We sold Chevron (CVX) in all dividend strategy* portfolios last week. Since we had already sent you two email updates earlier in the week, we held off on an immediate update at the time of the CVX sale to avoid inundating your inbox with another email.
U.S. shale oil and fracking has changed the dynamics of the world’s oil market. The old oil market can best be best explained by The Economist.
Big companies making big bets on big oilfields, while a cartel of oil-producing states fixed the price to keep itself rich and others, including the oil majors, profitable. That, in caricature, was how the oil industry once ran.
With the dramatic increase in shale oil production over the last several years, the U.S. has now become the large swing producer for oil. Shale producers can respond quickly to changes in oil prices by quickly ramping their drilling up or down. Their ability to increase supply when prices are high and decrease production during periods of low prices will likely keep a lid on oil prices for at least the next few years.
Out of the 3 U.S. super major oil companies, we estimate that Chevron has the highest break-even price per barrel of oil (i.e. price required to cover its capital expenditures and dividends) at approximately $80. Anything below this level would likely require the company to take on debt in order to maintain its current dividend. Unfortunately, if oil were to creep back towards $80 a barrel we would expect the shale producers to increase supply thus bringing the price per barrel of oil back below Chevron’s break-even price.
To be clear, we still view Chevron as a quality company. Their estimated production growth is higher than its super major peers, and its downstream operations (refining and marketing) help balance out its earnings during periods of low oil prices. However, as we have discussed in past letters and portfolio updates, we are most interested in building a portfolio of companies that can grow their dividends at above average rates over time.
We expect that the market dynamics of shale oil will prevent Chevron from organically growing their dividend at above average rates for the foreseeable future. While Chevron may be able to increase their dividend through the issuance of debt, we greatly prefer to invest in companies that are growing their dividends through operational cash flow not through increased balance sheet leverage.
As always if you would like to discuss this further, please contact us.
Your Portfolio Management Team
* Clients with specific restrictions against eliminating CVX, and/or clients with significant taxable gains on their position in CVX may still hold the position.