Recommendation: BUY Estimated Fair Value: $107 $133

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1 Recommendation: BUY Estimated Fair Value: $107 $ Reasons for the Recommendation Reason #1 Chevron s recent reorganization will leave the company poised to capitalize on current and forecasted market trends. Chevron s ongoing effort to streamline downstream operations will continue to generate an increase in margins on refining, manufacturing and marketing of products that include gasoline, jet fuel, diesel, lubricants and fuel additives among others. Chevron has taken aggressive steps to divest assets that are not in line with the new corporate vision for downstream operations. These steps include the sale of its Pembroke Refinery and fuel marketing and aviation assets in over 16 countries in Europe, Caribbean and Latin America. The company has also scheduled the release of a portion of its employee base that will allow it to further increase efficiency. Reason #2 Chevron is aggressively expanding its footprint in the natural gas market to capitalize on emerging technologies. Its recent acquisition of Atlas Energy Inc. has provided Chevron with a substantial natural gas resource position in the United States and strengthened the company s recent entrance into shale gas ventures in Canada, Romania and Poland. Chevron is also pursuing development of natural gas projects in Australia and China. Chevron and ConocoPhillips joint-owned subsidiary, Chevron Phillips Chemical, is spearheading the commercial development and utilization of gas-to-liquids technology that enables a variety of uses for natural gas. Demand for natural gas is estimated to rise by more than 60 percent through Chevron s aggressive expansion into the field coupled with the introduction and further pursuit of technological innovations will allow the company to be at the forefront of the natural gas industry in the coming years. Recently, natural gas prices have experienced downward pressure in the United States. The commodity has dropped approximately 80 percent in the past four years. The decrease in natural gas prices in the country is the result of a decrease in demand during the winter as a result of warmer weather coupled with abundant production. However, natural gas prices internationally have increased during the same time period, rising by as much as 50 percent in some countries. Liquefied natural gas provides the opportunity to meet international demand with domestic supply and Chevron s current operations internationally as well as its development and investment in liquefied natural gas will allow it to capitalize on these opportunities more effectively than many of its competitors. Reason #3 Chevron s diversification in its upstream operations gives the company a competitive advantage. Over 60 percent of the world s proven oil and natural gas reserves are controlled by national oil corporations (NOC s). These NOC s are increasingly creating an environment that is detrimental to the continued growth of their competitors. As a result, Chevron s continued expansion into deep-water exploration mitigates the company s dependence on NOC controlled assets and gives it an advantage over many of its competitors. The company operates the deepest producing field in the Gulf of Mexico and is currently the top leaseholder in the U.S. Gulf of Mexico. In Australia, Chevron is investing on liquefied natural gas to capitalize on the massive deposits of offshore natural gas in the region. Chevron s operations in the Gulf pg. 1

2 of Mexico, West Africa, Northwest Australia and Thailand have already begun to increase production for the company and will serve as the primary engine for Chevron in the future. Reason #4 Compared to its competitors, Chevron has one of the highest dividend yields at approximately 3 percent. Chevron has also demonstrated a strong commitment to creating a trend of dividend growth, with 24 consecutive years of dividend increases. Chevron has one of the highest return-on -equity ratios trailing only ExxonMobil and BP. However, Chevron has the lowest debt-to-equity ratios in the industry, at It also has the lowest PEG ratio at These statistics all suggest that Chevron is a company that is not only undervalued compared to its competition, but has strong potential for stability and growth as an investment. 2. Company Analysis Chevron creates value through the exploration and acquisition of crude oil and natural gas as well as the refinement of these materials and the manufacturing of chemical products. Its fortune is closely tied to the fluctuations in supply and demand of these commodities. The strengths and weaknesses of Chevron are a direct result of the company s internal decisions in response to external opportunities and threats. Strengths Recent efforts to restructure downstream resources and capital on strategic assets will improve operating margins on downstream operations including fuel refining, chemical production, and marketing efforts. Chevron currently enjoys one of the highest profit margins in the industry and these efforts are likely to increase this metric. Chevron has the lowest level of debt out of all its major competitors. In addition, strong growth in its upstream operations has created a growth forecast of a 20% increase in production by This growth will primarily be driven by deep-water drilling and exploitation of unconventional oil sources including shale and heavy oil extraction. Chevron s heavy investment in technological advancements allows it to capitalize on emerging trends and be a lead player in the commercialization of new technologies. Chevron is currently the largest geothermal energy producer in the world. Chevron Phillips Chemical, a joint venture, is currently on track to building the largest 1-Hexene plant in the world, which will further cement Chevron s lead in the petrochemical industry. Weaknesses Heavy investments in technology, particularly in previously unproven segments can create instability in the company. Large scale commercialization of geothermal energy, natural gas liquefaction and shale gas drilling require heavy capital investments, and the return on investment of these ventures is particularly exposed to fluctuations in energy prices. Furthermore, deep-sea drilling and exploration operations also require heavy investment and are prone to costly delays. Deep-sea operations are also more vulnerable to legal ramifications as a result of oil spills or similar environmentally damaging incidents. Chevron is increasingly relying on these operations as a source of growth and will become increasingly sensitive to these fluctuations. pg. 2

