Chevron (IL/A): Shares theoretically inexpensive, but reality that another E&P acquisition may be needed could keep shares under pressure - Goldman Sachs - January 29, 2006
We believe Chevron's 2005 reserve guidance in its 4Q earnings release and conference call underscores investor concerns about Chevron's organic growth opportunities that first came to question with the announcement of the Unocal acquisition. Although large field development projects lend themselves to lumpy reserve bookings, we are concerned that two consecutive years of poor organic reserve replacement could be a harbinger of challenging times ahead. With some of Chevron's major projects not likely to come on-line until the latter part of the decade, we believe the company could continue to struggle growing its reserve base without further meaningful acquisitions. Although Chevron shares trade sufficiently inexpensive to warrant investor interest, we see a better combination of relative risk/reward and catalysts in other oil equities. Chevron remains In-Line/Attractive rated.
COULD POOR 2005 ORGANIC RESERVE ADDITIONS BE A SIGNAL THAT ANOTHER E&P ACQUISITION IS NEEDED? In its 4Q 2005 earnings release, Chevron revealed that 2005 organic reserve replacement was effectively zero. The company added no reserves organically to offset production for the year. All of the reserve adds in 2005 essentially came from the Unocal acquisition. Unocal's 2004 year-end reserves were approximately 1.75 billion barrels of oil equivalent (BOE). Deducting Unocal's 2005 production prior to the closing of the transaction as well as the Northrock asset sale in Canada, we estimate net reserve additions to Chevron from Unocal would be about 1.5 billion BOE. Given management guidance that it added 1.5 billion BOE in 2005 including the Unocal acquisition and adjusted for asset sales, we deduce that there likely was no meaningful net organic reserve additions last year--a point management confirmed on its conference call. To be fair, year-end pricing effects due to production sharing contracts (PSC) reduced Chevron's net reserves which in a lower commodity price environment would be added back. On its 4Q 2005 earnings conference call, management estimated that without year-end pricing effects, organic reserve replacement would have been a still sub-par 40%-50%. For companies that do not routinely make acquisitions, we have often found that large deals have coincided with periods of weak organic reserve replacement results. Whether coincident or otherwise, Chevron's acquisition of Unocal followed a poor 2004 organic reserve replacement ratio of 49% (72% on a price-adjusted basis) versus the 110%+ achieved in the previous 3-years. This has now been followed by an essentially 0% organic reserve replacement ratio for 2005 (40%-50% on a price-adjusted basis). Management also noted in its conference call that the increasingly larger development projects are making it harder for super-cap oil companies to book reserves smoothly year-to-year due to the timing of sanctioning, development, and production. From the perspective of an investor/analyst, however, two consecutive years of disappointing organic reserve replacement meaningfully raise the risk that Chevron is struggling to grow its reserve base via internal projects. In our view, even if management does have a robust pipeline of reserve additions, given that most of its major projects do not come online until the 2008-2010 timeframe (for example, Gorgon and Angola LNG), Chevron could continue to face challenges replacing reserves in the near- to medium-term.
INEXPENSIVE VALUATION LIKELY REFLECTS LACK OF INVESTOR CONFIDENCE IN CHEVRON'S E&P PORTFOLIO We see Chevron trading at 4.8X 2006E and 4.3X 2007E EV/DACF (enterprise value to debt-adjusted cash flow), a discount to both the super-cap integrated oils average of 5.9X and 5.4X and the domestic oil/E&P average of 5.6X and 4.9X, respectively. Although we believed that the widening valuation discount especially to the domestic oil/E&P equities was becoming excessive, the increased risk of an acquisition and lower confidence in Chevron's ability to replace production organically appear to justify Chevron's valuation at the moment. Having said that, we do not believe such an inexpensive valuation is likely to persist indefinitely. There is no change to our view that over long periods of time, oil remains a commodity business where excess returns get competed away to the benefit of super-cap oils' business models that are geared towards robust returns on capital employed at lower normalized commodity prices. The key question, in our view, is how likely is Chevron to do an acquisition and are investors today appropriately rewarded for taking that risk. Note, we do not view acquisitions as inherently shareholder value-destroying. However, given the relatively high asset prices today and super-cap oils' generally high return hurdle rate, the likelihood of accretive acquisitions are not high. We note that Chevron currently trades inline with ConocoPhillips (COP; NR).
