It has been almost a year since I first covered Chevron (CVX) and took a long position in April of 2021. In hindsight, I regret that I did not act earlier since I was aware of the favorable position that oil majors were in even before that. If I had bought in October of 2020, when I laid out the strong investment thesis for Exxon Mobil (XOM), my returns would have been even higher.
Nevertheless, since April of last year, Chevron returned more than 70%, which was much higher than its major peer – Exxon Mobil, higher than the overall sector as measured by the Energy Select Sector SPDR Fund (XLE) and with a staggering difference to the broader market.
Even if it was not for recent events that drove the price of oil to new highs, Chevron would have been a far superior investment than most large-cap US companies during this period, including many of the equity market darlings in the tech sector.
But let’s ignore the historical performance and similar to one year ago, when pessimism in the oil & gas sector was very high, ignore the rear-view mirror and look to what lies ahead.
The Current Setup
In contrast to a year ago, the outlook for Chevron and all other oil majors appears very favorable at the moment. In addition to the inflationary pressures, the full swing of the realized geopolitical risk is also feeding the share price rally. As the world becomes more polarized and deglobalization accelerates, as I predicted in the months following the pandemic, security of energy supply will be of paramount importance. Consequently, a large chunk of global energy resources will become too risky to depend on and that will favor local energy providers.
Moreover, during times of peak globalization and loose monetary and fiscal policies, the market does not care much about companies like Chevron or Exxon Mobil. On the contrary, they were seen as the legacy dinosaurs of the corporate world that should be replaced by fancy solar tiles or wind turbines. However, as inflation starts to bite and affects predominantly lower-income consumers, the overall sentiment will likely continue to shift towards security in the face of low-cost energy producers. Like it or not, the front seat here is reserved for the oil majors.
However, as this narrative gains momentum, so are the valuations in the sector. The market has a tendency to overshoot in both directions – both on the downside when the outlook is grim and on the upside when market conditions are favorable.
That is why Chevron now trades at one of its highest market premiums to its book value of equity. Current P / B multiple of 2.3 is roughly 30% higher than previous highs in 2011, when oil prices were at similar levels.
Part of the reason for that is Chevron has become much more efficient in recent years, as less competition and declining inflows into the sector allowed the company to pursue more cost-efficient projects.
Chevron’s high multiple already takes into account the currently expected further improvements in upstream operating expenses.
As rosy as this scenario might look, all oil majors will likely face increased political pressure to expand production more rapidly. The reason being that energy security of the United States and Europe, in particular, is now at significantly higher risk due to rising tensions with Russia. Given Europe’s dependency on Russian oil & gas (see below), global investments in the sector will likely skyrocket in the coming years.
Breaking away from Russian oil & gas will be a long and challenging process that will push exploration companies into less profitable projects.
Caution Is Advised At Current Levels
Having said all that, I still believe in the long-term success of Chevron as it will benefit from a push towards more energy security, while at the same time the company will invest heavily into future energies, such as hydrogen, carbon capture & storage , and renewable fuels. However, future earnings are unlikely to increase on a straight-line basis as current valuations seem to suggest.
Starting with upstream earnings, they rebounded strongly in 2021 – both in the United States and internationally (see below), and will most likely experience another strong year in 2022.
Although Chevron has no direct exposure to Russia, the company’s operations in Kazakhstan which contributed roughly $ 3bn to earnings are at risk, the current escalation should continue.
Idiosyncratic risks aside, we could calculate a reasonable estimate for Chevron’s earnings, in an event that oil prices remain at their current levels. For the past decade, annual average oil prices explain nearly 90% of the variance in Chevron’s upstream earnings (see below).
Based on current oil prices of around $ 100 per barrel and the current average for the year of $ 92, CVX upstream earnings are likely to come within the range of $ 21bn to $ 25bn.
Downstream earnings have also improved significantly over the course of 2021.
The 2022 results, however, would most likely be far less spectacular than the upstream ones as the crack spread remains near 2021 levels. This most likely explains why Warren Buffett favors pure upstream players at the moment.
As a result, it will be prudent to assume flat downstream earnings for 2022, which are largely offset by all the other expenses which amounted to $ 3.1bn in 2021.
The total number of shares of Chevron will likely be reduced, given the high-end guidance of share buybacks for 2022. At the moment the range stands within $ 3bn and $ 5bn per annum and is consistent with oil prices gravitating around $ 100 per barrel.
Based on that range and Chevron’s current price per share, the company could buyback between 20m and 30m shares by the end of 2022. As a result, the company’s EPS for 2022 could come in between $ 11 and $ 13.2 in the most optimistic scenario. These numbers do not take into account any other idiosyncratic and political risks highlighted above.
These numbers are roughly within the range of the current analyst consensus estimate for this year of $ 12.28.
Even if we use the best case scenario above and use the $ 13.2 EPS number and also assume that oil prices will remain at current levels, we arrive at a forward P / E multiple of slightly above 12. This might seem like a low number, if one is comparing it to multiples of high growth tech companies, however, it is on the high end for a large-cap oil major during periods of elevated oil prices.
Shown from a different angle, Chevron’s current gross margin will also need to improve over the course of 2022, in order to justify the currently elevated EV / EBITDA multiple (see below).
As we saw earlier operating margins are expected to improve somehow in the coming year, however, gross profitability does not take into account fixed cost efficiencies. Moreover, as Chevron scales up its New Energies unit, margins will likely face further pressure from larger investment rates in less profitable categories.
Moving down on free cash flow, the record high numbers will also be pressured as capital expenditure will need to increase significantly over the coming years in order to reach a more sustainable level relative to depreciation expense.
The long-term investment thesis for Chevron remains intact. Oil & gas investments will need to increase in order to provide secure energy in a more destabilized world, while higher oil & gas prices will allow the company to make the necessary investments in new technologies. However, investors should not forget that the industry is a highly cyclical one and prone to political risk. At the moment, Chevron’s valuation appears stretched and already prices in a massive improvement in earnings for 2022. Therefore, the risk-reward profile of the company is now far less appealing than it was a year ago and calls for a more cautious approach. For the time being, I will abstain from increasing my positions in the company.