The energy industry is in the middle of a commodity downturn. While that's not unusual, this particular trough is unique and likely to linger. In response, Chevron (NYSE:CVX), along with many peers, is pulling back on its capital spending plans.
The headlines around what's going on, however, don't really explain the extent of the situation at Chevron. Here's a different look at the moves the company is making.
Not an ordinary downturn
Oil and natural gas are commodities subject to often swift and large price swings. So, on one hand, the current price drop isn't unusual for the highly cyclical industry. However, this time around, there's a confluence of events that suggest that this is going to be a deep and long downturn.
The energy industry has been working to adjust to increasing U.S. output for roughly a decade or so. That's kept a lid on oil and natural gas prices, and was largely being dealt with via OPEC-led production cuts. The problem with this approach, however, was that U.S. production just offset every cut made. Eventually, OPEC and Russia parted ways on a broader production cut agreement that essentially started a price war that pushed oil sharply lower. While this was going on, COVID-19 led countries around the world to effectively shut down their economies. That put even more pressure on energy prices.
Eventually Russia and OPEC got back on the same page, with the United States fully in the loop, and production cuts are again on the table. But oil prices haven't really recovered, because the bigger problem now is demand, which fell off a cliff because of the worldwide effort to slow the spread of the coronavirus. With less oil and natural gas being used, excess supplies are piling up in storage. And all of that has to be worked off before energy prices can start to recover in a meaningful way. Put simply, oil and natural gas prices are likely to be low for longer than anyone was expecting just a few months ago. That's a troubling backdrop.
Pulling back on spending
Not surprisingly, companies throughout the energy industry are pulling back on their spending plans. That's a good move for two reasons: Not only does it help to conserve cash, but it will also reduce output. Chevron is no different in this regard, as it announced its intention to trim its 2020 capital spending plans by roughly $4 billion. About half of that cut, by the way, is going to come out of its U.S. onshore drilling efforts. So it's not only pulling back -- it's pulling back in what is probably the biggest trouble spot.
That $4 billion figure amounts to roughly 20% of Chevron's original $20 billion capital spending budget in 2020. It's worth noting that Chevron's $20 billion in spending was already among the lowest relative to cash flow in the industry. The cut, meanwhile, will provide it with extra breathing room as it looks to maintain its dividend through a deep industry downturn. However, the 20% number that headlined the company's move isn't the full picture. It takes time to change direction in the energy space -- oil and natural gas wells aren't something that can be turned off and on like a light switch.
So Chevron's effort to pull back will, indeed, lead to a $4 billion spending reduction in 2020. But the longer-term impact will be larger, because the cost cuts aren't going to be evenly distributed throughout the year. For example, the company is expecting capital spending to be roughly $7 billion in the second half of the year. That's a run rate of $14 billion.
Going back to the original $20 billion plan for 2020, we now have a very different number to look at. In 2020 Chevron will spend about 20% less than originally expected. But it will exit the year with spending that's on a trajectory about 30% below the original plan. That "$4 billion in cost reductions" number isn't the whole story. Assuming nothing changes from here, Chevron will enter 2021 at a run rate that's $6 billion below the original 2020 plan -- and, thus, will already have another 13% or so year-over-year reduction in capital spending baked into its numbers without the need to do much of anything.
A strong position
Chevron is dealing with an ugly oil market as best it can, just like all of its peers. That includes cutting back on spending, and the cuts it's making are bigger than they at first appear. That's good, because the oil downturn is likely to be longer than usual because of the extra oil piling up in storage. Now add to this story that Chevron has one of the strongest balance sheets in the industry, entering 2020 with a financial debt to equity ratio of just 0.12 times or so -- well below most of its peers.
If you are looking at the downtrodden energy sector for investment opportunities, Chevron increasingly looks like one of the best positioned names today.