3 Opportunities Since 2005, China and India have accounted for 59 percent and 29 percent of incremental oil demand, respectively, but oil consumption is still low compared with developed nations. However, energy demand from China is expected to increase by 75 percent by Overall energy demand in Asia is predicted to grow substantially in comparison to Europe and the Americas. These emerging markets provide Chevron with the opportunity to expand its market share in its downstream operations and acquire assets that can expand its reserves in the upstream. Natural gas liquefaction will increase the versatility of natural gas as a source of energy that is dependable and cleaner than coal at a substantially lower price than oil. Chevron s recent acquisition of Atlas Energy and its increase in investment in natural gas exploration can be leveraged to increase its revenue and market share. Threats Chevron, like most of its competitors, is subject to stringent and often costly government regulation. The company has faced costly litigation for contamination of the environment in many regions across the globe. Currently, the company is involved in an ongoing class action lawsuit as a result of allegations of alleged contamination of the Ecuadorian Amazon rainforest. The plaintiffs in the case have claimed damages of up to 18 billion USD. Chevron is also involved in litigation with prosecutors in Brazil for an oil spill off the coast of the country. Prosecutors allege Chevron is liable for damages and can potentially face a fine of approximately 14.7 billion USD. The threat of environmentally damaging accidents and the resulting financial impact will always be a continuing threat to Chevron and its competitors. (Bloomberg) National Oil Corporations currently control approximately 60 percent of proven oil and natural gas reserves. The expansion of these entities is a direct threat to Chevron and its competitor s ability to acquire sizeable reserves. In the long run, this directly impacts Chevron s ability to compete as effectively in the oil and natural gas markets. The primary threat to Chevron s operation in both the short and long term is the fluctuation of energy prices, specifically a decline in the prices of oil and natural gas. The fortune of the entire energy sector is closely tied to that of global economic growth. The energy sector is subject to the risk of a global economic decline. Although the price of oil has remained relatively high at around $100/barrel (WTI), recent worries of slowing economic growth in the BRIC countries, specifically China, have resurrected the potential for dwindling energy demand and falling prices. 3. Industry Analysis The operations of the energy industry and consequently its profits are influenced by many factors. The price of oil, natural gas as well as petroleum products is generally determined by output capacity and current demand. Algeria, Angola, Ecuador, Iraq, Libya, Nigeria, Saudi Arabia, Venezuela and other members of OPEC are generally the largest producers of crude oil. Their production levels are a major factor in determining worldwide supply. Through a combination of production quotas and other internal collaboration, OPEC is able to largely influence and control crude oil price ranges. Demand for crude oil and its derivatives as well as natural gas is to a large extent driven by the conditions of the current economic climate throughout the world. Changing weather patterns also play a significant part in influencing both supply and demand. Government policies and regulations, particularly through taxation, laws and regulation regarding energy and the environment can affect how companies conduct their pg. 3

