Global oil markets remain as uncertain as ever. As we write, tensions between Israel and Iran are escalating, raising concerns about potential disruptions in a key oil-producing region. Meanwhile, in Guyana, output projections continue to rise with new discoveries, amid ongoing uncertainty about Chinese demand trends. It’s a delicate balance between supply and demand, with limited price flexibility and constrained inventories. A small misjudgment can send markets into turmoil, reminiscent of the early days of the COVID-19 lockdowns.
This article is about Occidental (NYSE:OXY), a company that leases huge swaths of land in the prolific Permian basin and builds extensive infrastructure on top of it hoping to pull oil from down under. With uncertain production levels and selling prices, this venture initially didn’t catch our eye as viable long-term investment. However, significant purchases by Berkshire Hathaway (BRK.B) and comments of its Chairman piqued our curiosity. Occidental’s stock price, once below $30, now hovers around $66 per share. Yet, questions linger about peak global oil demand and short-term price fluctuations, adding to the uncertainty surrounding oil recovery efforts.
Despite these uncertainties, we find ourselves revisiting this opportunity. Is it driven by regret for not buying earlier, or perhaps a fear of missing out on sector-wide surges? With this in mind, we ponder: is it too late to join the party? Historical stock price charts have often led us astray, – winners just kept on winning and losers just kept on losing, suggesting that relying solely on them for predictions is futile. Instead, we turn to fundamental value analysis rather than chart-based speculation.
And that is what we intend to do with this article and the continuing coverage of the energy sector. We do not intend to predict short-term oil price movements and doubt that any industry expert can. Short-term trading of the Oil stocks therefore makes no sense to us. We are long-term holders and investors, with a full knowledge that commodity prices are volatile and so are commodity stocks. We are hopeful though that in the presence of strong tailwinds, we will generate attractive risk premiums for our long-term patience and resilience.
Is Occidental still cheap?
Buy property when there is blood on the streets once Buffet said… and back in 2020, during oil market carnage sold all of his Occidental shares. Wasn’t he supposed to… buy? There is more to investing than price movements. Circumstances change, opinions shift, and when facts change, what do you do, sir? Indeed, just as a price decline isn’t necessarily a signal to buy, price appreciation alone isn’t reason enough to sell. It all boils down to current value, future growth expectations, and, of course, risks.
Oil Exploration and Production (E&P) businesses derive their value from proved reserves, these can be valued at future expected average prices deducting production and associated costs. Sounds straightforward, doesn’t it? Well, here’s where it gets tricky. While there’s plenty of oil in the ground, extracting some of it can be a pricey affair. Reported reserves hinge on price—higher prices mean more economically extractable oil. Uncertainty lurks here, but it’s not all doom and gloom. Higher average extraction costs could lead to higher average prices, potentially maintaining stable profit margins per barrel, even as production moves to marginal acreage. And this is the key point why we write this article about Occidental, but more on this later!
Currently, Occidental boasts 4 billion barrels of oil equivalent in proved reserves. Last year, the average weighted realised price per barrel of oil equivalent stood at $48, while the average cash cost to produce and sell liquids and gases hovered around $21 per boe. So, after taxes, every boe of reserves was worth roughly $21, translating to a $80 billion for the entire 4-billion-barrel treasure trove.
As of now, Occidental’s enterprise value stands at $90 billion. Considering Occidental’s significant midstream and chemical production assets, this quick calculation suggests that Occidental is trading close to fair value. But hey, what else would you expect from a publicly traded company in the hyper-efficient US market? Given the current expectations, the company appears to be selling at a fair clip. Of course, any changes in production output, realised prices or operating costs could send these value estimates spinning.
Downside price risks are limited
In the hypothetical scenario of a permanent decline in average selling prices coupled with creeping production costs due to inflation, the value of oil reserves would undoubtedly take a substantial hit. However, such a scenario would only materialize if global demand experienced a rapid downturn. Without the need for additional investments in oil production capacity, prices could spiral down to match the cash production costs of the market’s marginal producers. Take Canadian Oil Sands, for instance, one of the costliest production methods, with cash costs hovering around $30 per barrel or below.
