With the Energy Information Administration predicting that Brent prices will hit $76 per share in 2017 and many analysts anticipating a supply shortfall in the back half of 2016, the worst seems over for the crude sector. Given that energy fundamentals are on the mend, and risk appetite is reemerging, some investors wonder whether Chevron (NYSE: CVX) might make an acquisition. Royal Dutch Shell (NYSE: RDS-A) (NYSE: RDS-B) did buy BG Group in 2015, after all. Although the prospect that Chevron could make a transformative acquisition certainty sounds appealing, the scenario is unlikely. Here are three reasons why.
Asset values have climbed sharply since February
Potential takeover candidates aren't exactly cheap. Given the 70% rally in crude spot prices, many quality shale companies no longer trade for bargain prices. When factoring a takeover premium, the rationale for acquiring another company might not make much sense unless crude prices rally substantially. Given the uncertainties in the market, substantially higher crude prices aren't guaranteed, and pulling the trigger on a big acquisition is risky.
Another factor working against M&A is that company bid-ask prices are wide. Earlier in the cycle, ExxonMobil (NYSE: XOM) approached several potential takeover targets but failed to make any deals because the take-over targets asked for too much. Given ExxonMobil's experience and the crude price surge, there's no reason to think Chevron will get a better deal.
The balance sheet is strained
If Chevron makes an acquisition large enough to move the needle, it will probably need to fund some of the acquisition with cash. Given that analysts anticipate Chevron to report $15 billion in negative free cash flow this year because of its large percentage of pre-productive projects, Chevron can't take on more debt without making some sacrifices on core principles such as consistently maintaining and raising the dividend and keeping the debt ratio below 0.30 most of the time. Given that Chevron management has said the dividend is its No. 1 priority and that having a strong balance sheet is a major competitive advantage, it's unlikely to have a change of heart. The negatives of cutting the dividend or endangering the balance sheet simply outweigh the upside of making an acquisition.
Chevron doesn't need to make an acquisition
Perhaps most importantly, Chevron doesn't really need to make an acquisition to do well. Unlike Royal Dutch Shell, which struggled with finding reserve replacements before its BG Group acquisition, Chevron has been able to successfully replace its reserves. The company has one of the industry's best reserve replacement ratios over the past five years, at 113%. Chevron has also plenty of places to invest where it can get a solid return on investment. Chevron owns around 2 million net acres in the Permian that holds total potentially recoverable oil equivalent resources of 9 billion barrels. The company estimates that 4,000 of its well locations in the Permian can offer a 10% return at $50 per barrel, and 5,500 well locations can deliver a 10% return at $60 per barrel.
In addition, Chevron's production is expected to rise sharply organically. Because of the ramp-ups of major pre-productive projects such as Gorgon and Wheatstone over the next two years, management expects Chevron's production to rise to 2.9 million to 3 million barrels per day in 2017 from 2.62 million barrels per day now.
One of the main reasons long-term investors like Chevron is its management knows how to deliver value through the commodity cycle. Its management has run the company conservatively enough to raise the dividend for 28 straight years through multiple booms and busts. Conservative investors don't necessarily pull the trigger when the opportunity isn't guaranteed to pay off.
At this point, the valuations of potential acquisitions are too high, and Chevron doesn't really need to pull the trigger because it could get better returns by developing its own resource base.
TMFJay22 has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chevron. The Motley Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.