4 operations and formulate their products. All of these factors determine how and where all of the members of the industry, including Chevron, decide to operate. The energy sector can best be segregated by upstream and downstream operations. Upstream operations consist primarily of exploration, development, and production of crude oil and natural gas. They also include processing, transportation, liquefaction, and regasification associated with natural gas. Upstream activities also include transporting crude oil, which is generally achieved by utilizing major international oil export pipelines. Downstream operations consist of refining crude oil into petroleum products and the manufacturing and marketing of petroleum derived chemicals, plastics and fuel and lubricant additives. Strong competition exists in virtually all sectors of the energy and petrochemical industries. The competitive groups within the industry include fully integrated, global energy companies and independent national energy companies such as Chevron, which compete for the acquisition of crude oil and natural gas leases and other permits as well as all of the necessary equipment required to develop and operate these properties. In the downstream operations, fully integrated oil companies compete with other independent refining, transportation, marketing, and chemical entities and national petroleum companies in the sale of various products. Although competition is stringent and diverse, the primary competitors to Chevron within the industry are other large integrated energy companies including ExxonMobil, BP, TotalSAFina, ConocoPhillips, and Royal Dutch Shell. The North American natural gas industry consists of multiple companies controlling a small percentage of market share, with the largest producer controlling only 4 percent of U.S production. Refining activities are similarly fragmented. The largest shareholder, ExxonMobil, only controls 6.8 percent of global supply. The costs of product refinement are similar internationally. Combined with the low cost of transporting fuel, low-cost production in one region can affect profitability in another. (Bloomberg) Fueled by rising fuel costs pre-recession, energy companies injected large capital investments into increasing refinement capacity which has resulted in overcapacity in the global refining sector. An increase in capacity coupled with a downturn in demand and fragmentation in the sub industry have recently pushed margins to historically low levels. However, as investment in refinement cools and world economies begin to recuperate, refining margins should rebound to their previous levels. In fact, global demand for refined products is already showing signs of improvement. Despite a healthy price of oil, production for this commodity has essentially remained flat since Crude oil prices have risen by 160% since the beginning of 2000 but production from traditional sources has lagged behind demand growth rates. Without the addition of biofuels and oil production from associated natural gas (NGL s), there has been no growth from crude oil since However, stagnant production from traditional sources has fueled an increase in oil prices which in turn has created additional demand for the exploration and extraction of nontraditional energy sources such as shale gas and oil and deep-water drilling, among others. (Bloomberg) Fragmentation and downward pressure on downstream operational margins have recently caused some energy companies to move away from downstream segments. Others, including Chevron, are choosing to divest less lucrative investments to strengthen core businesses in the upstream. This trend should result in an increase in efficiency and productivity for the industry. pg. 4

5 Appendix A: Inputs into the Discounted Cash Flow Valuation Risk-free Rate 0.96% Default Spread 1.15% Cost of Debt (after Tax) 1.37% Bottom-Up Beta 0.91 Yahoo! Beta 0.86 Weighted Average MRP 8.06% Cost of Equity (bottom-up) 8.27% Cost of Equity (Yahoo!) 7.89% Weight of Debt 8.57% Weight of Equity 91.43% WACC (bottom-up) 7.68% WACC (Yahoo!) 7.33% Growth Rate 5.77% *Sources: Yahoo! Finance Glossary: Bottom-up beta This is calculated by taking a weighted average of the unlevered betas for each business segment, and then relevering the weighted average unlevered beta using the firm s D/E ratio. Each segment is weighted by revenues from that segment. Weighted average market risk premium This is calculated by taking the market risk premium from each country or region of operation and weighted by the revenues from that country or region. The country risk premiums are from pg. 5

6 Appendix B: Inputs into valuation using multiples Comparable Firms Firm EV/EBITDA Chevron 3.91 ConocoPhillips Royal Dutch Shell PLC-A Total SA BP ExxonMobil *Source: Yahoo! Finance Historical Multiples TTM Price/Earnings CVX S&P Price/Book CVX S&P Price/Sales CVX S&P *Source: Morningstar, Inc Price/Cash Flow CVX S&P pg. 6