Undergraduate Ann Rife Cox Endowment Fund

Chevron Corporation (NYSE: CVX) is a large multinational corporation involved in all aspects of the oil, natural gas, and geothermal energy industries. The firm is headquartered in San Ramon, California and has operations in over 180 countries (with over half of revenues coming from operations overseas). Among the three subsectors of the energy—upstream, midstream, and downstream—Chevron’s operations include all three, making the firm a fully integrated self-supplier.

Chevron is involved extensively in the exploration, production, and transportation of oil and natural gas; the refinement and distribution of oil and natural gas; as well as power generation and energy services. With a market capitalization just shy of $200 billion, Chevron is a behemoth in terms of outstanding equity and is also one of the largest companies in the world by revenue.

Our recommendation is to hold our Chevron position, which will be explained in more detail in coming sections. When performing a Porter’s Five Forces analysis, the threat of substitute products is low. Although alternatives to gasoline such as alternative energy and clean energy are making strides, they are far from being a substitute for the colossal demands for oil and natural gas. The bargaining power of suppliers is also considered to be a low threat.

Chevron is fortunate to essentially be its own supplier, due to its involvement in all subsectors of the broader energy sector. While OPEC essentially dictates prices of oil worldwide, only 20% of Chevron’s production occurs in OPEC nations. The bargaining power of buyers is a high risk, essentially because oil is a commodity and the competing gas station across the street can often provide the same product at a slightly lower price. The threat of new entrants is a low risk because the energy industry is mature and capital intensive. Further, existing large companies have a strong hold on market share.

Competitive rivalry is high, again because competitors all provide nearly identical products at slightly different prices. It is important to note the impact of the Organization of Petroleum Exporting Countries on gas prices and the competitive landscape of the energy industry. As seen in the graph following this paragraph, since 2006, United States imports of crude oil have declined at the same time costs of oil per barrel have risen sharply.

This is primarily because just shy of 80% of the world’s proven oil reserves are in OPEC countries. The organization sets the tone for the rest of the market in terms of prices and supply. Even as our dependency on foreign oil has declined in the past 6 or so years, prices have increased at the same time U.S. based companies like Chevron are obtaining oil with cheaper transportation costs.

Within the Ann Rife Cox Fund, our Chevron holdings include 650 shares, which comprise just over 3.1% of the entire portfolio. Acquired at a cost basis of $82.76 per share (gross value of $53,794), the current trading price (as of November 19 2012) of $104.35 per share gives us a current gross value of $67,828. Without dividends reinvested, our CVX holdings have experienced 26.09% of capital appreciation.

Coupled with a healthy quarterly dividend currently yielding $0.90 per share (roughly 3.4% annually), CVX has made a very positive impact on the fund. It is also important to note that Chevron’s dividend declarations have become more generous over time, ranging from $0.18 quarterly in 1990 to $0.90 quarterly today. This is indicative of management seeing revenue increasing in a significant and stable manner in years to come in order to service the obligations made to shareholders. The firm’s payout ratio is currently 25% (as of November 2012) based on current earnings. This is an attractive metric that we do not anticipate changing because of the impressive free cash flows Chevron uses to pay dividends.

3rd Quarter Earnings 2012

Chevron Corporation released earnings on November 2, 2012. The company reported 3rd quarter net income of $5.3B and an adjusted earnings per diluted share of $2.69. Unfortunately, these earnings fell short of analyst expectations of $3.19 adjusted earnings per diluted share. Additionally, they are significantly below 3Q2011 adjusted earnings per diluted share of $3.92; the earnings for this quarter was the highest in company history. Chevron detailed their lack of earnings and broke it down into three main reasons: weather and refinery issues, foreign exchange account and inventory valuation.

Hurricane Isaac affected Chevron’s Gulf of Mexico operations for part of August. During this time, there was no production in that area, which decreased output by 3.3% from a year ago and 2.9% from last quarter. Chevron said that this storm caused its Gulf of Mexico average production to fall 19,00 barrels a day below second-quarter production. Additionally, flooding from the storm caused extended downtime at its refinery in Pascagoula, MS. Another event that impacted Chevron’s earnings was a major fire at its Richmond, CA refinery.

This refinery produces 245,000 barrels a day, and its ceased operations significantly affected earnings. Along with significant maintenance activity, these different events hit earnings for Chevron this quarter. Chevron Corporation started out the third quarter of 2012 with a net positive position in their FX account of approximately $200M. This position slid by the end of the third quarter to a net negative position of approximately $300M. They use these positions to hedge their operations around the world.

This loss counterbalanced a significant asset sale that Chevron had that would have helped their earnings this quarter otherwise. Lastly, with the price of oil falling this quarter and natural gas prices remaining at very low levels, Chevron had to value their inventories at market price which represented a loss on their income statement. In the fourth quarter, Chevron is expected to pick up operations with no interruption. Additionally, they plan on expanding into the petrochemical business in Texas; they will build two polyethylene plants with production capacity of 500,000 mt/year, which will come online in 2017. This expansion project will cost an estimated $5 billion.

------------------------------------------------- Recommendation/ Target Price

Our recommendation is to hold our position in Chevron Corporation at 650 shares. The portfolio’s initial cost to open this position was 82.76, and it now trades $104.35 (approximately 35% return with assuming dividends are reinvested). Additionally, Chevron bought back $1.25 billion of their own shares, and they plan on repurchasing the same amount in the fourth quarter. This may mean that they believe their shares are undervalued, so they are making the investment in themselves. This year, Chevron has gone through several unforeseen events such as a fire at their refinery in California and Hurricane Isaac, and these have negatively affected their firm value.

In the fourth quarter, production is going to be “higher than in the third quarter as it is restored following the weather and maintenance-related downtimes,” says Jeff Gustavson, General Manager of Investor Relations. Additionally, Chevron’s LNG projects in Australia are going to drive their growth in the near future. With one set to start in 2014 and the other in 2016, these projects are projected to increases production by 2.2 million barrels of oil equivalents/day (MBOE/D). More and more of the easily accessible fuel sources belong to OPEC countries and national oil companies, so closing these deals will help to sustain Chevron for several more years.

Furthermore, as these easily accessible reserves are being depleted, the world will have to rely on offshore drilling (deepwater and ultra-deepwater). Chevron has already begun to focus on this portion of upstream oil and gas, so they may have an advantage in the years to come; however, there is substantial risk that comes with this advantage. Exploration costs will be much higher than they would be if searching onshore, so they will have to proceed carefully to ensure successful drilling.