It’s been a little while since you last heard from me, I know, but have no fear for your investment guru is here! Haha just kidding…I couldn’t be less deserving of such a title, but maybe some day…we’re taking it one Ticker Talking post at a time here!
This week’s Nick’s Pick is Occidental Petroleum (ticker: OXY), which has attracted a fair bit of attention over the past few years due to Warren Buffett’s growing stake in the company (about 20% at the time of writing). In a year where the market has favoured energy stocks, OXY sits at the very top - with a price return of approximately 135% YTD, it’s the third-best performing stock in the S&P 500.
Occidental Petroleum is quite an interesting company. Historically, OXY was your typical dividend-paying oil and gas company (dividend was about 5% of their stock price); however, that changed when Occidental agreed to acquire Anadarko Petroleum for $57 billion (including debt) in 2019. OXY found itself in a bidding war with U.S. oil giant Chevron (ticker: CVX) for Houston-based Anadarko, and a $10 billion contribution from Buffett’s Berkshire Hathaway helped OXY secure the deal.
There were plenty of critics of the merger when it was initially announced, including activist investor Carl Icahn, who called the deal “hugely overpriced.” In hindsight, the timing of the transaction couldn’t have been any worse. OXY used quite a bit of debt to finance the acquisition, meaning the company was very highly leveraged at the onset of pandemic (the purchase saddled OXY with around $40 billion in debt), when oil prices sank to below $20 per barrel as demand collapsed (oil had started the year at $61/barrel). Prior to the 2019 transaction, OXY’s market cap was $50 billion; that figure dropped to under $9 billion around the end of 2020. OXY suspended its share repurchase plan and slashed its dividend payment in 2020, from $0.79/share to a meagre $0.01/share.
However, just like nobody saw Covid-19 coming, few could’ve predicted oil’s gigantic turnaround as economies re-opened and then as Russia infamously invaded Ukraine. Surging oil prices have spurred enormous revenues, profits, and free cash flows for many oil companies, and OXY is certainly no exception. In Q2 Occidental recorded a record $4.2 billion of free cash flow, and they delivered another outstanding result this past Wednesday when the company announced earnings.
In terms of where to allocate these robust cash flows, OXY’s main priority has been de-levering its balance sheet (as it should be). Management initially aimed to pay off $5 billion in debt this year; the company shed over $8 billion of its debt by the second quarter (and another $1.8 billion in Q3)! Hollub estimates that the company will only have about $15-$17 billion in outstanding debt at year end. This significant debt repayment progress has allowed OXY to focus on other uses of capital as well, such as getting back to returning more cash to shareholders. Investors are now receiving a quarterly dividend of $0.13/share—still a far cry from the $0.79/share investors received prior to the Anadarko merge but a 1,200% boost from the $0.01 dividend OXY has been issuing since 2020! OXY plans to continue its share buybacks—they repurchased $1.1 and $1.8 billion of shares in Q2 and Q3, respectively.
Circling back to the dividend, Hollub said that she “expects future dividend increases to be gradual and meaningful” especially as the interest payments continue to fall, but she doesn’t “anticipate the dividend returning to its prior peek.” Therefore, if you’re looking for a monster dividend, this likely isn’t your answer, but investors should nonetheless see modest dividend growth over the next several quarters.
As I mentioned, Occidental’s stock has enjoyed quite a bit of success this year, so at its current price OXY certainly doesn’t appear to be a bargain. However, I found Buffett’s 2022 OXY transactions to be quite interesting—he started picking up shares trading at $47 in March, and he’s been consistently buying the stock throughout its price surge (with the latest filing disclosing that Berkshire bought shares as recently as the end of September for $61). So is it still a buy, trading at about $70/share? Looking at select financial ratios (Enterprise Value/EBITDA, Price/Earnings, Price/Book Value) of OXY as well as comparable companies in the oil and gas sector (See Exhibit A), it appears that OXY is trading around the median of most of the multiples of the listed competitors. However, OXY’s P/E being on the lower end of the set could potentially indicate that the stock is undervalued in comparison to these companies.
At the end of the day, there’s simply no getting around the fact that valuations in the oil and gas industry are very dependent on oil prices. Personally, even with the risk of a recession reducing demand (and thus sending oil prices down), I’m still bullish on oil. Both OPEC’s announcement last month of a production cut of 2 million barrels per day, and the imminent end to the US’s special petroleum reserve releases (now that the midterm elections are over and the government doesn’t mind the prices heading to the high heavens) point to continued tight supply in the oil market. Additionally, there are signs that China may soon end its zero-covid policy, which should increase demand as the economy is finally able to re-open entirely and on a permanent basis. I believe these factors could keep oil prices elevated for at least the next several months. There is no doubt that these prices will eventually start to come down though, at which point oil may become a less appealing investment. In OXY’s case, their rapid debt reduction (significantly trimming down interest expense) has provided significant protection for their bottom line when prices inevitably dip. Furthermore, OXY has said that they would still be able to sustain their operations and pay out dividends (break-even cash flow) if oil fell to just below $40/barrel (WTI Crude is currently about $90/barrel), so clearly there is still a wide margin of safety that should comfort investors.
Although I’m advocating for oil and gas, it’s no secret that this industry isn’t poised for growth over the long-term, so how is OXY preparing for the future? The company’s sustainability efforts are actually a major reason why Buffett is picking up shares left, right, and center. While OPEC forecasts booming demand for oil through to 2050 (See Exhibit B), there is no doubt that the world is gradually transitioning to a net-zero future.
Occidental Petroleum sees this as an opportunity—earlier this year they outlined plans to further their clean energy ambitions by spending $1 billion on a facility dedicated to capturing carbon dioxide (CO2) from the air. The facility, located in the Permian basin (the largest oilfield in the U.S.), broke ground this month and will be the world’s largest direct air capture (DAC) project, cementing OXY as a leader in global net zero efforts. Such a plant with cutting-edge technology will enable the company to take CO2 from the air and transfer it into the ground, earning the company carbon credits. This is shaping up to be a very profitable endeavour for OXY, with companies already lining up to purchase these credits, which thereby offset their own carbon emissions. For example, back in March, airplane-producer Airbus signed a long-term contract to buy Occidental’s credits.
The carbon capture and sequestration market size is expected to expand from its current mark of USD $2 billion to USD $7 billion by 2028 (a CAGR of about 19.5%), and new government policy will continue to drive growth in the industry thereafter. Hollub calls this “a sure opportunity” and expects this new division to provide immense value to investors (more than their chemical operations, which netted $1.5 billion in 2021) as they build out the rest of their DAC facilities over the next few years.
To conclude, I think OXY is a stellar company with a steady and experienced leadership team. The company’s main internal risk was their large debt load, but by addressing that they are a much less risky investment. Secondly, even though the stock has shot up this year, it still appears to be relatively cheap, especially if my forecast about oil prices holds true. Additionally, OXY certainly isn’t putting all of their eggs in the oil basket, so to speak, as they are setting the bar on the sustainability front by executing on their revolutionary net zero plans. Finally, there is no denying the elephant in the room—the risk of this sector. If you’re a very risk-averse investor who avoids volatility at all costs, I would advise against purchasing OXY. However, if you’re someone who is comfortable with a bit of risk and is open to betting on a fundamentally strong company, I believe that this stock could be a buy in short to medium term.