Correcting Oxy Modeling Error: No Impact to Valuation; Fair Value Slightly Reduced on Oil Volatility
Correcting Oxy Modeling Error: No Impact to Valuation; Fair Value Slightly Reduced on Oil Volatility
Analyst Note| by Dave MeatsUpdated Apr 11, 2022
Our net income and earnings per share estimates for Oxy have changed after correcting a modeling error. The error had no impact on our valuation, but after marking our model to market for changes to the near-term commodity strip we have lowered our fair value estimate to $45 (from $47).
Our updated estimates for earnings per share in 2022 and 2023 are $10.20 and $6.95 respectively.
Business Strategy and Outlook| by Dave MeatsUpdated Apr 11, 2022
Occidental Petroleum has cut the chaff from its upstream portfolio in the past few years, shedding noncore assets to focus on core holdings in the U.S. and Middle East. The portfolio was further transformed by the 2019 acquisition of Anadarko Petroleum. This transaction bolstered the firm's unconventional footprint in the Permian to 1.6 million acres, and augmented its U.S. midstream portfolio with a stake in WES Midstream (which it subsequently reduced to 51%). It also gave the firm entry into the DJ Basin, where Anadarko was a leading operator, as well as adding assets in the Gulf of Mexico and Algeria.
This acquisition was announced in 2019 with an asking price of about $55 billion (78% cash). We suspect expanding Oxy's extensive Permian Basin footprint was the primary motivation. As one of the leading operators in the play, the firm saw an opportunity to leverage its scale and experience in the basin to improve the profitability of Anadarko's Permian operations. However, we're sceptical that much value was unlocked. It's true that Oxy consistently delivers peer-leading well performance as measured by initial production rates, but that doesn't tell the whole story as its wells also decline more quickly. Even so, we rate the acquired acreage highly and believe Oxy can compete with the top Permian firms on profitabilility.
But the Anadarko deal was a huge undertaking for Oxy, which itself had an enterprise value of about $50 billion at the time the deal was announced. The cash portion was partly financed with a $10 billion equity investment from Berkshire Hathaway along with the proceeds from the sale of Anadarko’s Mozambique assets (which Total purchased for $3.9 billion in late 2019). Despite these arrangements, the deal left Oxy with significantly higher financial leverage, preventing it from adopting shareholder-friendly capital return initiatives like peers (despite being a historical leader in this, with a peer-leading free cash yield). But the firm has turned the corner. Leverage ratios have dramatically improved and the firm has resumed dividends (modeling the yield of the S&P 500). Management intends to supplement this with substantial share repurchases.
Economic Moat| by Dave MeatsUpdated Apr 11, 2022
Historically, Oxy has done a better job of generating returns for shareholders than most upstream oil and gas producers, but this record was derailed by the downturn in global crude prices that began in late 2014. Like peers, Oxy eventually adapted to lower prices by cutting costs and is now able to generate substantial free cash flows and earn economic profits on the incremental dollars it invests, even in a midcycle oil price environment (our long-term forecast is $55 for WTI). However, it further delayed the potential for excess returns at the corporate level by entering into a very large and expensive corporate acquisition in 2019. The target, Anadarko Petroleum, did not itself warrant a moat and Oxy paid a substantial takeover premium. The cost of the acquisition will directly flow to invested capital while the benefit will accrue over time, as Oxy progresses the development of Anadarko's assets. We believe the firm has turned the corner and is on the cusp of earning its cost of capital again, but the margin of safety is too thin to award a moat rating.
What's more, like all E&P firms, the firm is exposed to a range of potential environmental, social, and governance issues that could hurt its ability to generate strong returns. The most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills).
Greenhouse gas emissions are the biggest threat, and these are unavoidable for oil producers. Firms can clean up their operations in the field as much as possible by avoiding unnecessary flaring and using technologies like electric fracking and carbon capture to reduce CO2 volumes released into the atmosphere during the extraction process. Occidental's emissions intensity in the Permian, its main focus area, is already lower than most peers. And the firm does have another edge over peers, as it is uniquely positioned to divert CO2 bound for the atmosphere and store it underground instead. This advantage stems from its extensive enhanced oil recovery operations (a technology that boosts productivity in mature oil fields by injecting CO2 into the reservoir, creating a sink for CO2). Through its Low Carbon Ventures business unit, Oxy aims to construct a Direct Air Capture plant in the Permian area, which will reduce atmospheric CO2 and offset a portion of the emissions in Oxy's value chain.