But fear not—our crystal ball suggests that oil prices are unlikely to settle at such dismal levels, as the world clamours for additional production capacity. Estimates vary, but conventional production fields are said to experience natural decline rates ranging from 2.5% to 4.4%. Additional investment would only become unnecessary if global oil demand were to nosedive beyond these rates. Shale oil, on the other hand, boasts much more rapid decline rates and currently accounts for a hefty 8% of global production. In the absence of fresh oil investments, most of this shale production would bid adieu to the markets, likely within 2–3 years.
But hold your horses—will demand truly dwindle to such depths, or will it falter at all? The world’s population is on an upward trajectory, and so is the demand for oil, particularly in India and other low-income countries lacking the infrastructure to embrace electric mobility—even if batteries become more wallet-friendly. It’s the affluent countries that are more likely to tighten their belts. Collectively, the U.S., EU, and Japan guzzle a modest 34% of global oil. To achieve a global oil demand reduction of, say, 3-5%, while demand in low-income countries holds steady or rises, the wealthy nations would have to trim their consumption by a jaw-dropping 10% or more annually —a feat that seems highly improbable.
So, in the grand scheme of things, while uncertainties loom large, the notion of a drastic decline in global oil demand and sustained demand in prices remains quite distant.
Additional oil production capacity will be needed
Indeed, additional investment in new oil production capacity becomes imperative to counteract the depletion of existing fields and potentially meet burgeoning global demand. Production expansion hinges not only on oil prices covering cash operating costs but also on capital costs and offering a competitive return.
While most new oil projects planned up to 2040 boast an average breakeven cost below $50, the least attractive marginal project may only break even at prices in excess of $70. Without these projects, the market could face undersupply, suggesting a reasonable mid-cycle oil price expectation of approximately $70 per barrel.
J.P. Morgan forecasts a significant rise in oil prices due to the impending shortage of conventional oil production capacity. However, such predictions are inherently uncertain and self-defeating. Significant low-cost discoveries, like those offshore in Guyana with breakeven costs as low as $30 per barrel, could alter the landscape. Unanticipated shifts in demand could also play a role.
Naturally, projects with the lowest breakeven costs are favoured, thereby influencing the mid-term oil price in the markets. While large low-cost discoveries like those in Guyana may temporarily weaken the market, such discoveries aren’t an annual occurrence. Oil prices are likely to average over $70 to incentivise the development of even the marginal oil projects, which are needed to satiate the global demand. It is also very likely that over time the marginal breakeven costs will rise as low-cost resources are exhausted, and E&P companies have to move to less favourable areas. Nevertheless, the prices will continue fluctuating in the short term.
Why Permian?
The intricacies behind global oil prices in the short and mid-term highlight the numerous factors at play. Looking further ahead, entirely new factors could emerge, potentially tipping the supply-demand balance significantly. Under this uncertainty it is a great advantage to have control over prices.
Realised prices will fluctuate, sometimes exceeding and sometimes falling short of anticipated mid-cycle prices. Over a sufficiently long period, deviations from the mid-cycle price should balance out. However, when it comes to the mid-cycle price, Permian producers hold a distinct advantage.
The rapid decline rates in unconventional oil production mean shale producers must keep drilling to replace depleting wells. With shale output nearing 8 million barrels per day, it’s a daunting task to replace such a significant portion of supply, especially with a competitive breakeven price. The U.S. shale producers are now wielding considerable influence over global oil prices. Saudis still have control over the short term prices, but it’s the Americans who will determine the mid-cycle prices, as they decide when to drill.
Shale producers, adept at managing their drilling inventories well, can safeguard their mid-term average profit margins under almost any market scenario. Let’s say Tier 1 inventories run out unexpectedly, or new taxes are passed, – not a problem these costs can be passed on to the market. Only shale players, particularly those in the Delaware Basin, possess such flexibility over their capital spending and margins. Consequently, the shale oil business carries significantly less risk than conventional oil.
