Over the past 52 weeks, shares of Chevron Corporation (NYSE:CVX) have soared 35% in value. Chevron has outperformed the S&P 500 (up 10%). It's beaten ExxonMobil (NYSE:XOM) -- up 20% -- and quite simply buried ConocoPhillips (NYSE:COP) stock, which is down 8%. With Chevron performing so nicely so far, one new analyst hopped aboard the Chevron train today, and recommend buying the stock here at the top.
This morning, Canadian banker BMO Capital announced that it has decided to initiate coverage of Chevron stock with an outperform rating and a $120 price target. If BMO is right about that, then investors in Chevron today stand to earn 20% profits on the stock, and collect a 4.2% dividend yield on top of that.
But what if BMO is wrong? Here are three things you need to know.
1. The inflection point
Everyone in the oil industry loves to talk about inflection points -- the point at which oil production hits its fastest rate, ceases to increase, and inexorably declines (peak oil); the price point(s) at which producing oil generates profits (or losses) for producers; and yes, even the point at which an oil stock becomes cheap enough to buy.
BMO believes that Chevron stock is about to hit that final inflection point, and urges investors to buy ahead of it.
Oil companies are capital-intensive businesses, investing millions, even billions of dollars on exploration, on drilling wells, on building derricks and infrastructure to transport oil once it's extracted, before being able to deliver even a drop of gasoline to the pump. But as StreetInsider.com explains, what gets BMO excited about Chevron is that it thinks Chevron is approaching a point at which it can ratchet its costs up and down as oil prices dictate, so as to maintain its dividend payments and maximize its profits.
According to BMO, development of "unconventional" (i.e., fracked) and "brownfield" (i.e., depleted, but not yet empty) oil fields is less expensive for Chevron than development of entirely new fields. The company intends to "increasingly prioritize" investments in such opportunities, and according to BMO, this will permit Chevron to grow its production 4% annually over the next five years at minimal cost.
The analyst notes that in 2015 (according to S&P Global Market Intelligence, Chevron's least profitable year of the past decade), 50% of Chevron's capital was tied up in "pre-productive" projects. Focusing on fracking and exploitation of existing fields, says BMO, will permit the company to reduce pre-productive claims on its capital to just 25% by 2018. It will also shift 25% of Chevron's total production into frackable fields, where production can be ramped up when prices are good, and scaled back when prices are bad.
3. Which is absolutely key
And here's where we get to the really important part of BMO's analysis: Perhaps the most important factor affecting Chevron's fortunes is the price of oil. According to BMO, it takes a per-barrel oil price of about $50 to provide enough cash to cover Chevron's 4.2% dividend yield, for example.
Moreover, "Chevron is increasingly leveraged to a recovery in the oil price environment," says BMO. So prices above $50 per barrel pay for both the dividend, and also leave some profits for Chevron -- while prices below $50...don't.
The most important thing: BMO's record
So what does all of this mean for investors in Chevron stock, which is currently unprofitable and trading at a negative P/E?
Currently, oil is selling for about $46 a barrel, bumping its head against the $50 barrier repeatedly in recent months, only to fall back down below it. For BMO's thesis to play out, though, the price of oil must rise past $50 -- and stay there.
BMO apparently is of the opinion that oil is about to return to supra-$50 levels. That's really the inflection point that the analyst is looking for. And yet, a review of Chevron's history over the past 10 years shows that while oil prices well above $50 usually permit Chevron to produce strong free cash flow (and GAAP profits as well), that isn't always the case. For example, prices as high as $90 and even $100 a barrel did not guarantee that Chevron would generate positive free cash flow in 2013 and 2014.
That calls into question BMO's major thesis that $50-a-barrel oil will help to create an inflection point in Chevron stock -- and produce the 20% profits promised by the analyst's new price target. Additionally, before acting on BMO's recommendation, you should know that this analyst has a rather poor record of picking winners in the past.
According to our data, accumulated over more than a decade of tracking the performance of BMO's stock picks on Motley Fool CAPS, BMO Capital correctly predicts price movements in the oil sector only 35% of the time -- and as a general rule, loses money on these types of recommendations. (In fact, our records show that over 10 years of stock picking, BMO's Oil, Gas and Consumable Fuels recommendations have underperformed the S&P 500 by about 1,910 percentage points.)
Long story short: If you're thinking of following BMO's advice and buying Chevron stock today, caveat emptor.