by Allen Good (Morningstar Analyst)
We've lowered our estimate of the marginal cost of domestic natural gas from $6.50 per thousand cubic feet to $5.40 per mcf, driven primarily by an updated analytical approach. Because our upstream valuation methodology incorporates an out-year marginal cost-based view on oil and gas prices, it follows that a reduction in marginal cost results in a revaluation of our gas-weighted upstream energy coverage universe. For those firms most leveraged to gas production, our fair value estimates have decreased 10%-15%. However, oil and liquids exposure provides insulation from any meaningful change to fair value estimates for the majority of our upstream coverage list. Our valuations also reflect our current midcycle view on oil, incorporating $95 per barrel West Texas Intermediate and $99 per barrel Brent. In addition, we assume that North American natural gas liquids composite prices trade between 40% and 50% of crude oil throughout our forecast period.We remain bullish on domestic natural gas and continue to see considerable upside to current gas prices. Our analysis indicates that Henry Hub gas prices tend to track marginal cost quite well over longer time intervals, strongly suggesting a rebound from today's $3.70 per mcf within a few years. This is reflected in our stock calls, as for the most part our 4- and 5-star stocks remain just that, even after updating our models with a lower out-year gas price assumption. We continue to view Ultra Petroleum UPL and Devon Energy DVN as the most attractive gas-weighted names, Apache APA and Canadian Natural Resources CNQ as the most attractive mixed-oil/gas stocks, and Suncor SU and Occidental Petroleum OXY as the most attractive oil-weighted firms.
Like its fellow supermajor integrated peers, Chevron is finding it increasingly difficult to expand production and add reserves in a world with a shrinking investable resource base. Much of the remaining pools of cheap, easily accessible resources large enough to interest the larger players reside in the hands of governments and national oil companies. Resource-rich nations are bolstering their nationally owned or controlled energy companies in an attempt to capture more value for their own countries. While this can create an opportunity for firms that can offer oil and gas development expertise, it also forces them to greater lengths to acquire reserves. In Chevron's case, that means focusing on deep-water exploration.
In recent years, Chevron concentrated its exploration efforts on a few key areas that have yielded a high level of exploration success. Discoveries in those key areas of the Gulf of Mexico, West Africa, northwest Australia, and the Gulf of Thailand have already begun to contribute production and will serve as the growth engine for Chevron in the years to come, setting it up for peer-leading growth beginning in 2014-15. Success in each of these regions also demonstrates Chevron's ability to thrive in a highly competitive environment with limited access to resources. Exploration and production efforts in West Africa and the Gulf of Thailand involve numerous partnerships with governments and national oil companies. In the Gulf of Mexico, Chevron's success rests on its ability to deliver production from highly technical projects as it pushes into deeper water to secure resources. In Australia, Chevron is relying on liquefied natural gas to capture the value of massive offshore deposits of natural gas.
The two LNG projects in Australia, Gorgon and Wheatstone, will be the primary drivers of growth in the next few years. Gorgon, slated for startup in late 2014, will add more than 200 thousand barrels of oil equivalent per day of production at peak production. Wheatstone, scheduled for startup in 2016, will add almost another 200 mboe/d. In addition to the volume growth, we see other benefits. Both projects allow for future expansion, given the physical space for additional trains and ongoing discoveries in the region. LNG production, while primarily gas volumes, has prices indexed to oil, which should allow Chevron to preserve its peer-leading liquids exposure. Also, projects like LNG with long-plateau production levels that require little additional capital expenditure help to reduce decline rates while generating significant free cash flow to support reinvestment elsewhere or shareholder returns.
While Chevron's focus on deep water, and by extension larger projects, brings production growth, it also holds substantial risk. Since the cost of drilling offshore wells can be more than $100 million, exploration risks can be quite high. Even after a discovery is made, Chevron then must confront engineering risk. Deep-water projects are technically challenging, and they can often incur higher costs and delays before production comes on line.
Cost inflation in areas with high levels of activity such as Western Australia can jeopardize the economics of projects if not properly managed. This is a specific threat to Chevron's two large LNG projects as other operators in the country have had to revise project budgets upward based on currency appreciation and materials inflation. However, we estimate that even if costs for Gorgon's first three trains come in at $55 billion (compared with $37.5 billion originally), Chevron will still break even on the project. Also, once operational, the four-train development will deliver more than $3 billion in free cash flow annually to Chevron.
Our valuation hinges on Chevron's ability to deliver production from these deep-water and LNG projects on time and within budget. As recent events in Brazil and Nigeria illustrate, incidents at deep-water operations that result in oil spills put the company at risk of negative headlines at the least and potentially stiff monetary fines or permanent cessation of operations at worst. On the downstream front, Chevron is well positioned for the future with highly complex facilities that serve key developing markets. Not only are its facilities capable of producing lower-quality crudes, but many also have the flexibility to produce highly valued diesel. Diesel consumption is likely to drive future refined product demand growth, particularly in the United States.
