Chevron’s major gamble: Baffling spending amid production declines

May 5, 2014, 7:56 PM UTC

FORTUNE — Chevron may need to rein in the spending if it ever hopes to pump up its sagging profits.

The oil giant reported sour earnings on Friday, missing analyst quarterly estimates by a wide margin. While the company blamed the miss on bad weather, currency exchange, and unforeseeable production problems, it was the massive upsurge in spending and subsequent decline in production that appeared to be the real culprit.

Despite its troubles in the field, Chevron (CVX) continues to spend like mad on projects in questionable regions of the world where it faces high drilling costs and expropriation risk. While growth is important, it may not be worth it in certain cases. Chevron may be better served by following rival Exxon’s lead and cutting spending and returning more of its cash to investors.

Chevron has had a tough time communicating with Wall Street. The company, America’s “second” oil giant, behind ExxonMobil (XOM), managed to miss analysts’ estimates for the past four quarters in a row. The latest miss occurred on Friday, when the company reported adjusted net income of $2.36 a share for the first quarter of 2014, missing estimates by an average of 15 cents a share.

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While the company still made a profit of some $4.5 billion for the quarter, its quarterly revenue of $51 billion was 5% lower than it was a year earlier, all despite the fact that natural gas and oil prices remained strong in the quarter, maintaining even higher highs than it did during the same period last year.

Companies usually lower expectations in advance of earnings to avoid the sort of investor panic that follows a miss. John Watson, Chevron’s chief executive, probably thought he did just that in March when he lowered the company’s production guidance numbers through 2017 from 3.3 million to 3.1 million barrels a day.

Despite boosting exploration and production costs in the last quarter to $9.4 billion from $8.9 billion, the oil giant actually reported a decrease in production volumes across the board for the quarter, far worse than analysts had anticipated, even with the lowered production guidance. The company’s net oil-equivalent production was 2.6 million barrels per day in the first quarter, down from 2.65 million barrels per day from the same time last year. The most glaring decrease in production volumes came from Chevron’s international portfolio, where the company reported earnings of $3.4 billion for the quarter, a whopping $1.4 billion decrease from the first quarter of 2013.

Watson blamed the decreased production volume on a variety of issues, ranging from problems in Kazakhstan, the source of one out of every eight barrels of oil it pumps out of the ground, to unfavorable currency exchange. It would be nice to think that these were just one-off events and that production will proceed normally from now on, but that would be denying the risk profile of Chevron’s international energy portfolio. The truth is, Chevron is mixed up in some pretty shady places where corrupt and dictatorial governments have little to no respect for international contract law.

For example, Chevron said on its earnings call that it was planning on drilling 140 wells in Argentina’s Vaca Muerta basin this year, making it the lead foreign energy company in the country. Now, Argentina isn’t the friendliest of countries to do business in — especially if you’re a foreign company. After all, it was just a couple of years ago that Argentina re-nationalized its energy company YPF, kicking Spain’s Repsol out of the country. Repsol is claiming at least $10 billion worth of damages. It will be lucky if it gets a fraction of that. Some would say Chevron’s involvement in Argentina is risky, but it seems pretty reckless.

But Argentina isn’t the only high-risk country Chevron has double-downed on recently. In March, the company said it had amassed a large acreage position off the coast of Myanmar, whose quasi-military-led government isn’t known for its stability and rational decision-making. While Chevron, through its Unocal subsidiary, has been in the country for a while, political changes in the region make further investment appear unwise. Like Argentina, the whims of the government could shift at any moment, leaving the energy giant in the lurch.

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To be sure, every energy company does business with one or two countries they wish they’d never set foot in. Since oil projects take years to get off the ground, by the time production starts rolling, a company could be dealing with an entirely different set of political actors and circumstances than when they first negotiated their entry.

At the end of the day, the only countries where an oil company is totally safe are probably the United States and Canada. But spending billions in countries that are unstable may not be the smartest use of investor cash. Exxon decided earlier this year that it would cut its exploration and production budget because it saw a dearth of opportunities on the horizon. That was a risky move, one that might end up hurting the oil giant. But Chevron has taken the opposite path, doubling down on the search for new oil — no matter where it leads them.

So far, investors haven’t decided which view is correct. Exxon and Chevron’s stock prices have moved in lockstep with each other since the two diverged on the exploration and production front. This latest quarter shows that Chevron is spending way more than analysts are comfortable with. But Chevron seems committed to taking the riskier path. Only time will tell if it is the best one.