Investing in commodity stocks provides a particular challenge since it often entails getting two things right -- the fundamentals of the company and the direction of the underlying commodity, including the supply/demand balance and overall economic factors that can swing the balance.
Usually, the stocks tend to be trading vehicles that require well-timed buying since they are more cyclical in nature than secular growth situations.
With Warren Buffett's Berkshire Hathaway (BRK.A) (BRK.B) loading up on Occidental Petroleum (OXY) -- now with a 23.5% stake after recent purchases plus $10 billion in preferred notes -- it's worth taking a close look at the company's appeal.
Berkshire's initial foray into OXY came about when Occidental outbid Chevron (CVX) to purchase Anadarko Petroleum. Warren Buffett negotiated, in 2019, $10 billion in preferred notes yielding 8% to help fund the $55 billion deal. After Occidental closed the deal, significantly leveraging its balance sheet, oil prices promptly tanked as the global Covid pandemic emerged.
"We are upgrading Occidental Petroleum to outperform from market perform," Cowen acted last week with a $70 price target, "as we see a superior risk-reward balance of superior exposure to crude pricing, capital structure shifts, captive buying support from Berkshire Hathaway, a favorable free cash yield, well productivity and a differentiated catalyst rich profile in a world of relative homogeneity across E&Ps."
In addition, Cowen speculates that since Berkshire also owns a 10% stake in Chevron, and Chevron once bid to buy Anadarko, there may be a strategic rationale for a tie-up between CVX and OXY, presenting a compelling long-term narrative.
Occidental has capitalized on higher oil prices by vastly improving its balance sheet, potentially allowing more future free cash flow directed toward shareholders. OXY currently offers a competitive 8.4% FCF yield at $75 per barrel of crude. Over the last two years, OXY used its FCF to pay down $14 billion in debt.
Starting in 2023, OXY began paying down the $10 billion in preferred notes on the road to saving the $800 million annual interest payment. Buffett has been a defender of stock buybacks, and likely envisions the potential for OXY shareholders down the road.
Interestingly, after the deal with Anadarko, OXY had an enterprise value (EV) of around $85 billion, the same as it currently has. However, Occidental's $50 billion in debt and preferreds have been paid down to about $30 billion, with the $20 billion reduction accrued to the equity value. As OXY continues to pay down borrowings, equity holders can see gains if the enterprise value (EV) remains flat.
In an attempt to bolster oil's sagging price, OPEC announced over the weekend a surprise 1.16 million barrel per day reduction in production. Pickering Energy Partners predicted the cuts could lift oil prices by $10 per barrel.
Many investors avoid oil exploration and production companies for environmental reasons, especially climate ramifications from burning fossil fuels. However, Occidental at least has a credible initiative to lead in removing carbon from the atmosphere, including carbon capture and storage along with net-zero concrete and chemicals through their Oxy Low Carbon Ventures (OLCV) subsidiary.
Investors who buy oil stocks face the volatility of an economically sensitive and heavily manipulated oil market. With that caveat, Occidental is well-positioned within the industry, with production in established regions with reliable reserves like the Permian, the Gulf of Mexico, and the Middle East.
Occidental can be a longer-term winner as it pays down debt and rewards shareholders while further improving its balance sheet. Still, like Berkshire, buying on weakness is the prudent way to invest in the volatile oil sector.
