NEW YORK (Money Magazine) - When Chevron and Texaco merged, back in October 2001, it looked like an unstoppable combination.

The union of $52 billion (market cap) Chevron, with its top-notch exploration and production assets, and $45 billion Texaco, with its vast retail network, would create a powerhouse.

ChevronTexaco's management predicted that the company would rival ExxonMobil's 3 percent rate of annual production growth, further boosting its return on capital, which ranked among the highest in the industry.

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Instead, ChevronTexaco's profits dried up faster than a drop of water in the Sahara. Even before the ink was dry on the merger agreement in 2001, oil prices headed south, causing both Chevron and Texaco (still separate entities) to post losses in the third quarter of that year.

In 2002, weather disasters and geopolitical turmoil curtailed Chevron's production volume by 3 percent. Moreover, as the global recession depressed oil demand last year, ChevronTexaco, which gets a lot more of its profits from the retail business than its rivals, saw earnings sag 66 percent.

Then there was the Dynegy fiasco. In 1996, Chevron made its first investment in the energy-trading firm, hoping to pump up returns with trading profits. To Wall Street's dismay, ChevronTexaco continued to sink money into the company even after accounting scandals sent Dynegy shares crashing down.

ChevronTexaco, which ultimately had to write off almost all of its $2.7 billion stake, fell short of earnings estimates three times in a row in 2002. Return on capital is now among the lowest in the industry.

Disgruntled investors have pushed the stock 30 percent off its 52-week high to $64. ChevronTexaco (CVX: Research, Estimates) now trades at just 1.8 times book value, with a P/E of 12 based on next year's estimated earnings vs. 17.2 for ExxonMobil and 13.9 for BP.

But a number of value investors are true believers. "The price completely overdiscounts the problems," says Tom McKissick of TCW Galileo's Large Cap Value fund, which counts ChevronTexaco as a top 10 holding.

For starters, ChevronTexaco fans say the impact from the Dynegy flop was overblown. Manager Kevin McCloskey of Federated funds, who began increasing his stake when the shares dipped below $70 last fall, believes that the market was "unduly harsh" in judging the impact of the Dynegy investment.

And, in fact, ChevronTexaco has written off all but $347 million of its Dynegy investment, so the fiasco will have little impact on future earnings.

Macroeconomic trends have also tilted back in the company's favor. While we don't know how events in Iraq will play out, they shouldn't have much impact on ChevronTexaco's production.

And with oil prices having recently vaulted as high as $38 a barrel and now hovering around $28, profits from exploration and production (down 5 percent in 2002) should come roaring back.

That provides an automatic boost to the bottom line, notes fund manager John C. Thompson of Thompson Plumb Growth. Even with its earnings slump, ChevronTexaco has maintained its solid balance sheet, with nearly $3 billion in cash and a lower debt-to-capital ratio than many of its peers. It boasts a 4.3 percent dividend yield, the largest of its rivals.

Ultimately, good weather (that is, no big natural disasters) and high oil prices won't provide more than a temporary boost to the oil giant.

A more significant positive change should come in October, says Michael Kagan, a portfolio manager at Salomon Bros. Asset Management. That's when the two-year post-merger pooling period, during which the company is legally barred from making major structural changes, expires.

ChevronTexaco's chief financial officer, John Watson, says he can't comment on specific planned restructuring moves, but confirms that the company intends to shed underperforming assets as soon as possible. "Our goal is to improve return on capital by 2 to 3 percent within the next two years," he says. The company recently boosted the expected merger-related savings to $2.2 billion a year, up from an initial $1.2 billion.

ChevronTexaco is banking on its exploration-and-production business to drive future growth -- and perhaps shield it from the severe cyclicality of the refining business.

That strategy could prove sound, as ChevronTexaco has exploration contracts in some of the most oil-rich areas worldwide.

One good sign: Replacement reserves -- a measure of exploration success -- rose 14 percent last year. Of course, worsening geopolitical turmoil, such as the escalating warfare in Nigeria, could hurt production growth.

Even the bulls say that ChevronTexaco can't afford any more big missteps. "The company has enough good assets in attractive places," says Kagan. "Its destiny is in its own hands."