It's awfully hard to argue against the merits of investing in Chevron. If you had invested in Chevron 10 years ago, you would have more than doubled the S&P 500 on a total return basis. Chevron's vertically integrated operations and massive global footprint in a market that has relatively inelastic demand make for a pretty compelling investment thesis. The old adage about the stock market, though, is that past results do not necessarily indicate future performance, and there are some key factors that could send Chevron's shares down.
This isn't a prediction that Chevron's shares will fall. I'm not here from the future and have no real way of knowing that for certain. Instead, let's take a look at three things that could impact the the value of Chevron's shares over the long term and what you as an investor can look for to monitor the health of the company before that happens.
1) Continued weak cash flow generation
Quarterly updates from a company are commonly referred to as earnings releases, but I would argue that for a company like Chevron knowing how much cash the company generates can be just as important because it is such a capital intensive business. In recent years, though, Chevron has not been very good at converting its operations into free cash flow.
Since the beginning of January 2012, Chevron has generated $3.28 billion in cash from operations after capital expenditures. By itself that sounds great, but over that same time period the company has doled out $22 billion to shareholders in the form of dividends. To meet those cash needs, Chevon has needed to sell assets, issue debt, and cash in some of its investments to cover the operations shortfall. Compare that to its biggest rival -- ExxonMobil -- which over that same time period generated $48 billion in cash after capital expenditures to pay out $32 billion in dividends.
To be fair to Chevron, though, a large part of the reason it has seen such weak cash generation is because it has been spending so much on capital expenditures, and that should start to wind down as some major projects come online. Today, more than 40% of the company's capital employed is called pre-productive, which means that the money is spent but operations have not yet begun and they're not producing.
Source: Chevron Investor Presentation
Over the next couple of years, management hopes to get the percentage of pre-productive capital down to 35%, which should help to boost returns on capital employed and free up cash for its shareholder initiatives.
2) Future tied to the success of two projects
Source: Chevron Investor presentation
That picture right there is one of Chevron's most ambitious projects to date. It's the company's Gorgon LNG facility in Australia. This massive facility -- in which Chevron is the majority operator -- not only represents part of Chevron's future, but also one of its greatest risks.
Once online, the Gorgon facility as well as the similar Wheatstone LNG project in Australia will represent over 300,000 barrels per day of oil equivalent production for the company. Based on Chevron's growth plans, it will represent over two-thirds of its production growth between now and 2017 and will be over 10% of total production.
The one issue with having so much of its future in these baskets is that they have been considerably more expensive than originally anticipated. The Gorgon facility is estimated to be a $54 billion project that has gone 47% over its original budget, and the Wheatstone project is estimated to cost anther $29 billion. Cost overruns and delays on these projects have the potential of eating into returns for many years, and it will mean that just about every other project will have to be close to perfect to offset it.
3) Likely to experience higher costs in the future compared to its peers
One of the interesting aspects of Chevron compared to its peers is that it isn't exposed to as much geopolitical risk. Chevron is the only one of the big names in integrated oil and gas that doesn't have operations in Russia, and its operations in the Middle East only represent 3% of total production. While this means that it is less likely to suffer production or potential reserve losses from these slightly more contentious parts of the world, it also means that it doesn't have as much access to some of the few remaining "cheap" sources of oil and gas in the world.
Source: Chevron Investor presentation
This image covers just about every major capital project Chevron has planned over the next couple of years. It is littered with offshore and shale gas/tight oil projects both domestically and internationally. These types of projects generally have much higher marginal costs per barrel of oil equivalent produced.
Source: Chevron investor presentation
The biggest variable for Chevron here is deepwater exploration. More than 30% of its future growth is dependent upon deepwater development, mostly in the Gulf of Mexico but also part of the Gorgon and Wheatstone projects. As you can see in the graphic above, deepwater breakeven costs can be as high as $110 per barrel, and the average breakeven costs for international shale gas/tight oil are approaching the $100 mark. This puts Chevron at risk for higher operational costs than many of its peers in the future, and could significantly impact profitability long term
What a Fool Believes
Investors that look at a company like Chevron need to keep in mind one thing. Companies of Chevron's scale need to make their investment decisions on a time horizon measured in decades. So if you plan on making Chevron part of your portfolio, you should make your investment decision based on a similar time horizon.
There are reasons to believe that Chevron can be successful in the future, but the three things discussed here could deter that. The best way to make sure Chevron remains on the right path for you is to watch production costs and project budgets. As long as Chevron can deliver projects reasonably within budget and production costs remain modest compared to oil and gas prices then it should be just fine, but if it starts to lose ground to its competitors in this aspect it may be time to reconsider your investment.
