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Chevron Takes Advantage of Short-Term Uncertainty

By Roger Conrad on December 28, 2012

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It’s no wonder so many investors can’t think past Jan. 2. After all, the financial media have trumpeted that date as doomsday as often as tabloids did the end of the Mayan calendar earlier this month.

To be sure, if Washington fails to agree on a deal to soften the so-called fiscal cliff, the resulting slew of automatic tax increases and federal spending cuts will have a deleterious effect on the US economy. In fact, growth could turn negative.

Whatever happens, however, the economy and financial markets won’t fall apart no matter how bad things get in the near term. In fact, those who are able to look past potential near-term pain can take advantage of the situation to lock in long-term gains.

One good example: Super oil Chevron Corp’s (NYSE: CVX) announcement this week that it will buy a 50 percent stake in the Kitimat project in British Columbia. The purchase of the planned liquefied natural gas (LNG) facility also includes 644,000 acres in the nearby shale-rich Horn River and Liard Basins.

Chevron will operate the LNG terminal and pipeline, while its 50 percent partner Apache Corp (NYSE: APA) runs the acreage that will eventually fill it. Kitimat already has a license from Canadian regulators to export 10 million metric tons per year of LNG. Now armed with Chevron’s deep pockets, there’s potential for boosting capacity further.

The deal’s estimated price tag of $1.3 billion, for example, is a drop in the bucket compared to the more than $21 billion in cash Chevron has on its balance sheet.

On the other hand, the most recent projection of Kitimat’s ultimate cost is $15 billion. Those costs are likely to go higher by the time the project is completed later this decade.

Chevron, however, may be able to use the expertise and scale in LNG development gained from its massive Wheatstone LNG project off the coast of Australia. Plans there have seen several sizable increases in construction costs, which are now estimated at $54 billion. But the facility is still on track to start making shipments in 2015. And Asian markets are hungry to absorb whatever output is produced.

Asian markets will, of course, be key to Kitimat’s eventual profitability. And with demand for fuels such as LNG expected to double on the continent by 2025, there’s plenty of room to expand output.

Shielded From Headwinds

North American natural gas prices remain deeply depressed, and in fact at levels where it’s uneconomic for many companies to produce. That’s despite a sharp recovery from lows reached in spring and early summer.

The primary reason is a lack of export capacity, which means all supply is essentially trapped on the North American continent. That which isn’t consumed here must go into storage, and that means a supply glut that’s grown to record proportions. Most producers have dramatically slashed new drilling of natural gas, instead shifting their focus toward much more favorably priced oil and natural gas liquids.

In fact, that includes both of the former Kitimat partners that Chevron is buying out: Encana Corp (TSX: ECA, NYSE: ECA) and EOG Resources (NYSE: EOG). Of the two, EOG is by far the most profitable now, due mainly to a strategy of increasing liquids production the past few years.

Encana, however, took the unfortunate step of spinning off almost all of its oil and liquids operations as Cenovus Energy (TSX: CVE, NYSE: CVE). As a result, Encana’s profits have taken a hit, even though it has ramped up liquids output significantly the past year.

The proceeds raised from the sale represent real money to both companies, particularly Encana. And selling the stake also eliminates a huge potential future expenditure to develop Kitimat, which Encana may not have been able to afford.

In addition, since announced, Kitimat has seen competing projects arise, including from the takeover of the former Progress Energy by Malaysia’s national oil company Petronas. That’s raised some questions about who would be willing to lend to the developers of this project, which in turn has stalled progress.

Bringing on Chevron as a partner eliminates this concern, just as turning to deep Asian pockets has done so for other gas and oil sands projects this year in Canada. And by contrast, Chevron can afford to take the long view on this project, just as it has done in Australia. Its participation in Kitimat is certain to get development back on track, and that’s not dependent on the near-term prospects for the North American energy sector.

If austerity does indeed take a severe toll on the economy as so many fear, it’s a safe bet that the energy sector is going to feel it big time. That’s the message of continued softness in oil and gas prices in North America, which remain well below global prices, even for oil.

Should that come to pass, Chevron is likely to continue taking advantage by making purchases of good assets at low prices from owners that can’t afford to maintain them in a tough price environment. And the transactions will only make the company that much stronger when the energy downturn runs its course in the US, and factors like China’s apparent acceleration in economic growth start to carry more weight with global markets.

Beyond Energy

There’s also a bigger lesson here for investors. Mainly, the best place to be in a market with so much uncertainty is companies that have weathered previous downturns to emerge better wealth builders than ever–thanks to the ability and vision to think and act long-term, while others can’t look past the near term.

As 2008 proved, even stocks of the strongest companies can fall in tandem with the broad market. But that turbulent year also showed a number of companies were able to stick to plans and even invest in growth. And by 2009, they were well on their way to generating record profits.

Regardless of the blather about a fiscal cliff countdown, a reprise of 2008 is still very unlikely. Mainly, investors, businesses, households and even governments have been preparing for a similar debacle since the last one ended. The market’s mood may be decidedly gloomy, but leverage and operating risk have been sharply reduced.

That’s an extreme divergence from late 2007 and early 2008, on the eve of the last great crash, when both optimism and leverage were in heavy supply. In fact, as I pointed out last week, debt-service ratios in late 2012 are at their lowest levels since the early 1990s, which preceded a breakout for both the economy and the stock market.

A deal on the budget may indeed eliminate enough uncertainty to unleash the estimated $1 trillion-plus in cash idling on S&P 500 companies’ balance sheets and ignite growth–as it did in 1993. Or inept politicians will fail to negotiate a deal, thus precipitating sudden austerity along with an economic shock and stock market slide.

Either way, the smart money will continue to focus on opportunities to build real wealth over the long term, despite near-term headwinds. And companies that are able to capitalize on such temporary dislocations will continue to be sound investments.

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