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Year to date, shares of Chevron (NYSE: CVX ) have declined around 6.8%. This slip has largely been a function of the wider negative sentiment around Big Oil's spending problems -- production is slowing against the backdrop of a disproportionate increase in costs.
Chevron's silver lining could prove more elusive. Following Chevron's recent announcement regarding a slowdown in 2017 production, it is likely that the integrated oil major won't offset the year-to-date decline in the mid-term. Chevron recently lowered its production guidance for 2017 from the previous 3.3 million barrels of oil equivalent per day to 3.1 MBoed at its annual analyst meeting, citing an expected slowdown in natural gas prices, project delays, and higher costs.
Chevron's natural gas production as a percentage of total output is 33.2%. Its exposure to natural gas has thereby put a drag on production output as natural gas prices have been too low to comfortably accommodate the high costs of production, especially in the U.S. where natural gas prices are depressingly low when compared with the international market prices. Thereby it is likely that this exposure will weigh on the stock in the mid-term.
Despite the validity of the arguments expressed in Chevron's annual analyst meeting, the slowed production guidance does not dampen the oil major's long-term outlook. As they say, the devil is in the details. Looking more closely at some of the details that accompanied Chevron's lower production outlook announcement, it becomes clearer that the long-term outlook is brighter than previously imagined.
Prudent upstream capital allocation safeguards long-term goals
The key highlight in Chevron's annual analyst meeting was how it plans to allocate its upstream budget. This is very important for investors as the upstream sector accounts for up to 95% of Chevron's net income, according to recent quarterly reports.
Over 90% of Chevron's entire 2014-2016 upstream budget will focus on oil-linked assets. Oil has a significantly higher price than natural gas and will allow Chevron to make a buck even in the face of rising costs of production. Overall, natural gas assets will only get 2% of the capital allocated for upstream activities during the period. Similarly, 42% of the upstream budget will be allocated to international oil assets. Again, this signals prudence as it will allow Chevron to minimize the downside risks in U.S. unconventional plays such as shale formations. Despite the U.S. production resurgence in unconventional plays, technologies such as fracking make the cost of production uncomfortably high, introducing uncertainty into the profitability outlook when compared with operations in other conventional plays in the international market.
By reducing exposure in natural gas and spreading exposure in both the U.S. and international oil markets, Chevron will use its capital prudently, allowing it to get the highest production output it possibly can per unit of capital used.
This presents a two-fold benefit.
First, greater efficiency will allow Chevron to maintain sufficient margins needed to sustain its attractive dividend policy. At the current share price (as of this writing), its $4.00 a share dividend yields around 3.50%.
Second, efficiency gives Chevron a lifeline, at least until major projects that expand the growth horizons such as the Gorgon and Wheatstone LNG project in Australia come to competition. Collectively, these two projects will add around 400,000 barrels per day of oil equivalent production for Chevron in the mid-term, significantly widening its profit margins.
It is also worth noting that divestments of non-core assets between 2014 and 2016 will increase to $10 billion from $7 billion in the previous period. Additional capital from divestments will allow Chevron to fast-track its Australian projects, which as is, have been delayed and need not delay any further. Gorgon was expected to be completed this year but has since been pushed a year ahead to mid-2015.
Shares of Chevron have been stuck within a trading range for quite some time -- not an enticing scenario for investors, despite the strong dividend yield,
Chevron's investment strategy for 2014 through 2017, however, offers some hope that Chevron could gain in the long term. Essentially, prioritizing long-term projects through efficiency and divestments will allow it to increase margins drastically, so the stock could be trading at a great discount in view of the overall long-term picture. This could be a great opportunity for both income and long-term growth investors.
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