With a 36-year history of increasing its dividend and currently yielding 3.6%, Chevron (CVX 0.29%) is an income-seeking investor favorite. It also doesn't hurt that Warren Buffett's Berkshire Hathaway has the stock as its third-biggest holding. It adds up to a robust case for the diversified oil major, but is it enough to make the stock a buy?
It's still all about fossil fuels
The first point is that an investment in Chevron is, by default, a positive view on upstream oil and gas. While it's true that Chevron is investing in lower-carbon technologies and has a significant downstream business, its upstream oil and gas business is what really counts. In other words, it's what moves the needle on its earnings.
As is often the case with large-cap exploration and production operations, Chevron's revenue and earnings are commodity price dependent, so it's essential to have a view on the price of oil and gas before buying the stock -- even if that view is "no view."
The chart below shows how Chevron's earnings before interest, taxation, depreciation, and amortization (EBITDA) vary with the price of oil.
Data by YCharts
Moreover, the following chart shows Chevron's earnings from upstream (mainly exploration, development, and oil and gas production) and downstream operations (refining crude oil, marketing and transporting crude oil and refined products, etc.). Chevron's downstream operations provide earnings resilience when the oil price is weak, but the real swing factor comes from its upstream oil and gas operations.
Data source: Chevron presentations.
This time it's different
These are the most famous last words in investing. However, this time, just maybe, it is different. The oil industry is traditionally characterized by cycles of boom and bust driven by oil price fluctuations and how oil companies respond to them. In a nutshell, a high price tends to induce a flood of investment that creates a cascade of supply, leading to a sharp price fall when demand tails off.
That happened in the previous cycle up to 2015, but as you can see below, oil majors, and Chevron in particular, have been much more cautious in ramping up spending.
The reason for this comes down to a combination of the lesson learned from the previous cycle, fear over the long-term viability of fossil fuel in the light of the threat from renewable energy, and in addition, in Chevron's case, a conservative mindset focused on generating cash flow for investors.
Data by YCharts
Furthermore, oil bulls point to the increasing restrictions placed on exploration and production by governments, and the recent decision by key OPEC members to cut production is a sign of increasing geopolitical tension and a willingness to support prices through restructuring supply.
Meanwhile, on the demand side, despite fears that U.S. demand will fall over the long term, the International Energy Agency (IEA) still sees global demand excluding North America rising over the long term.
Why Chevron is a good value
While the arguments above speak to Chevron's earnings and cash-flow generation being supported by a relatively high oil price, management argues that it doesn't necessarily need an elevated price of oil for it to be highly profitable.
Image source: Getty Images.
Indeed, on Chevron's investor day in late February, management argued that thanks to the focus on profitable investment, it was on track to double the free cash flow it will produce in 2027 compared to 2022 based on the price of oil remaining at around $60 a barrel. Moreover, management's focus on using the bumper cash flow from the increase in the price of oil to reduce debt has strengthened Chevron's balance sheet and reduced interest payments.
Buy, sell, or hold Chevron?
Holding an energy stock in your portfolio for diversification alone makes sense. So, if you want to do so, there are a few better ways to do it than by buying Chevron. The dividend looks sustainable, and it's as conservatively run with an excellent balance sheet as you might expect in a Berkshire Hathaway holding. As such, Chevron is worth picking up for investors looking for energy exposure.
