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Will Warren Buffett Buy Occidental Petroleum?

Oil prices are experiencing a downturn, with the global economy heading towards a possible recession and a crisis of confidence in the banking system. This led to a drop in oil prices and a sell-off of oil drilling company stocks. So why might Warren Buffett be about to buy one?

Some analysts, including JP Morgan, are optimistic and cite underlying balancing trends as strong support for future improvement. This sentiment is shared by legendary investor Warren Buffett, who’s been quietly building a massive stake in one company over the past year.

Oil Opportunities

Occidental Petroleum (OXY) is a global company focused on discovering and extracting energy resources such as oil and gas in the early stages. As an independent exploration and production company, OXY operates upstream of "brand name" companies like ExxonMobil (XOM) or British Petroleum (BP) that include retail sales as a part of their business.

Ranked one of the Fortune 500, OXY's oil and gas (O&G) operations are primarily in the United States and the Middle East, although they own oil field stakes in Colombia. OXY also owns and operates subsidiaries focused on chemical manufacturing to capture every bit of value from sourcing and extracting O&G (you'll find petrochemicals in everything from asphalt to synthetic clothing) and vertically integrate its supply chain by producing compounds needed for primary O&G operations.

While not necessarily a household name, OXY is well-known to investors for its novel approaches to industrial problems. OXY also leans into energy efficiency and climate sustainability approaches, targeting operational net-zero emissions by 2040. 

OXY is well-positioned financially, with a $54.2B market cap and a substantial $12.40 diluted EPS. Critically, OXY's 2022 free cash flow is a whopping $12.46B, up more than 40% from the previous year; it intends to maintain its high free cash flow and return substantial portions to shareholders in 2023 and beyond.

That might be why Warren Buffet is snatching up as much OXY as possible.

The OXY chart

OXY is consolidating, and there is room for both bullish and bearish interpretations, depending on which trendline you put more weight on.

 

OXY_2023-03-22_16-28-46

Source: FlowBank / TradingView

 

OXY_2023-03-22_16-29-27

Source: FlowBank / TradingView

Buffett’s Big Buy

You’d be forgiven for being pessimistic about O&G investing. Consulting firm Deloitte deems the heavy downward pressure on O&G stocks (and the industry at large) as a trilemma:

  1. Security: regulatory uncertainty, ongoing geopolitical disruptions, and increased interest in ESG-centric investing suppress stock prices despite continued demand.
  2. Transition: pressure to reduce climate impact faster and more efficiently increases costs to producers and, if they can’t meet lofty goals set by themselves or the community, could impact their returns.
  3. Diversification: increased consolidation means fewer choices for consumers and pent-up pressures on supply, demand, production, and trade – all of which lead to volatility increases in both energy costs and stock prices.

 

Warren Buffett disagrees.

What Happened?

As a devotee of value investing, if Buffett builds a hefty position in a company, he must see market inefficiencies to take advantage of.

OXY stock tumbled nearly 20% from its high, but Buffett wasn’t dissuaded by short-term market moves and continued building his position.

Over the past year, Buffett’s bought an increasingly large cut of OXY, hitting a 23% equity stake worth $12.5B as of March 21st, 2023. He also has warrants, which give him the right to buy stock in the future, equivalent to an additional 9% stake and $10B worth of preferred stock generating millions of dollars in dividend distributions quarterly.

But why? Buffett himself attributes his success to a handful of great picks alongside many mistakes, saying in his 2022 annual letter that Berkshire’s portfolio is comprised of

“of a few enterprises that have truly extraordinary economics, many that enjoy very good economic characteristics, and a large group that is marginal.” 

Presumably, he thinks Occidental has the potential to be extraordinary!

Although he didn’t dive into the details of why he’s building such a massive position, we can look to some cornerstones of value investing, compared to industry averages, to see how healthy OXY is financially:

 

Ratio

Occidental Petroleum

2023 Industry Averages (Source)

Price/Earnings

4.86 (2022)

6.7

Price/Book

2.61 (TTM)

2.43

Debt/Equity

1 (Latest Quarter)

2.85

 

These stats, combined with the healthy free cash flow we covered, indicate that OXY may be undervalued. The P/E ratio alone indicates significant valuation compounded by the comparison with its peers.

Assuming Buffett projects continued earnings health, the low P/E combined with a typical P/B value might mean the stock is on track to reverse its recent downward trend in the future.

Further, a D/E ratio of as low as 1 indicates strategic and prudent financial management, mainly since the O&G industry leans heavily on debt. In uncertain times selling volatile products and maintaining minimal debt service is a sign of deliberate planning.

Alternative Assessments

O&G investments carry outsized idiosyncratic risk in many cases. Market volatility, strict environmental regulations, declining demand due to climate change concerns, technological disruptions, and geopolitical risks like conflicts, trade wars, and sanctions all put pressure on the industry, so it's no surprise that other analysts oppose Buffett's building a position.

The sell-side market consensus pins OXY's fair value price at $53, which, at around $60 today, means there's room to fall further. The sell-side thesis, as aggregated by Morningstar, centres around a few key concerns:

But remember: Buffett, and value investing in general, focuses on a buy-and-hold mentality rather than trading for fast profit, so he may see short-term volatility as a fair tradeoff for long-term excellence. Still, objectors may point to his pandemic-era airline stock acquisitions that he later dumped for a substantial loss, admitting it as a mistake.  

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