Are Chevron (CVX, Financial) and Exxon (XOM, Financial) now value stocks? This is something I have been thinking about recently because I am a contrarian by nature. I am also always on the lookout for investments that I believe the rest of the market is overlooking, and when it comes to these two oil giants, I think the market is missing something.
Under pressure
Shares in Exxon and Chevron have faced selling pressure over the past few years for many reasons.
First of all, there is the volatile price of oil. At one point last year, the crude oil price went negative, which is an extreme example of the volatility in this market. If asked to choose between a company like Apple (APPL), with its stable profit margins and relatively predictable sales, and Exxon, which has always been and will always be exposed to the volatile price of oil, I would almost always choose Apple.
Investors have also become more environmentally conscious. Hundreds of billions of dollars of assets have flowed away from companies with insufficient environmental credentials into businesses at the forefront of the green energy revolution. In the long run, fossil fuels are destined to become an unsustainable fuel source, and many want to avoid the inevitable collapse of the oil industry.
As the cost of renewable energy falls, I believe it is only a matter of time before oil and gas demand starts to drop significantly. However, in the meantime, demand remains high. What's more, the most extensive collection of oil-producing nations globally, OPEC+, has a vested interest in keeping oil prices high. Therefore, they're incentivized to match supply and demand. If demand starts to slip, they can cut production. That's exactly what these nations did last year.
As such, I believe it could be premature to avoid these oil companies today on the assumption that they won't be able to find buyers for their output. Even the most pessimistic forecasts do not see oil demand peaking until the end of this decade.
Cash cows
Many smaller oil companies operate on the brink of bankruptcy, but thanks to the rebound in oil prices, financially strong oil giants such as Exxon and Chevron have also become cash cows.
In the first half of the year, Exxon's cash flow from operations totaled $18.9 billion. Capital spending consumed just $5.1 billion of this, leaving $13.8 billion for shareholder returns. This suggests the company is trading at a free cash flow ratio of 5.8% based on the first half cash flow alone. Annualized, the rate is above 11.5%, although that assumes oil prices remain high for the rest of the year and capital spending stays the same.
Chevron generated $7.7 billion of free cash in the first half, suggesting an annualized rate of $15.4 billion and a free cash flow yield of around 7.7%. Once again, this is based on a large number of assumptions.
These metrics look appealing, and they are the primary reasons why I think both Chevron and Exxon could offer value at this point in time.
The one thing that concerns me is uncertainty. The oil price may stay elevated, but it could drop. Furthermore, these companies are almost certainly going to have to increase capital spending.
Chevron's capital spending in the first half totaled $3.5 billion compared to depreciation of $8.8 billion. In theory, this suggests the company's asset base is shrinking, and if the group continues to underspend, it will shrink to nothing. The company will need to spend more to maintain output and maintain its equipment.
Both companies may also need to spend more on investing in renewable technologies. Peak oil may still be some years away, but that does not mean these firms should ignore the threat. The old phrase "adapt or die" comes to mind.
Conclusion
Considering all of the above factors, it becomes challenging to project the cash flows of Exxon and Chevron over the next few years. This makes them difficult to value. There might be an opportunity here for investors who have a better understanding of the sector, but personally, I am not comfortable trying to place a value on these stocks.
