Chevron (CVX) stock has risen with oil's move higher. It is also likely to report strong Q3 cash flow and a dividend hike soon. Shorting out-of-the-money put options for income looks like an attractive play here.
In early trading on Friday, Sept. 29, CVX stock was just below $170 at $169.89. This is higher than it was when I wrote my Sept. 10, 2023, Barchart article, “Chevron Is Moving Higher With Oil's Rise - CVX Stock is Still Cheap.” At the time it was trading for $167.10 per share.
Higher Oil Means Higher Cash Flow
Moreover, it is becoming clear that the company's cash flow is likely to benefit exceedingly well this quarter from the rise in oil and gas prices. The company provided guidance in its Q2 presentation that it expects its production to be flat.
But that is hard to believe given how fast oil prices have risen. Most companies would try to increase production when they receive higher prices for their products.
Moreover, in Q2 it produced $9.4 billion in cash flow from operations (CFFO) before working capital changes. That was well over the expense of its dividends, which costs just $2.8 billion. It also covers its large buybacks that cost $4.4 billion.
The total of these two uses of free cash flow, $7.2 billion total, is still well below the $9.4 billion in CFFO cash flow. With this quarter's oil price rise, expect to see an even higher CFFO figure.
CVX Stock is Still Cheap
Assuming it makes $10 billion in CFFO for the quarter, that puts it on an annualized rate of $40 billion annually. Given that it has a market cap of just $323.1 billion, this means its CFFO yield (i.e., before capex and working capital cash charges) is high at 12.3%.
Even if capex and working capital changes use up half of that amount, the stock still has a free cash flow (FCF) yield of 6.15%. That makes it very cheap.
For example, at a 5.0% FCF yield, Chevron stock should have a market cap of $400 billion (i.e., ($40b x .50)/0.05). That is still 23.8% over today's market cap.
In other words, CVX stock is worth 23.8% more than $170, or about $210 per share.
Moreover, CVX stock has had an average price-to-earnings (P/E multiple) for the past 5 years, of just 12.6x, according to Morningstar. (That excludes 2020 when it was 31x.) That is 7.2% higher than its 2024 11.75x forward multiple.
In other words, CVX stock is worth between 7% and 23.8% more than today. That puts its price target 15.5% higher on average at $196.35 per share over the next year. This is just if the company rises to its historical and expected valuation parameters.
One way to play this is to short out-of-the-money (OTM) put options to gain extra income.
Shorting OTM Puts for Income
In my last article, I suggested that shorting the OTM puts at the $160 strike price for the Oct. 6 expiration period looked like a valuable trade. At the time, the premium received from selling short those puts was 94 cents per contract.
That produced an immediate yield of 0.5875%, and on an annualized basis, if it can be repeated every month, a 7.05% expected return.
However, today, those puts have already fallen to just 13 cents. So most of the money from this trade has already been made. It makes sense to cover that trade and redo it for a slightly further out expiration period.
For example, the Oct. 20 option expiration period (3 weeks from now) shows that the $162.50 strike, which is 4.3% out-of-the-money (i.e., below the spot price today), has a premium of 95 cents per contract.
That means that an investor who enters an order to “Sell to Open” at that put option strike price will receive a yield of 0.585% (i.e., $0.95 / $162.50). On an annualized basis that works out to 9.9%, since there are 17 periods of 3 weeks during which this trade could be repeated.
The investor has to secure $16,250 in cash and/or margin to get that done. The account will then receive $95 in return for the short sale. If this is repeated every three weeks, the account could earn $1,615 annually, which is 9.9% of the $16,250 at risk.
Moreover, the investor's risk is not that high. At worst, they would have to buy the stock at $162.50. This could lead to an unrealized loss, but, in return they would receive a dividend yield of over 3.7% before any dividend hike.
In addition, given that the investor keeps the income from shorting puts, the actual breakeven price is $162.50-$0.95, or $161.55. That provides a breakeven level that is 4.4% below today's price.
Conclusion
In addition, in order to be more conservative, the investor could sell short the $160 strike price. That provides 61 cents in income but it is 5.78% below today's price. The yield is lower at 0.381%, but on an annualized basis still is high at 6.48% if it could be repeated every 3 weeks.
The bottom line is that CVX stock looks cheap here with at least a 15% higher target price. One way to play this for extra income is to short OTM puts. That could bring in an additional 10% over the next year.
On the date of publication, Mark R. Hake, CFA did not have (either directly or indirectly) positions in any of the securities mentioned in this article. All information and data in this article is solely for informational purposes. For more information please view the Barchart Disclosure Policy here.
