Oil prices have cooled off considerably in recent months. After topping out at more than $120 a barrel last summer, the global oil price benchmark, Brent, was recently in the low $70s. Because of that, oil companies are producing much less cash than they were.
While that's a problem for some oil companies, it's not for Chevron (CVX 1.54%). That's because Chevron can thrive even if crude prices fall to an average of $60 a barrel. Here's why further downside in oil prices wouldn't be a problem for the energy giant.
Making a noticeable improvement
Over the years, one of the biggest issues in the oil industry was that the sector did a terrible job of investing shareholder capital. Many companies incinerated money by investing in growing production at any cost. That increased output weighed on oil prices, causing those investments to lose money. The sector's inability to generate attractive returns on capital caused woeful underperformance.
That lackluster performance led many companies in the sector to shift their strategy from focusing on expanding production to growing shareholder value. One of the key metrics they've concentrated on improving is their return on capital employed (ROCE), a financial ratio assessing a company's ability to produce profits from shareholder capital.
Chevron has become a leader among big oil companies in improving its ROCE:
Image source: Chevron Investor Relations presentation.
Chevron achieved a ROCE of more than 20% in 2022, its best level since 2011, partly thanks to improved oil prices.
However, the company isn't banking on higher oil prices to improve ROCE in the future. It aims to enhance returns based on a flat oil price of $60 a barrel by focusing its investments on its highest return opportunities.
Because of that, the company expects its free cash flow to rise in a flat oil price environment. Chevron estimates that free cash flow can grow more than 10% annually, even if oil prices average $60 a barrel through 2027. That has the company on track to more than double the free cash flow it could produce at that price point in the coming years.
Positioned to thrive at lower oil prices
Thanks to its improving ROCE, Chevon can thrive in a downside scenario where oil averages $60 a barrel over the next four years:
Image source: Chevron Investor Relations presentation.
As that slide shows, at $60 oil, it can produce enough cash from operations to cover its dividend (which it intends to continue growing) and planned capital spending program of $13 billion to $15 billion a year. That's enough money to increase its oil and gas production at around a 3% compound annual rate while expanding its lower carbon energy businesses.
The company could then use a combination of excess cash and some incremental debt while maintaining its top-tier balance sheet to repurchase $10 billion of its shares each year. That share repurchase rate would reduce its outstanding shares by about 3% annually. Chevron has ample debt capacity to fund that repurchase rate considering its net debt ratio was a mere 3.3% at the end of last year, well below its 20% target (and the peer group average).
Meanwhile, in an upside scenario where oil averages $70 a barrel, Chevron would produce more cash. It would likely increase capital spending and share repurchases to the high end of its target ranges. At the top end of its repurchase range, the $20 billion per year could enable Chevron to reduce its outstanding shares by a 6% annual rate. In this scenario, leverage would likely continue to fall since Chevron wouldn't need to borrow money to fund repurchases.
Downside protection with significant upside potential
Chevron's focus on improving its ROCE has paid big dividends for investors. It enabled the company to cash in on higher oil prices last year. Meanwhile, it positions the company to generate a lot of cash even if oil prices continue cooling off. Because of that, Chevron can continue to return lots of money to shareholders while it invests in expanding its production and lower carbon businesses. That makes Chevron a solid oil stock to buy for the long term since it should be able to grow shareholder value even if oil prices fall.