To be able to control princess effectively coordination among major producers is necessary. In the past the sector was dominated by indebted wildcatters, infrastructure was limited and exports not allowed. This has now changed, consolidation and increasing output share of financially strong integrated players is making the sector a lot more rational. Effective coordination will not be possible.
Why Occidental?
Occidental reigns supreme as the largest holder of Permian acreage, particularly in the coveted Delaware basin. Yet, despite its expansive land holdings, Occidental isn’t topping the charts as one of the field’s top producers. One plausible explanation could be the quality of the acreage, while another could be its conservative drilling strategy aimed at preserving Tier One inventories. We can’t say for certain, but what’s undeniable is the immense potential of the Permian basin, especially the multi-layered richness of the Delaware basin—its deepest and most rock-abundant sub-basin. There’s no shortage of oil beneath Occidental’s leased land; the challenge lies in getting it out profitably.
Technological developments help, but most importantly it’s the price appreciation that helps. Looking ahead, if mid-cycle (average breakeven) oil prices continue their upward trajectory over the coming decades, Occidental could find itself sitting on significantly larger reserves, even without expanding its acreage position.
Enhanced Oil Recovery (EOR) stands as a prime example of a production method where output could soar if oil prices experience a meaningful uptick. Occidental leads the charge as the largest EOR player in the Permian, boasting over 13,000 wells, with only a fraction currently in production. The primary hurdle? The hefty price tag of EOR operations and the absence of on-site CO2. However, as oil prices climb and direct air capture technology advances, it could become economically viable to tap into more of these partially depleted wells, unleashing a surge in production.
Shall we buy it?
Occidental appears to be fairly valued at current prices, but the promise of future mid-cycle oil price appreciation suggests a treasure trove of untapped reserves, making it a company ripe with growth potential.
However, the rollercoaster ride of oil prices will continue, veering significantly around the industry average breakeven price, and the stocks of sector companies will follow suit. While integrated majors like Exxon and Chevron boast diversified revenue streams to weather market downturns, Occidental’s reliance on the oil market, with its chemicals operation playing a minor role, exposes it more to industry volatility.
The mid-cycle investment management will help to steady mid-term earnings but in the short term the volatility will remain. Buying into Occidental today carries the risk of enduring significant pain in the event of a rapid temporary price decline. Conversely, geopolitical tensions, Chinese demand resurgence, and OPEC+ adjustments could send oil prices soaring.
During the last fiscal year, Occidental (OXY) boasted an average realised price of $47.7 per barrel equivalent, with an average WTI price of $78—a figure likely above the mid-cycle price. However, Henry Hub natural gas prices remained depressed due to ongoing overproduction as a by-product of oil and limited export infrastructure. When we consider this mix of strong oil prices and weak natural gas prices, it’s arguable that the average realised prices were more or less in line with mid-cycle averages.
With these realised prices, Occidental generated $4.2 of earnings and $5.3 of free cash flow (after preferred dividend) per common share over the past fiscal year. Given the current share price hovering around $65, Occidental is trading at approximately 15.5x price-to-earnings ratio and boasts an 8% free cash flow yield. It’s not exactly a bargain, especially given the volatility of its earnings. However, it’s crucial to note that the business is poised for growth over time.
But when is the right time to buy? Deciding when to pull the trigger is a Herculean task, with myriad factors at play and timing never guaranteed. It is fair to say that we will not get the timing perfect no matter what, we should just try to avoid buying at the extremes. Currently Occidental’s reserves seem to be valued at close to the mid-cycle price. It is not super cheap, neither super expensive. Our decision has to be based on future growth potential.
Growth Outlook
Future production volume growth will be constrained. As Vicki Hollub pointed out in Q4 2021 Occidental Petroleum Corp Earnings Call:
At the point where it is appropriate to invest in future cash flow growth, we will only do so if supported by long-term demand. Any future production growth will be limited to an average annual rate of approximately 5%
At the same time, the growing production volumes are expected to command a gradually increasing average price. The higher Oil price thesis is primarily based on underinvestment and declining spare capacity, especially given Saudi Arabia’s recent decision not to increase capacity further.
