What’s Driving Our Valuation Of Chevron’s Upstream Operations?
California-based Chevron (NYSE:CVX) is the second largest energy company in the U.S. after Exxon Mobil. The company manages its investments in subsidiaries and affiliates, for which it provides administrative, financial, management and technological support. This extends both to its U.S. subsidiaries and to its international subsidiaries, engaged in fully integrated petroleum, chemicals and mining operations, as well as power generation and energy services. It generates annual sales revenue of around $230 billion with a consolidated adjusted EBITDA margin of ~21.8%. [1]
Like all the other integrated oil and gas companies, Chevron generates most of its cash flows from the upstream division, which is primarily involved in exploration and production (E&P) activities. According to our estimates, crude oil and natural gas E&P operations contribute more than 88% to Chevron’s consolidated subsidiaries’ value. Here, we discuss the key factors (apart from crude oil prices) driving our valuation estimate of Chevron’s upstream operations.
We recently revised our price estimate for Chevron to $128/share, which is almost 12x our 2014 full-year GAAP diluted EPS estimate for the company.
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Bright Production Outlook
The valuation of an integrated oil and gas company’s upstream division largely depends upon new discoveries of technically and economically recoverable hydrocarbon reserves and ongoing projects that would boost the rate of hydrocarbon production. The long term prospects of Chevron’s upstream division look bright as the company expects to grow its average hydrocarbon production rate from around 2.6 million barrels of oil equivalent per day (MMBOED) in 2013 to 3.1 MMBOED in 2017. It expects to draw most of this production growth from the start-up and subsequent ramp-up of new liquefied natural gas (LNG) projects in Australia and Angola, and the development of deepwater reserves in the Gulf of Mexico and offshore Brazil. (See more on Chevron’s Deepwater prospects: A Look at Chevron’s Key Deepwater Projects)
Chevron is betting big on the global LNG market, spending billions of dollars in the construction of around 25 Million Ton Per Annum (MTPA) gross LNG capacity. The Gorgon LNG project, Chevron’s biggest LNG bet, forms the centerpiece of its aggressive hydrocarbon production ramp-up plan, as it is expected to contribute over 0.2 MMBOED to Chevron’s net daily production rate in the long run. Not only this, the Gorgon LNG project, along with Wheatstone LNG, which is also under construction in Australia, would make Chevron one of the top ten players in the global LNG market. (See more on Gorgon LNG: A Closer Look At Chevron’s Biggest Bet In The Global LNG Market)
Chevron also holds a 36.4% operating stake in the $10 billion Angola LNG project that shipped its first LNG cargo in June last year. Some technical issues, primarily related to the variable feed-mix, have hindered its ramp-up so far. However, Chevron expects the project to boost its net hydrocarbon production rate by around 0.06 MMBOED in the long run. In its latest annual SEC filing, the company noted that the Angola LNG project would be operating at around 50% of its peak capacity till 2015, when it expects to complete the required modifications to fix these technical issues. (See more on Angola LNG: A Closer Look At Chevron’s Angola LNG Project)
Soaring Capital Expenditures
Soaring capital expenditures is the biggest valuation concern for Chevron right now. The company’s net capital expenditures have soared from around $17 billion in 2009 to almost $37 billion last year. More than 92% of this $37 billion was spent on upstream projects. This has been primarily due to the ongoing development of LNG projects in Australia, where cost structures have significantly elevated over the past few years due to rising labor costs. Gross cost estimate for the Gorgon LNG project has risen by more than 45% since 2009 to $54 billion today.
Apart from this, Chevron also exceeded its 2013 capital budget target by as much as $4 billion due to unplanned resource acquisitions in Canada, Australia and the Kurdistan region of Iraq. Due to the rising proportion of currently unproductive capital employed in ongoing projects and resource acquisitions, the company’s total return on capital employed (ROCE) has taken a major hit. Unproductive capital constituted more than 40% of Chevron’s total capital employed last year, which was almost double the historical average. As a result, the company’s ROCE declined by more than 500 basis points year-on-year to just 13.5% last year. [2]
However, Chevron plans to slightly tone down capital investments this year as it plans to reverse the growing trend in favor of higher cash flows. According to the capital budget plan for this year, Chevron looks at spending around $2 billion less on leasing rigs, floating oil platforms, installing pipelines and repairing oil-refineries than it did last year. [3]
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Notes:- Chevron Annual SEC Filings, sec.gov [↩]
- 2013 4Q Earnings Conference Call Presentation, chevron.com [↩]
- Chevron Announces $39.8 Billion Capital and Exploratory Budget for 2014, chevron.com [↩]