Summary
- Warren Buffett's Berkshire Hathaway has been buying Occidental Petroleum stock all year long.
- He has bought it at relative highs as well as lows.
- Most recently, he revealed in a filing that he had purchased an additional 6 million shares.
- In this article, I explain why Buffett is likely correct about OXY being a good value.
Recently Berkshire Hathaway ( BRK.B ) (BRK.A) disclosed that Warren Buffett had bought another 5.99 million shares in Occidental Petroleum ( OXY ), following earlier buys. Reuters reported that the shares cost $352 million, implying an average cost of $58.76. Thanks to falling oil prices, OXY fell well below its average price for the year, and Buffett jumped on the opportunity.
This year, oil stocks like OXY have been pretty tightly correlated with the price of oil. It's natural to an extent, because the higher oil prices go, the more money oil companies make. However, traders seem to be underestimating the kinds of profits oil companies will generate even with oil just at $80. This year, oil companies have been reducing their debt, which makes more profit possible leaving revenue unchanged. Occidental Petroleum, for its part, retired $8 billion in debt by May , with more payments having occurred in subsequent months.
So, it appears likely that OXY will beat on earnings in its next few releases. Based on its trading behavior, it is simply moving with the price of oil - investors seem to be ignoring the possibility of improved profits due to lower costs. Debt creates interest expenses, sometimes a lot of them. For example, if you finance $8 billion at 5% interest, you get $400 million in annual recurring costs. A company that knocks out that much expense can grow even if the commodity it's selling is just staying flat.
Given all of these factors, it looks like Occidental Petroleum is still a good value. At least, for those with very long time horizons and realistic return expectations. At this point it's pretty clear that pie-eyed fantasies about WTI Crude going to $380 aren't coming true, but there are enough economic factors working in its favor that oil should hold above $70. That alone should be enough for OXY to be worth more than today's stock price.
Why I Expect Oil To Hold Above $70
As I wrote earlier, Occidental Petroleum doesn't need oil at $100, $120 or $380 to grow. With the massive amount of debt it's retiring, it should be able to eke out strong earnings growth even at today's prices. With that being said, it won't thrive if oil falls dramatically, so I should outline briefly why I expect oil to hold at least $70.
We can start by looking at supply.
The supply of oil has been held back by the conflict in Ukraine, and that shows no signs of ending any time soon. After Ukraine made some territorial gains, Russia responded by mobilizing (i.e. drafting) Russian men with fighting experience. Now, Russia claims that it has up to 1 million soldiers at its disposal. Ukraine had achieved some impressive wins with the advanced U.S. weaponry it was given, but now it has to contend with a larger number of Russian soldiers. So, the conflict in Ukraine looks likely to drag on for a while.
The war in Ukraine pushed oil prices higher this year by curtailing Russian exports. Initially, Western sanctions caused Russian oil output to plummet, which caused prices to rise. Russian oil output later recovered. However, Russia is mainly selling oil to markets like India , it's still under sanctions from Western nations, so the supply it's moving is "geographically locked." This means it's not truly part of the "world market," leaving upward pressure on prices.
The second factor influencing oil supply this year is strategic petroleum reserve ("SPR") releases. The U.S. and other countries have been releasing oil from their reserves. The U.S., for example, is selling a million barrels a day. That's offsetting the loss of Russian oil exports, but it's set to end soon. Originally, the release was supposed to end in October, but it was extended to November. However, the November release is down to 10 million barrels , so the selling is being wound down. As the selloff grinds to a halt, the supply will go down, putting upward pressure on the price.
Finally, we have the fact that OPEC is consistently missing its production targets. In the early days of the oil rally, lowering prices was a big priority for the Biden administration. At one point, Biden travelled to Saudi Arabia to try to get the country to sell more oil. The Saudis agreed to hike oil output by 100,000 barrels a day, but it didn't matter, because they and other OPEC countries missed their production targets. Today, OPEC is still missing targets and mulling output cuts too . So, that's more supply that will leave the market shortly.