However, Chevron has a measured view of the long-term economics of the refining business. As a result, over the past two years, Chevron has restructured its downstream operations and shed assets, which should lead to improved returns. Also, returns should improve as it shifts downstream capital to its higher-return chemical operations to fund projects designed to take advantage of low-cost feedstock in the Middle East and North America.
Valuation
We are maintaining our fair value estimate of $125 per share after lowering our long-term natural gas price assumption from $6.50 per thousand cubic feet to $5.40/mcf. The lower natural gas prices reduce our fair value estimate by $5 per share, all else equal. However, the reduction is largely offset by the rise in short-term oil prices since our last update.
Our fair value estimate is approximately 3.9 times our 2013 EBITDA forecast of $60 billion. We expect natural gas to contribute a greater share of production, about 36%, by 2016 compared with 31% in 2011. However, a significant portion of these volumes will be LNG, whose pricing is linked to oil. Also, close to 75% of Chevron's oil production comes from international assets and is tied to higher Brent prices.
In our discounted cash flow model, our benchmark oil and gas prices are based on Nymex futures contracts for 2012-14. For natural gas, we use $2.87 per thousand cubic feet in 2012, $4.08 in 2013, and $4.31 in 2014. Our long-term natural gas price assumptions for 2015 and 2016 are $5.40. For oil, we use Brent pricing of $112 per barrel in 2012, $108 in 2013, and $104 in 2014. Our long-term oil price assumptions for 2015 and 2016 are $99 and $102, respectively.
In our forecast for the next few years, we expect Chevron to see little production growth. Also, rising oil prices will probably mean Chevron's production-sharing contracts yield lower oil volumes. Production growth should increase to 4%-5% by the end of our forecast period as large LNG projects start up. In the downstream segment, we expect profitability to improve in the coming years as a result of improved refining margins, stronger chemical results, and the benefit of recent restructuring.
Risk
Chevron's profits and cash flow are largely tied to oil and gas production and could suffer as a result of a significant fall in prices. Additionally, long-term price depreciation would expose the company to overinvestment risk as current projects would see returns languish with weaker economics. Regardless of commodity prices, these projects also are subject to cost overruns or completion delays. Many of the company's new investments are in politically challenging areas that sometimes have fickle leaders and populations hostile to outside firms. With significant exposure to the Gulf Coast, extended delays in permitting could result in higher costs and delayed production volumes.
Management & Stewardship
John Watson assumed the CEO and chairman position in 2010after serving as vice chairman. He joined Chevron in 1980 and hasheld several different senior management roles, including presidentof international exploration and production and CFO. We like that Watson has a mix of financial and operational experience that should lead to better capital allocation decisions, in our opinion. We also like that other senior executives have significant operating experience in various parts of Chevron's business throughout the world.
We give Watson high marks for his leadership to date, despite the stream of negative headlines. His greatest challenges may be yet to come as Chevron develops its multi-billion-dollar LNG projects and fights an ongoing legal battle over environmental damages in Ecuador. Positive outcomes on both fronts would speak volumes about current leadership.
We also like Chevron's measured approach to acquiring U.S. unconventional assets and the fact it stayed out of places like southern Iraq where the returns are questionable. We think this speaks to Chevron's overall emphasis on returns over growth and is reflected in its returns on capital, which rate near the highest in the sector. Unlike other majors, Chevron has been reluctant to rush into acquisitions or add projects in foreign countries where it cannot add value for the host countries or shareholders. We think this is wise, given the increasingly competitive environment for resources and the willingness of some international competitors to pay for access. As a direct result, Chevron's upstream segment's returns have outperformed peers of late. Also, the firm remains focused on cash returns to shareholders. Its preferred method is through dividends, which it has historically steadily increased. Given these factors, we think Chevron earns an exemplary stewardship grade.
Overview
Financial Health:
Chevron has one of the strongest balance sheets and lowest debt/capitalratios among its peer group. Strong cash flow fromoperations should be sufficient to fund investments and pay thedividend; however, if oil prices retreat significantly, the company may need toincrease its debt load.
Profile:
Chevron is an integrated energy company with exploration,production, and refining operations worldwide. With production of2.67 million of barrels of oil equivalent a day (69% oil), Chevronis the second-largest oil company in the U.S. Refineries arelocated in the United States, South Africa, and Asia for totalrefining capacity of almost 2 million barrels of oil a day.Proven reserves at year-end 2011 stood at 11.2 billion barrels ofoil equivalent (58% liquids).
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