(Goldman Sachs & Co. and/or one of its affiliates is acting as financial advisor to ConocoPhillips in the proposed acquisition of Burlington Resources Inc. Goldman Sachs & Co. and or one of its affiliates will receive a fee for its financial advisory role. See Exhibit 1 for comparative risk/reward and valuation.)
We believe the analyst meeting scheduled for March 7, 2006 will be an opportunity for Chevron management to provide, among other things, a detailed review of its 2005 reserve data, management's expectations for the sources of future reserve additions, progress on Unocal integration, and longer-term E&P production and capital program outlook.
MEANINGFUL THEORETICAL UPSIDE EXISTS FOR SHARES, BUT DILUTION RISK COULD KEEP SHARES UNDER PRESSURE On an absolute basis, we see the potential for Chevron to have meaningful upside given our bullish commodity macro outlook. We calculate 17% upside to a $69 traditional mid-cycle value that is based on a $35 per barrel long-term WTI oil price assumption. Our $89 traditional peak value is based on roughly a $45 per barrel long-term WTI oil price. By way of comparison, we estimate the super-cap integrated oils having on average 12%/39% upside to traditional mid-cycle/peak valuations. Note, with the super-cap integrated oils trading well below "traditional" mid-cycle valuations, we believe the relative risk/reward is becoming increasingly more attractive versus the domestic oil/E&Ps overall, even for investors that are bullish on the commodity macro outlook (as we are) and have favored higher-beta oils in the current up-cycle. The challenge for investors, however, is that if Chevron needs to make an acquisition in order to keep its E&P asset base from declining, it is not clear how much dilution could exist to the above estimated mid-cycle and peak values. Until an investor can greater confidence that Chevron has a sufficiently robust E&P portfolio to allow for modest reserves and production growth as opposed to a declining E&P asset base, the shares may continue to trade at a discount to theoretical mid-cycle and peak values. Perhaps said another way, our view that super-cap oils should trade at valuation premiums to other energy sub-sectors could be called into question.
4Q 2005 RESULTS SLIGHTLY BELOW EXPECTATIONS Chevron's 4Q 2005 EPS of $1.86 (on both reported and adjusted basis) was slightly below the $1.89 First Call consensus estimate and our $1.90 forecast. The negative variance was primarily driven by lower-than-expected international R&M earnings, somewhat offset by a small gain in the corporate segment relative to an expected $190 million charge. E&P volumes and realized prices were largely in-line with our forecast. Chevron reported 4Q E&P production of 2.68 million BOE/d versus our 2.67 million BOE/d forecast. Management's guidance for 2006 E&P volumes of 2.7-2.8 million BOE/d was slightly disappointing given that our original 2.8 million BOE/d forecast assumed roughly 80,000 BOE/d of asset sales in the US. We are no longer assuming any E&P asset sales and are forecasting the mid-point of the guidance at 2.75 million BOE/d.
UPDATING ESTIMATES We are updating our full-year 2006-2010 EPS estimates for Chevron, which now stand at $8.65 ($9.15 previously), $9.05 ($9.45 previously), $3.85 ($4.25 previously), $3.90 ($4.40 previously), and $4.10 ($4.59 previously), respectively. Our updated EPS estimates reflect higher E&P unit D&A, lower assumed international R&M earnings, updated E&P production profile, and minor other adjustments. We are also introducing our quarterly 2006 EPS estimates, which stand at $1.97, $2.21, $2.25, and $2.22 for 1Q, 2Q, 3Q, and 4Q, respectively. Note, we have updated our 2006 Henry Hub spot natural gas price assumption to $9.50 per MMBtu ($10 before), our 2006 and 2007 California refining margin to $24 per barrel ($28 before), and our 2006 New York, Chicago, and Mid-continent refining margins to $10.75 ($11 before), $11.50 ($13 before), and $11 ($13 before) per barrel, respectively. See Exhibit 2 for a summary model of Chevron.
Each of the analysts named below hereby certifies that, with respect to each subject company and its securities for which the analyst is responsible in this report, (1) all of the views expressed in this report accurately reflect his or her personal views about the subject companies and securities, and (2) no part of his or her compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report: Arjun Murti, Luis Ahn. |
