Attractive investment opportunities have been hard to come by in a climate plagued by inflation, recession risks, and higher rates. So the fact that Warren Buffett has dropped billions of dollars over the past six months to buy nearly 20% of Occidental Petroleum (OXY) does make me want to sit up and pay attention. And if that wasn’t enough, the sage himself recently won approval to buy up to half the company. That really made me curious, so I decided to take a look at what makes Occidental so interesting. And it turns out, it’s got quite a few things going for it…
1. Exposure to US shale.
If there’s one thing to know about Buffett, it’s that he’ll “never bet against America”. The growth of hydraulic fracturing, more commonly known as fracking, since 2010 has made US shale a force to be reckoned with. It has transformed the country’s energy landscape and has secured its energy independence. The current US oil production of 11.6 million barrels per day is more than double what it was in 2008, when it hit a low after four decades of decline. And Occidental, having bought Anadarko in 2019, is now one of the largest shale producers in the Permian Basin, with up to 80% of its hydrocarbon production based in the US.
2. Growth from high oil prices.
The oil and gas business is easy to understand – precisely the type of business Buffett enjoys. After all, there are only two main drivers of earnings: 1) how much is produced, and 2) the price of oil and gas. The latter is more important since it naturally influences the former. While the transition to green energy is happening, it won’t be dominant for many years – and that means the world still needs oil and gas. As the chart below shows, the ESG-led higher cost of capital for oil companies has meant that oil producers are only incentivized to develop new projects at $90 a barrel compared to $57 a barrel at a lower cost of capital – and that keeps oil supply constrained and oil prices higher for longer.
3. Room to grow for cheap.
Perhaps the crown jewel in Occidental’s portfolio is its US onshore acreage: 2.9 million acres of the Permian Basin, the sprawling shale field beneath Texas and New Mexico. Compared to other shale basins, the Permian has the longest resource life. It’s also where the bulk of US oil production growth is expected to take place, and it has one of the lowest costs of production. Having a large and continuous shale acreage like that is important as it allows for economies of scale to drive down costs, and that’s a big competitive advantage. Occidental is not only one of the largest oil producers in the Permian as the chart shows, but it’s also one of the most cost-efficient ones.
4. Good management.
Buffett first started buying Occidental shares early this year and said the company’s CEO was “running the company the right way”. By that, he meant she was prioritizing profits over production. See, when interest rates were at their lowest, many companies were spending to expand, basically chasing growth at the expense of returns, to the detriment of investors. Occidental’s management team, on the other hand, has been focusing on delivering strong and sustainable cash flows. This explains why cash generation has been so strong in the past few quarters. The management team has also said it’s got three objectives for its free cash flow: reducing its debt, paying dividends, and buying back shares. With net debt expected to be materially lower by the end of this year, Buffett can expect a strong cash payout over the next couple of years.
5. A healthy cash flow.
Even more so than growth, free cash generation is an important metric when investing: it tells you how much a company has left over after investing in its future. The higher the free cash flow, the better it is for you since this cash can be deployed to many uses: pay down debt, make acquisitions, reinvest in the company, or be returned to shareholders as dividends or through share buybacks. At current oil prices, Occidental is expected to be a cash-generating machine with up to 14% free cash flow yield. That means it could potentially buy back all of its shares in roughly seven years at its current run rate. Its dividends are sustainable at an unlikely low price of $40-a-barrel, and the company also recently launched a $3-billion share repurchase program, which could have it buying back up to 4% of its market shares over the next year.
6. A solid margin of safety.
Overpaying for a stock is not Buffett’s forte. He only buys when he thinks there is greater value to be had longer term. The best way to value an oil and gas company is to sum up the net asset value (NAV) of all its assets. This involves assuming a long-term sustainable oil and gas price for the future, and then discounting the net cash generated from production over the life of the asset. The chart below, which is based on Goldman Sachs’ estimates, shows that Occidental is worth materially more if you believe, as the vast majority of analysts do, that long-term oil prices will stay higher for longer at $60 a barrel or more. That’s because Occidental’s outsized exposure to US oil production means it has one of the greatest sensitivity to oil prices compared to the rest of the sector.
So what’s the opportunity here?
Buffett’s got a $38-billion exposure to the energy sector through both Chevron (CVX) and Occidental, and that speaks volumes about his optimism on long-term oil prices. If you share that view, and are bullish on oil prices and particularly on US shale, you could invest directly in Occidental. Or you could diversify your sector exposure through the iShares U.S. Oil & Gas Exploration & Production ETF (IEO, expense ratio: 0.39%). You could also consider the iShares Global Energy ETF (IXC, expense ratio: 0.40%) for a more global exposure.
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