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Chevron's Balance Sheet Runway Appears Supportive of Dividend For Now

On March 6, we discussed why Chevron appeared to have one of the safest dividends in the energy sector. Days later, the price of oil plunged from around $45 per barrel to below $35 as Saudi Arabia engaged Russia in a price war for market share.

At the time, we shared our thoughts that the price of oil could remain very weak for at least a few quarters, if not for more than a year. Since then, a bad situation has only gotten worse.

With the coronavirus pandemic suddenly bringing many parts of the economy to a standstill and depressing short-term demand for fuel, last week oil suffered its worst loss since 1991, settling near $20 per barrel.

This is an unprecedented environment for oil producers, with severe supply and demand shocks occurring simultaneously. The industry's imbalance doesn't seem sustainable in the long term, but it's anyone's guess how long this dynamic could persist for now.

Many energy companies have already announced plans to further slash spending and reduce shareholder distributions to preserve as much capital as possible for these uncertain times.

Barring a sustained rebound in oil prices back to $40 to $50 per barrel, these developments reduce the runway Chevron has to protect its dividend.

Therefore, while we still believe Chevron is one of the best houses in a bad neighborhood, we are downgrading the firm's Dividend Safety Score from Very Safe to Safe.

At $45 per barrel oil, we estimated in our March note that Chevron's cash flow from operations would fall to around $18 billion (from $27.3 billion in 2019 when Brent oil averaged $64 per barrel). 

Assuming capital expenditures remained stable at $15 billion per year (as they have since 2016) and its $9.6 billion dividend was maintained, this would result in an annual cash flow deficit of around $7 billion.

Now, with Brent oil prices sitting near $30 per barrel, Chevron's cash flow deficit will widen further until the environment improves. 

The company previously stated that its cash flow fluctuates $450 million for every $1 change in Brent oil prices. The $15 per barrel fall in oil prices since our earlier analysis suggests that our estimate of Chevron's annual operating cash flow should be reduced from $18 billion to around $12 billion.

All else equal, Chevron's annual cash flow deficit after covering capital expenditures and dividends would widen from around $7 billion to about $13 billion.

Management may find a way to squeeze out a couple billion dollars of savings by axing all non-essential operating expenditures and capital spending, but we are still looking at a much bigger hole in today's oil price environment.

Chevron will have to rely on its balance sheet to plug the gap until prices recover. As we discussed earlier this month, Chevron's net debt to equity ratio, or gearing, was about 13% at the end of 2019. 

Gearing measures the proportion of a company's financing that is from debt (net of cash) rather than equity. Most of Chevron's investment grade-rated peers have gearing closer to 20% or as high as 30%. 

Let's assume management was comfortable increasing gearing to 20% and that Chevron didn't generate any net income this year (reducing its equity balance by around $10 billion to pay the dividend).

All else equal, we estimate Chevron could borrow about $12.5 billion to reach a net debt ratio of 20%. That's enough funding to cover our projected cash flow deficit for Chevron for a year, or perhaps a little longer if the company is able to dial down spending or complete any asset sales.

If management was willing to let gearing reach 30% and its equity declined by $20 billion over the next two years, then we estimate Chevron could borrow as much as $32 billion, or enough to support the current projected cash flow deficit for at least two years.

Whether or not management would choose to sacrifice all of Chevron's financial flexibility just to preserve the dividend is another question. 

On one hand, Chevron and its predecessors have paid uninterrupted dividends since 1912, and the company would like to protect its status as a dividend aristocrat. 

But Chevron also faces an unprecedented operating environment which increases pressure to preserve cash. Maintaining a very strong credit rating during these uncertain times is important, too. (Chevron has an AA rating from S&P.)

Overall, it would surprise us if an imminent dividend cut was in the cards for Chevron. The short-term outlook for the firm's cash flow is bleak, but management runs the business with a long-term perspective and went into this storm with one of the best balance sheets in the sector.

However, if oil prices do not recover within a few quarters (reducing the balance sheet's remaining runway) or management hints that the dividend may no longer be sacred in these extreme conditions, then Chevron's Dividend Safety Score could be downgraded.

The energy sector is an especially precarious hunting ground for income in this environment. Chevron remains one of the very few options for contrarian investors to consider, but even it requires a high tolerance for uncertainty and a willingness to bet that oil prices won't remain this low for more than a year or two.

We will continue monitoring these developments and provide updates as warranted.

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