On Wednesday, crude oil fell nearly 5% and is now precariously close to $60. This sell-off came after OPEC forecasted the market would be even more over-supplied in 2015 than it previously thought (report available here). With OPEC seeming unwilling to do a coordinated production cut, it appears the pressure on oil will be to the downside until high-cost producers take production off-line to balance the market. As a consequence, I believe investors must be careful when investing in oil stocks and only invest in names that can easily withstand a slump in oil prices. This is why I initiated a small position in Chevron (NYSE:CVX) on Wednesday. I recommend other long term investors use the drop to start buying strong companies like Chevron. However, I would not buy an entire position now in case oil keeps falling. Instead, now is a good time to open a partial position, and investors can use drops to dollar cost average into a full position.
Importantly, Chevron has parts of its business not tied to oil prices, which will help the company weather the decline in oil better than smaller, independent companies. Chevron is an integrated company, meaning that in addition to producing oil, it refines and markets products to end customers in the form of gasoline, jet fuel, diesel etc. Refining margins are tied to spreads in prices between regions rather than the actual price of crude oil, and Chevron's downstream unit can continue to make money thanks to regional spreads, especially in the heavier crudes. Downstream earnings account for about 13% of Chevron's earnings power, and this unit's profitability is not directly correlated with oil prices (operating and financial data available here).
As an energy producer, Chevron also produces natural gas in addition to oil. Natural gas accounts for roughly 33% of production, and natural gas prices have held in much better than oil. In the US, natural gas has held steady at roughly $4, and a cold winter (which seems increasingly likely, based on what I am experiencing in the Northeast) will further increase demand for natural gas. This would be supportive of natural gas prices and serve as a counterweight to the fall in the oil unit. As the majority of Chevron's production is oil, falling oil prices are clearly a drag, but CVX's natural gas exposure should help to soften the blow.
My major concern with Chevron has been the relatively slow production growth despite a large cap-ex budget of roughly $40 billion. I expect Chevron to only grow production by 0-1.25% in 2015, which is disappointing and was a reason why I was not a buyer of Chevron when it was over $125 per share. Now, this production growth should accelerate a bit over time towards 3% in 2017 as Chevron has been investing in massive multi-year projects like Gorgon LNG, which cost billions but will only start producing energy in mid-2015. Projects like this weighed on the cap-ex budget but only start producing oil and gas in future years. While in hindsight some of these cap-ex dollars could have been better spent due to the fall in oil and cost overruns, they should start to produce cash flow in 2015-2017.
Now, I had previously anticipated CVX would spend another $40 billion or so on cap-ex in 2015, but when the company offers official spending guidance in January, I expect a significantly lower number. Much of its cap-ex is for exploration and early stage projects, and Chevron can easily push back this activity 12-24 months to deal with the fact that lower crude prices will weigh on operating cash flow. With lower commodity prices, I expect Chevron to spend $30-$32 billion on cap-ex next year, which should keep the company roughly free cash flow neutral or slightly negative.
With $14 billion in cash and only $23.5 billion in debt, Chevron has the financial strength to ride out a prolonged slump, and it even has the flexibility to add assets from distressed sellers when valuation is attractive. This downturn could be positive for CVX's long term prospects if it can add great properties at bargain prices. Assuming oil at $60 for a full year, Chevron should still be able to earn north of $8 for a 13x forward multiple. With a 4.1% dividend yield, strong balance sheet, and growth projects coming online, Chevron is an attractive defensive oil investment. I would use this drop to add some Chevron stock, and if it falls further, I would buy more.
Disclosure: The author is long CVX.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.