oil, seeing it remain steady. These supply-side constraints include ongoing political instability in the Middle East, continued tensions over Iran's nuclear ambitions and Chavez's ongoing reactionary and nationalistic political rhetoric. I also believe that the long-term outlook for oil remains favorable, despite developed economies exhibiting sluggish growth prospects, as global oil consumption will continue to be boosted by economic growth in emerging powers such as India, China and Brazil.
Another aspect that I quite like about Chevron is that in the fourth quarter 2011 it purchased $1.25 billion of common stock as part of the company's share repurchase program. This is a positive sign indicating that Chevron is confident in its current financial performance and has further confidence in delivering a strong future performance. I also quite like Chevron's growth strategy the key planks of which are:
- building production from unconventional resources in the U.S, Europe and South America;
- the execution of a six year development program that will increase production from unconventional resources in the U.S, Europe and South America to 175,000 BOE per day by 2017;
- making large investments over the next six years in Liquefied Natural Gas (LNG) projects;
- the 2011 purchase of more than 700,000 net acres in the Marcellus Shale;
- the 2012 commencement of drilling in the company's 600,000 net acres exposed to Utica Shale; and
- the drilling of 200 additional wells in the Wolfcamp Shale in 2012.
However, of some concern are Chevron's problems in Latin America and in particular at the moment in Brazil. Brazilian federal prosecutors have recently filed criminal charges against Chevron and drill-rig operator Transocean (RIG) for a November 2011 oil spill. The charges stem from a 3,000-barrel leak in the Frade field, about 75 miles off the coast of Rio de Janeiro state. As a result of the oil spill, Chevron is facing an $11 billion civil lawsuit over the spill. In addition, Chevron has already been fined around 200 million reals ($110 million) for the spill by Brazilian regulators.
Chevron and Transocean have strongly disputed the charges and have issued statements arguing they are without merit. Whether Chevron is able to effectively defend the charges and settle the civil suit will depend on the political situation in Brazil. At this time it is my view that the results of these cases are unpredictable as there are those within the Brazilian government and political elite who are using it as a tool to shut out foreign resource companies. Interestingly larger sized oil spills from Petrobras (PZE), the Brazilian owned and operated oil company, in Brazil have resulted in little to no action being taken. Chevron's Latin American worries don't finish there, the company is also facing an $18 billion environmental verdict in Ecuador. All of this creates some uncertainty as to the extent it will damage Chevron's Latin American operations, leaving question marks not only over the quantum for costs and fines associated with the legal cases, but the overall impact it will have on the company's Latin American revenues.
Finally, in my opinion, at its current price Chevron is undervalued by the market, because it has an earnings yield of 13%, which is more than five times the current risk free rate. Even when allowing for a minimum generally accepted equity risk premium of 4% on top of the risk free rate of return, Chevron is undervalued. However, despite this, any investment in Chevron is made with a greater degree of risk than Exxon or BP, though its current issues have pushed its price down, creating what I believe is a buying opportunity. First, at its current price, the stock is undervalued. Second, it has a relatively cheap forward valuation in comparison to its competitors. Finally, it has a solid growth strategy, and with oil prices likely to increase over the long-term, the company is well positioned to capitalize on this with growing reserves and a strong balance sheet.