There's also the matter of demand. This year, gasoline consumption is up from the same time in 2021. It's currently down from the Summer peak, but still rising on a year-over-year basis. Consumption of jet fuel is also rising, thanks to the end of COVID-19 lockdowns in most Western countries. Taking all of these factors together-low supply and high demand-and you get a recipe for continued strength in oil prices. I can't say that we're going to rally over $100 again, but $70 seems like a reasonable support level, as that's where oil was at for most of 2021 .
How OXY Benefits
Occidental Petroleum benefits from rising oil prices more than other energy companies do, for two reasons:
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It does not have significant refining operations.
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It is paying off its debt.
Refining operations experience lower margins when oil prices rise. First, many refineries purchase crude oil with intent to sell it after refining it, and it gets more expensive to buy the input when prices go up. Second, oil refining is itself energy intensive , often using natural gas (whose price is positively correlated with crude oil) as a power source. Of course, refineries sell for higher prices when oil prices rise so, like any oil and gas operation, their revenue rises. Their margins however tend to fall. That tends to curb the profits of oil companies that have refinery operations, but Occidental Petroleum has none .
Second, Occidental Petroleum is paying off its debt at a rapid pace this year. It had paid off $8 billion worth by May, and is aiming to do more. In November, OXY will be releasing its earnings for the third quarter. The release will not only show all the revenue and earnings numbers investors are looking for, but also the amount of debt repayment. The level of debt is arguably more important than trailing earnings, because it shows how much interest expense the company will shave off its profit and loss statement. Because oil prices fell in the third quarter, we'd expect OXY's debt reduction to slow down. However, it is still possible for OXY to produce high profits at today's oil prices, as it breaks even at less than $40 .
Occidental Petroleum Valuation
Having looked at OXY's macro and debt picture, we can turn to its valuation. According to Seeking Alpha Quant, OXY is a very cheap stock, trading at the following multiples :
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8 times adjusted earnings.
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6 times GAAP earnings.
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1.7 times sales.
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3 times book value.
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3.9 times operating cash flow.
These are all low multiples for the stock market as a whole (for reference, the S&P 500 P/E ratio is currently about 18.5 ). Additionally, OXY is cheap in a discounted cash flow model. If you take OXY's free cash flow per share ( $12.12 ) and divide it by a discount rate, you get the terminal value estimates shown in the table below:
Discount rate | Fair value estimate |
6% | $202 |
8% | $151 |
10% | $121 |
12% | $101 |
As you can see, Occidental Petroleum is worth more than its current stock price even if you assume no growth. The table above is just a series of terminal value estimates, no "growth period" is assumed. Additionally, all the discount rates used are way above the current 10 year treasury yield. So, if OXY can simply maintain the prior year's cash flow levels, it's worth more than it currently costs.
One Big Risk To Watch Out For
As we've seen in the preceding paragraphs, Warren Buffett has every reason to be excited about the opportunity in Occidental Petroleum stock. Oil prices are likely to stay high, and Occidental Petroleum is paying off debt at a furious pace. What's not to love?
As of today, not much: OXY is a great stock.
However, there is one major risk for investors to watch out for:
Oil dropping below $40.
OXY's break even WTI Crude price has been estimated at just slightly below $40. Therefore, OXY is barely profitable when oil moves to $40, and likely unprofitable at $35. As I showed in the section on oil price economics, prices are quite unlikely to go that low. Oil supply is headed down this year, while demand is modestly up. Nevertheless, investors are going to have a bad time if prices go significantly lower. If they go below $70, stock market traders are likely to begin selling OXY; if they go below $40, the fundamentals will also take a hit.
So, remember to stay safe out there. Occidental Petroleum has a bigger margin of safety than the average stock, but it's not risk-free.
For further details see:
Occidental Petroleum: Buffett Buys $352 Million More