Oil majors are popular in the income-oriented investing community thanks to the generous dividend yields they offer. Chevron Corp. (CVX, Financial) is one of the eight best dividend-paying oil stocks based on its expected return potential. As a result, we will analyze the company's special characteristics, which render the stock a compelling investment.
Business overview
Chevron is the third-largest oil major in the world based on its $234 billion market cap, behind Royal Dutch Shell (RDS.B, Financial) and Exxon Mobil (XOM, Financial). The most striking difference between Chevron and other oil majors is its leverage to the oil price. While Exxon Mobil and Shell produce crude oil and natural gas at approximately equal amounts, Chevron produces them at a 57-to-43 ratio.
Moreover, as the company prices a portion of its natural gas based on the oil price, about 75% of its total output is priced based on the oil price. As a result, Chevron is much more leveraged to the commodity than its peers and, therefore, is an ideal holding for those who expect higher oil prices in the coming years.
On the other hand, as leverage is a double-edged sword, Chevron was more vulnerable than most of its peers in the recent downturn of the energy sector, which was triggered by the collapse of the oil price from 2014 to 2016. Nevertheless, the oil giant greatly enhanced its efficiency during the downturn. First, Chevron reduced its cash flow breakeven point (including dividends) from an oil price of $86 in 2016 to $53 now. In addition, it has drastically cut its production costs from $18 per barrel in 2014 to about $10 per barrel currently.
Growth prospects
Chevron has greatly improved its portfolio of producing assets in recent years. The oil major failed to grow production for a whole decade despite its excessive capital expenses. Between 2012 and 2014, when oil was trading around $100 per barrel, Chevron spent more than $30 billion per year on capital expenses, but failed to grow its output. However, as growth projects in the oil industry take several years to transition from inception to cash flow generation, the company has now passed into the positive phase of this cycle.
Chevron managed to grow its production by 7% last year and expects to grow it at the same pace this year. In addition, while the company previously guided for 2% to 3% annual production growth until 2023, it improved its guidance this week to 3% to 4% annual growth over this period. The improved outlook resulted from strong momentum in the Permian Basin, where management expects to reach a production rate of 600,000 barrels per day by the end of 2020 and 900,000 barrels per day by the end of 2023. These production rates are nearly 40% higher than the previous forecasts.
Even better, as Chevron now reaps the benefits from its past investments, it does not need to continue spending hefty amounts on capital expenses. In fact, the oil major is now growing its output while reducing capital expense. It is also remarkable that 70% of the capital expenses were invested in projects that began to generate cash flows just two years after their initiation. Therefore, as Chevron now invests in low-cost, high-value assets, which generate cash flows much sooner than before, the company has greatly improved the return on its investments.
Dividend
Chevron has raised its dividend for 32 consecutive years and, hence, is a dividend aristocrat. Chevron and Exxon Mobil are the only two energy stocks that belong to this group of dividend distributors. As the energy sector is highly cyclical, most companies incur dramatic swings in their results and, thus, cannot achieve a multiyear dividend growth streak. The exceptional dividend record of Chevron is a testament to the strength of its business model and its strong execution.
In the downturn of the oil sector between 2014 and 2017, Chevron froze its dividend for 10 consecutive quarters, but since it continued to raise its annual dividend, it remained a dividend aristocrat. At the end of 2016, the company raised its dividend by just 1%. However, the price of oil has recovered since then and growth prospects have greatly improved for Chevron. As a result, the oil major raised its dividend by 4% in 2018 and by 6% in 2019.
As its payout ratio has fallen to healthy levels this year, below 60%, Chevron will easily continue raising its dividend at a decent pace in the upcoming years. Moreover, the company has the second-strongest balance sheet in its peer group, behind Exxon Mobil. Furthermore, after posting negative free cash flow for four consecutive years, Chevron has posted remarkably strong free cash flows in the last two years. Given all these facts, investors can initiate a position in Chevron at its current 3.9% dividend yield and rest assured the dividend will remain on the rise for several more years.
Behavior in recessions
As Chevron is highly leveraged to the oil price, its earnings are pronouncedly affected by the gyrations of the commodity. As a result, the stock is highly vulnerable to downturns, such as a recession or a collapse in the oil price. This was prominent during the recent downturn of the energy sector, when Chevron saw its earnings completely evaporate, from $10.14 per share in 2014 to a loss of 27 cents per share in 2016.
Therefore, while the stock is ideal for those who expect higher oil prices in the upcoming years, it is not suitable for investors who want to have low exposure to collapsing oil prices. Investors who want to have exposure to the energy sector, but seek limited downside risk at low oil prices should prefer Exxon Mobil to Chevron.
Final thoughts
Chevron is one of the highest-quality stocks in the energy sector. The company failed to grow its output for a whole decade and was severely affected when the oil price collapsed between 2014 and 2016. However, the company has greatly improved the quality of its asset portfolio while enhancing its efficiency and reducing operating costs.
As a result, it is poised to keep growing its production for years and enjoy much higher margins than in the past at a given oil price. Since it is by far the most affected by oil prices, it is an ideal holding for those who expect higher prices in the coming years.
Disclosure: I am not long any stocks mentioned in this article.
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