Chevron To Ramp Up Permian Operations To Enhance Its Long Term Value

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The year 2017 has been a good one for Chevron (NYSE: CVX), the US-based integrated energy company. The company’s performance has improved significantly through the year with the recovery in commodity prices driven by the Organization of Petroleum Exporting Countries’ (OPEC) decision to extend their oil production cuts until the end of 2018. Besides, the remarkable results from the Permian assets have further contributed to the company’s growing valuation. Consequently, the company plans to ramp up its operations in the Permian basin, which when coupled with the anticipated recovery in commodity prices, is likely to contribute a large portion of Chevron’s value in the coming years. In this note, we discuss how the company’s Permian operations are expected to be a key driver of its value going forward. We currently have a price estimate of $118 per share for the company, which is lower than its market price.

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Chevron is among the few oil and gas companies that have a sizeable presence in the Permian Basin. At the end of 2Q of 2017, the company held an acreage of 1.5 million in the Midland and Delaware Basin, two of the most prominent oil plays in the Permian Basin. Since the basin is known for the abundance and superior quality of its oil reserves, the net present value of these assets is much higher compared to other assets. Consequently, Chevron’s Permian assets form a key contributor in its overall valuation. However, despite a strong presence in the region, the company continues to explore opportunities to acquire new acreage in the basin at attractive valuations to bolster its returns in the coming years.

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Source: Chevron’s Investor Presentation, November 2017

By virtue of operating in the Permian basin, Chevron enjoys a significantly low cost of production. This simply means that the economic returns of its output from the region are notably higher in comparison to that of other plays. For instance, based on the company’s estimates, it recovers an average of about 1.9 million barrels of oil equivalent (boe) from each well in the Permian Basin, with a capital, operating, and overhead expenditure of about $14 per boe. Now, assuming $50 per barrel of oil, $25 per barrel of NGLs and $2.5o per Mcf of gas, the company generates about $33 per boe on an average from the region. This translates into an IRR of more than 30% for the company’s Permian investments, which is materially higher compared to other plays.

Source: Chevron’s Investor Presentation, November 2017

Based on these remarkably high returns, Chevron expects the capital payback time for these assets to be roughly 2 years from the initial investment, which is evidently lower than its other assets. Also, the company anticipates the cumulative cash flow over the life of these assets to be nearly two times the capital cost of developing them. Thus, in order to enhance its profitability and cash flows, the company plans to meaningfully expand its operations in the region.

Currently, the company operates 15 working rigs in the area, and aims to increase this number to 20 rigs by end of 2018. Further, the oil major is using petro-physical technology and applying data analytics in the region to enhance the operational efficiency of its wells. For this reason, the company’s unconventional production in the Permian has been exceeding its own expectations so far. Chevron’s volumes jumped to 187,000 barrels a day in the third quarter of 2017, 30% higher compared to the same quarter of 2016, driven by the adoption of a new design for drilling the Permian wells. The graph below depicts how the actual production from the company’s Permian assets has been higher-than-expected so far due to the efficiency gains realized from the use of the aforementioned techniques.

Thus, based on the above discussion, we believe that Chevron’s strategy to expand its Permian operations to leverage the low cost of production and high quality reserves will work in its favor. The company’s relentless efforts to enhance the capital efficiency of its wells in the region, coupled with a timely recovery in commodity markets, will prove to be an added upside for the company in the long term. In fact, the Permian boom is likely to be instrumental in achieving the company’s production targets for the next few years, and will be a key factor driving its long term value.

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