PXE - Occidental Petroleum: Why Would Warren Buffett Buy A Dirty Cyclical Oil Company?

• How could Buffett be buying Occidental, an oil stock, amid a waterfall decline in the commodity?
• Everybody knows the greening of the world spells doom for fossil fuels, or does it?
• Former oil company bad behavior changes in the fight for self-preservation.

This is a big departure from Buffett’s normal approach toinvestment in energy assets where he is buying distribution assets with strong, dependable cash flows, Berkshire Hathaway Energy ("BHE") ( BRK.A , BRK.B ). Historically, the oil & gas exploration and production industry has been nothing like this, tremendous booms followed by equally horrible busts. Because every barrel they produce has to be replaced, and you have to find more than one barrel if you are to grow production, these companies constantly "climbed the down escalator". Tremendous investment is required for a company to stay in the game. They also have to contend with the risk of not finding hydrocarbons. When the music stops, earnings collapse and those who are overlevered to the price of oil get creamed.

Buffett’s initial foray into Occidental Petroleum ( OXY , $60.67) via a $10 billion investment in an 8%preferred (with 84 million warrants - strike price @$ 59.62) was more characteristic. He put himself ahead of the common shareholders in the event of a liquidation and got a very tasty yield to boot. Now he is buying the common stock, and on Friday announced he had purchased an additional 12 million shares on Tuesday and Wednesday at an average price of $58.17. Characteristically, this was done in the middle of meltdown in the group triggered by renewed fears of the impact that a recession might have on oil demand. Longer term, you have to contend with the industry returning to its boom-bust bad behavior and the crowd claiming the greening of the planet will destroy this group.

What about green eating oil’s lunch?

There is no question in my mind that demand for gasoline will be displaced in the Western world. Over time, this will be a very expensive proposition. It is not just charging stations (that seem to be getting more ubiquitous) that we will need to make this work. It is investment in major background infrastructure - the power grid and new generating capacity to handle the demand. What will you need dependably to provide that generating capacity that doesn’t need the sun to shine, the water to flow, or the wind to blow? My guess is it will be natural gas, assuming no rebirth in enthusiasm for nuclear. What about the housing stock in the US that is predominately heated with natural gas? Can you imagine the cost to convert to electric or solar heating (again, the sun has to shine or we have to have battery storage capabilities... also very expensive)?

Buffett, through his two decades-plus investment Berkshire Hathaway Energy, knows the alternative energy/renewable industry very well. BHE has a division (MidAmerican Renewables) dedicated to this area. If he saw the outlook to be a quick and easy fix, it is doubtful that he would be pouring money into OXY.

This is not to mention potential European demand for liquefied natural gas ((LNG)) coming from the fact that Russia cannot be viewed as a reliable supplier. Layer on top of this huge portions of the planet (Asia and Africa) without theinfrastructure to support electrification of any type, where fossil fuels are the only alternative for motor vehicles for the foreseeable future, and a case may be made for continued growth in demand.

Oil company bad behavior changes in the face of global efforts on climate change

The events of the past two years have profoundly affected oil company and sovereign producer (a la Saudi Arabia) behavior. In the past, a price surge such as we’ve seen recently would have brought on a rush of new drilling, exploration, and production... not so this time. The combination of a Russo-Saudi price war at the end of 2019, followed immediately by the pandemic-driven worldwide economic shutdown, was traumatic. At its worst, oil traded at minus $40/barrel. People not wanting to take physical delivery of the product had to pay people to take it off their hands. Couple this with a constant drumbeat on governmental policies to curb fossil fuels to combat climate change and the producers got the message:

• We better look elsewhere for investment to replace what we might lose in the future. "Chevron ( CVX ) will spend $3.15 billion to buy bio based fuel maker Renewable Energy Group" (March 2, 2022 - Chemical and Engineering News)
• We better take better care of our shareholders as we go through these perilous times. APA Corp. ( APA ) "Expect((s)) to generate ~$6.5 billion of free cash flow in 2022-2024 based on a WTI average price of $78/barrel (3-year strip)... Returning a minimum of 60% of free cash flow to shareholders through share repurchases and ordinary dividends." ( APA Corp. March 2022 Investor Presentation )

This is all money (almost $10 billion) that could be going to drill new wells and increase production (the normal reaction to higher oil prices). Instead, it is going toward alternatives... self-preservation. I also think it is important to note that these companies, like APA, would be very profitable with oil priced much below Friday’s close of $104.80 on West Texas Intermediate crude oil. (APA Corp. is a current holding in my personal account.)

Buffett applying analysis to an industry he knows

It’s just Buffett being Buffett, applying superb analysis to an industry where he has a depth of experience. He is taking a knowledge-based contrary view to the idea that the death of hydrocarbon fuels is at our doorstep. He is taking advantage of computer/algorithmic-driven market where in the last couple of weeks the computers have gotten hold of the notion that a recession (if it comes) might be bad for oil demand. Unlike the computers, he is playing the long game, which has served him and his shareholders well over the past seven decades.

What’s your take?

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