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As a result of the largest and fastest interest rate increase in the last 40 years, the yield curve has become steeply inverted. In other words, short-term rates at between 0.5% and 1.5% are higher than the benchmark 10-year yield of 3.45%. The inverted yield curve has a nearly faultless record of predicting a recession or at least a sharp economic slowdown.
While the Fed and other commentators are pointing to the still elevated level of CPI inflation, which is running at 6% rather than their 2% target, and 50-year lows in unemployment (3.5% in the U.S., 5.1% in Canada), these are lagging indicators. With the sharp increases in commodity prices due to the invasion of Ukraine now dropping out of annual comparisons, it’s virtually guaranteed that the CPI will fall further, even if it doesn’t get back down to 2%.
Nonetheless, the likelihood is that energy prices will remain substantially higher than has been the case for the last 15 years. The invasion of Ukraine and the resulting sanctions imposed on Russian oil and gas exports has reminded the world of the vulnerability of energy supplies to geopolitical factors. While Europe enjoyed a surprisingly mild winter in 2022-23 and gas prices plummeted as a result, the quadrupling of natural gas prices last summer meant governments were scrambling to subsidize energy bills to avoid consumers facing the choice between heating and eating.
The decision by the Biden administration to release oil supplies from the Strategic Petroleum Reserve last summer undoubtedly helped keep the price of gasoline under some sort of restraint. Commentators satirically suggested that the right to $4 a gallon gasoline was enshrined in the Constitution. But the move resulted in the Strategic Reserve being reduced to its lowest level in 40 years.
In the meantime, the U.S. administration is putting out conflicting messages. Energy companies are berated for not pumping more oil to keep prices down while the entire fossil fuel industry is supposed to switch over to carbon-neutral output by 2035. This has left energy companies evidently determined not to increase capital expenditure or go looking for new reserves, as they will not be rewarded for doing so by investors.
As a result, even with oil below $75 a barrel for much of the last few months, cash has been piling up on oil companies’ balance sheets. A few weeks ago, an article in The Wall Street Journal carried the headline, “Big Oil Has $150 Billion In Cash And Investors Want A Share.” The article began with the line, “Wall Street has a few ideas on how to spend the mountain of cash – and new drilling isn’t near the top of the list.”
The uncertain economic outlook has weighed on the price of crude oil in 2023, making the energy sector the S&P 500’s worst performer. But cash continues to flow into the coffers of the energy giants. The six global energy majors – ExxonMobil and Chevron in the U.S., the UK’s BP and Shell, France’s TotalEnergies, and Italy’s ENI – together had nearly $160 billion (all numbers in U.S. dollars) in cash and equivalents at the end of the first quarter. Of this, ExxonMobil (NYSE: XOM) and Chevron Corp. (NYSE: CVX) had $48.3 billion, up $1 billion from the end of 2022. The last time they had more than $40 billion in cash was in 2008, when oil had been at an all-time high of $145 per barrel.
Furthermore, as opposed to chasing production growth as producers have traditionally done, Exxon and Chevron have been spending more on returning cash to shareholders than on capital expenditures. This is a major shift in priorities. The two companies had spent more on capital expenditures than shareholder returns for 28 straight quarters up to June 2020. They have completely reversed that pattern every quarter since. In the first quarter this year, they paid out $14.8 billion in dividends and buybacks compared with $8.4 billion in capital expenditures.
Given how cyclical the energy industry has been, such conservatism is understandable. Chevron’s CFO Pierre Breber told analysts, “We know the good times don’t last.”
Oil and gas prices look set to remain at present levels or even higher over the next 18 months to two years. This is more than sufficient to offset any effect on demand from a recession in the developed economies. We should expect growing demand from emerging markets, especially now that China has ended its zero-Covid lockdown policies. Investors should maintain a sensible exposure to the sector.
Chevron is one of my top energy picks. The stock has been an underperformer in the energy sector, although it has rallied from its March 52-week low of $132.54.
In the first quarter of 2023, Chevron’s oil and gas production was down 3%, to 2.98 million barrels of oil equivalent (boe) per day. The reduced output was due to a contract expiration in Thailand and the sale of shale properties in South Texas.
Despite lower production, net earnings climbed 5%, to $6.57 billion ($3.46 per share). Profits from refining were up five-fold to $1.8 billion, even though profits from oil and gas production fell 25% on lower oil prices. Brent crude, the global benchmark, was down 16% to an average of $82 per barrel compared with a year ago. CFO Pierre Breber commented, “Brent prices are high yet down quite a bit, but you are still seeing a mid-double-digit return for every dollar spent by the company.”
Chevron has increased its base dividend for 36 consecutive years, with its most recent increase being 6%, to $1.51 per quarter in May ($6.04 annually). That’s equivalent to a 3.86% dividend yield.
Chevron sells at eight times trailing 12-month earnings. The stock is up only 25% over the last five years compared with 34% for ExxonMobil and 52% for the S&P 500, while yielding over 3.8%. Chevron is very reasonably valued and is expected to show growth in production and cash flow. It is generating enormous quantities of excess cash, which it has committed to return to shareholders over time. I’d look at buying in at current levels if you’re looking to add exposure to the energy sector. As always check with your advisor to ensure the stock fits with your risk tolerance and financial objectives.
Gavin Graham is Chief Strategy Officer of Calgary-based SmartBe Investments. He is a veteran financial analyst, money manager, and a specialist in international investing, with over 35 years’ experience in global investment management. This is an edited version of an article that originally appeared in the Jan. 30 issue of the Internet Wealth Builder newsletter.
Notes and Disclaimer
Content © 2023 by Gavin Graham. Used with permission.
The commentaries contained herein are provided as a general source of information, and should not be considered as investment advice or an offer or solicitations to buy and/or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however, accuracy cannot be guaranteed. Investors are expected to obtain professional investment advice.
The views expressed in this post are those of the author. Equity investments are subject to risk, including risk of loss. No guarantee of performance is made or implied. The foregoing is for general information purposes only. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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