As Morgan Stanley puts it:
Even to maintain current levels, oil companies need to drill new wells to compensate for the natural decline of older wells. Global capital expenditure for exploration has halved from its 2014 peak to less than $400 billion in 2022 whereas demand grew more than 5% during the same period”
When markets are undersupplied, the price of oil has historically oscillated between the marginal cost of new supply, which incentivises the introduction of new supply, and the cost of demand destruction, which occurs when high oil prices negatively impact economic activity. When the markets are oversupplied, prices tend to trade between cash costs, the price at which supply becomes unprofitable, and the marginal cost of new supply, estimated to be around $80 a barrel. Demand destruction typically occurs when oil prices surpass 4% of GDP, which would be around $110 a barrel”
We find this view of gradual Oil price appreciation as fairly reasonable. Growth in average selling prices paired with increasing production volumes will likely drive the continuing top-line growth of Occidental. Short term volatility will not be avoided but the longer term trends seem strong. The profit margin, on the other hand, will depend on OXY’s operational capabilities and technological innovation. As unconventional production moves to ever less favourable acreage and EOR share of production grows, OXY might find itself facing ever increasing per barrel cash costs, which could offset the benefits of stronger pricing. It’s up to OXY and their industry peers to continue innovating and unlocking efficiencies to keep production costs more less stable. With a say 10% revenue growth potential, production costs growth at a rate below 10% would produce a double digit earnings growth.
Double digit earnings growth trajectory will only be possible if OXY continues unlocking new efficiencies and thus keeping production costs per barrel growing at a pace slower than the market prices, also considering the effects of inflation. At this stage, we feel that we need to do more research and understand the technology better and get a sense for the further cost cutting potential and risks involved.
Conclusions
Occidental Petroleum presents a compelling opportunity amidst the ever-changing landscape of global oil markets. While uncertainties loom large, the company’s strategic positioning in the prolific Permian basin, coupled with its extensive infrastructure and potential for future growth, makes it an intriguing prospect for investors.
The intricacies of oil price dynamics, production costs, and demand trends underscore the complexities of the energy sector. Occidental’s valuation appears to be fairly aligned with current market conditions, but its future growth trajectory hinges on a multitude of factors, including technological advancements, geopolitical tensions, and market dynamics.
While short-term volatility is inevitable, the long-term trends suggest a favourable outlook for Occidental, especially as it continues to innovate and unlock efficiencies in its operations. The potential for double-digit earnings growth is contingent upon the company’s ability to navigate market challenges and capitalise on opportunities in a rapidly evolving industry.
Ms Hollub also continues reiterating her view of the lack of replacement capacity for aging Oil fields. The industry has been troubled by the lack of investment for a number of years, shale oil technology has saved the oil markets from the apparent lack of conventional investment, but now shale growth is tailing off. Having said it, Oil is not expected to appreciate significantly and stay at higher level as significantly higher prices would destroy demand, and encourage conventional capacity investments, thus potentially creating supply-demand misbalance in the future.
Risks
– Commodity Price Volatility: The oil and gas industry is inherently cyclical, subject to fluctuating commodity prices driven by factors such as geopolitical tensions, supply-demand dynamics, and global economic conditions. A sustained downturn in oil prices could adversely impact Occidental’s profitability and cash flows.
– Regulatory and Environmental Risks: Occidental operates in a highly regulated industry, facing scrutiny from environmental agencies and policymakers. Changes in regulations related to carbon emissions, drilling permits, or taxation could increase operational costs or restrict the company’s ability to explore and develop reserves.
– Geopolitical Instability: Occidental’s operations span regions prone to geopolitical tensions and conflicts, such as the Middle East. Escalating geopolitical risks, including trade disputes, sanctions, or military conflicts, could disrupt production activities, supply chains, or access to key markets.
– Technological and Operational Challenges: Extracting oil from unconventional reserves, such as shale formations, involves complex drilling techniques and high capital expenditures. Occidental’s ability to effectively deploy advanced technologies and manage operational risks will determine its long-term competitiveness and profitability.
Read the full article here
