- Under-investment during the pandemic era is showing its effect in crude oil price, and supply shortages will last for at least a year or two.
- Refinery production shortages and supply chain disruptions are causing gasoline and diesel prices to rise as well.
- Integrated oil giant Chevron is in the best place to take advantage of the widespread energy crunch.
Chevron Corporation (NYSE:CVX) is an integrated oil & gas company that operates across the entire industry supply chain. The upstream segment explores, develops, and produces crude oil; the midstream segment transports crude oil to refineries or petrochemical complexes; and the downstream segment refines the crude oil into gasoline, diesel, and other petrochemical products. Underinvestment during the pandemic era is causing significant shortages of crude oil. The impact will last for a while, since developing and producing a new oil well takes a couple of years. Also, disruptions in the crude oil supply chain, and lower production from weather damaged refineries, is causing gasoline and diesel prices to sky rocket. Since Chevron operates an integrated upstream to downstream business, they will see benefits across the whole oil & gas supply chain. Energy is leading the inflation indices, so I believe Chevron is an excellent investment in this high inflation environment because:
- Crude oil supply shortage will last for a year or two until resumed investment in 2021 from oil companies start to show an impact, which will be 2023 at the earliest.
- Refinery damage caused by the 2021 winter-storm in the Texas-Louisiana area has not been fully repaired yet, and gasoline and diesel outputs are not operating at full capacity. The crack spread keeps on rising.
- Cost reduction during the pandemic is increasing their margin, and profit margin will likely stay high for the foreseeable future.
Crude Oil Supply Shortage Will Stay
The precipitous drop in demand (combined with uncertainty) at the beginning of the pandemic, caused crude oil prices to drop all the way into negative territory. Some companies were actually paying others to get rid of oil, due to problems with overflowing storage. During this time, a lot of oil majors stopped developing their wells, and the effect of persistent underinvestment is really showing its effect right about now. In 2021, the recovery in oil price caused oil companies to start investing again, but it will take another year or so for production to reach its pre-pandemic level. Developing and producing oil wells is a slow process that takes at least a couple of years.
Additionally, the geopolitical conflict between Russia and Ukraine is adding another layer of supply pressure to oil, as Russia exports 8% of the global oil supply. Combining the supply shortage with recovering oil demand due to increased levels of travel, commute, and manufacturing, I expect oil prices to stay high for at least a year or two. In the mean time, a major oil and gas company like Chevron will make a lot of cash.
Downstream segment will flourish as well
Chevron is an integrated oil & gas giant, which means that it owns the entire oil & gas supply chain. It operates an upstream segment to explore and produce oil (basically pump oil out of the ground), transports this crude oil to refineries and petrochemical complexes, and refines the crude oil to produce gasoline and diesel in its refineries.
As you've probably already noticed at the gas station, gasoline and diesel prices are shooting up. These high prices are caused by high crude oil prices, along with supply chain disruption and reduced refinery production. A record number of people left their job during and after the pandemic, and the trucking industry is experiencing significant labor shortage, which is contributing to the gasoline and diesel supply shortage. Also, the record winter storm during February 2021 damaged a lot of refineries in the Texas/Louisiana area, and production capacity has not fully recovered yet. All of these factors combine to create supply shortages. Meanwhile, recovering demand from increased levels of driving is exacerbating the issue.
Reflecting this whole supply crunch of gasoline and diesel, the crack spread has been shooting up since the beginning of the year. The crack spread is basically the price difference between the petroproduct and the crude oil, which directly impacts refinery profit margin. So, the profit margin of refineries are rising at a rapid pace. Since Chevron also owns the downstream segment, they will capture the benefit of this rising crack spread.
Margin Improvement to Continue
During the crash in crude oil price, gasoline, and diesel prices at the beginning of the pandemic, Chevron's profit margin suffered substantially. However, rising prices enabled profit margins to recover nicely in late 2021, and they just keep improving ever since. According to the last earnings call, their Return on Capital Employed (ROCE) stands around 15%, and they generated free cash flow over $6 B in 1Q 2022.
The pandemic environment caused many oil and gas companies to realize the importance of operational efficiency, and many of them focused on cost reduction. Chevron executed headcount reduction, production efficiency increase, and unit cost reduction in the past year or so and will continue to do so in the coming years. Management mentioned that they expect to reduce 2026 operating expenses per barrel by more than 10%. These efforts will further improve their profit margin and operating cash flow.
Intrinsic Value Estimation
I used DCF model to estimate the intrinsic value of Chevron. For the estimation, I utilized operating cash flow ($33.1 B) and WACC of 8% as the discount rate. For the base case, I assumed operating cash flow growth of 1% for the next 5 years and zero growth afterwards (zero terminal growth). For the bullish and very bullish case, I assumed operating cash flow growth of 2% and 3%, respectively, for the next 5 years and zero growth afterwards. Given the strong demand recovery and under-investment during the past two years, I expect average crude oil, gasoline, and diesel prices to stay high, and Chevron will benefit from these trends.
The estimation revealed that the current stock price presents 10-15% upside. Given continuing strong commodity price and the recovering economy, I expect Chevron to achieve this upside.
Very Bullish Case
The assumptions and data used for the price target estimation are summarized below:
- WACC: 8%
- Free Cash Flow Growth Rate: 1% (Base Case), 2% (Bullish Case), 3% (Very Bullish Case)
- Current Operating Cash Flow: $33.1 B
- Current Stock Price: $156.67 (05/01/2022)
- Tax rate: 25%
As many of us are aware, the Electric Vehicle (EV) transition is in full swing. Major car companies (Toyota, Ford, GM, and etc) are releasing new EV models about every month, and the number of EV charging stations is also increasing at a rapid pace. The sharp increase in EV sales may impact the gasoline and diesel fuel price negatively.
Additionally, renewable power capacity is increasing at a rapid pace as well. In 2021, almost 290 gigawatts of new renewable power plants were commissioned. Also, the cost of renewable energy is dropping as well, and solar and wind plants are cheaper than fossil fuel at utility scale in some areas. Therefore, the rapid increase in power generation from renewable sources may present long term challenges to oil and gas companies.
Chevron's high operation efficiency, disciplined capital deployment, and vertically integrated business model has been serving Chevron well for several decades. I expect Chevron to be an excellent investment choice during the current high inflation environment. Their products (crude oil, gasoline, and diesel) are a large part of the inflation gauge, and these prices will proportionally rise with the inflation level. Therefore, Chevron's margin will likely improve during high inflation, whereas many other companies will suffer from rising costs. EV adoption and increasing levels of renewable energy do pose threats to Chevron, so the investor should monitor progress on these fronts. Overall, I expect 10-15% upside.
This article was written by
Analyst’s Disclosure: I/we have a beneficial long position in the shares of CVX either through stock ownership, options, or other derivatives. 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.
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