Unfortunately, downstream emissions--at the refinery and beyond--are beyond producers' control. Yet these account for the vast majority of total emissions. So there's no such thing as a "green" oil producer. As consumers get more averse to fossil fuels, the reputational risk grows for producers and the probability of widespread substitution away from fossil fuels increases. This also makes value-destructive regulatory intervention more likely (think fracking restrictions or carbon taxes). These threats are not likely enough to be included in our base-case forecasts, but because the impact would be material, it does further erode the firm’s moat potential.
Finally, spills are mainly a concern for firms operating offshore. Offshore activity is not the main focus for Oxy, but it does have operations in the Gulf of Mexico which it inherited from Anadarko. So, though the probability is very remote, a devastating accident like the BP Macondo disaster in 2010 could have a material adverse impact (that could be forced to cover cleanup costs and perhaps face other legal repercussions). Spills also occur from time to time during long-haul transit over land, and Occidental could be vulnerable there as well, since it has substantial midstream operations. Again, it's very unlikely, but there is a small chance that the firm could end up on the hook for an event like the Kalamazoo River (Michigan) spill, which also occurred in 2010.
Fair Value and Profit Drivers| by Dave MeatsUpdated Apr 11, 2022
Our primary valuation tool is our net asset value forecast. This bottom-up model projects cash flows from future drilling on a single-well basis and aggregates across the company's inventory, discounting at the corporate weighted average cost of capital. Cash flows from current (base) production are included with a hyperbolic decline rate assumption. Our valuation also includes the mark-to-market present value of the company’s hedging program. We assume oil (WTI) prices in 2022 and 2023 will average $98/bbl and $89/bbl, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $5.50 per thousand cubic feet and $4.60/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $3.30/mcf natural gas).
Based on this methodology, our fair value estimate is $45 per share. This corresponds to enterprise value/EBITDA multiples of 4.8 times and 5.2 times for 2022 and 2023, respectively. Our production forecast for 2022 is 1.14 million barrels of oil equivalent per day, which is consistent with guidance. That drives 2022 EBITDA to $22 billion, and we expect cash flow per share to reach $18.30 in the same period. Our 2023 estimates for production, EBITDA, and cash flow per share are 1.16 mmboe/d, $17 billion, and $14.98, respectively.
Risk and Uncertainty| by Dave MeatsUpdated Apr 11, 2022
As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure this firm’s profitability, reduce cash flows, and drive up financial leverage. An increase to federal taxes, or a revocation of the intangible drilling deduction that U.S. firms enjoy, could also affect profitability and reduce our fair value estimates.
Material ESG exposures create additional risk for E&P investors. In this industry, the most significant exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills). In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as fracking bans, drilling permit suspensions, and perhaps even direct taxes on carbon emissions.
Finally, as an offshore producer in the U.S., Oxy has an additional vulnerability. The firm's drilling campaign in the Gulf of Mexico requires ongoing approvals from the Department of the Interior. As this entity is controlled by the executive branch of the U.S. government, it can suspend permitting activity without congressional approval. President Biden is likely to enact legislation withholding future oil and gas permits, which could hurt Oxy's growth in the Gulf.
Capital Allocation| by Dave MeatsUpdated Mar 09, 2022
Our Standard capital allocation rating reflects Oxy's recently improved balance sheet, fair investment strategy, and appropriate distributions.
Vicki Hollub, a 35-year industry veteran who previously led Oxy's operations in North and South America, succeeded Stephen Chazen in early 2016. Hollub presided over the widely criticized 2019 acquisition of Anadarko Petroleum for $55 billion. This transaction forced Oxy to take on substantially more leverage than we were comfortable with, leaving it with very little wiggle room if commodity prices were to deteriorate. Less than a year after the deal closed, that's exactly what has happened due to the COVID-19 outbreak. As a result, Occidental was forced to cut its dividend and sell assets to ensure it can meet its looming debt obligations. While the acquisition may have made sense when it was first being considered, we think it was a mistake to enter into a bidding war with Chevron, as Oxy ended up overpaying. In addition, the deal was carefully structured to circumvent a shareholder vote, utilizing a large loan from Berkshire Hathaway with potentially expensive warrants attached (to minimize the equity component of the consideration being offered).
While we think it was a mistake to take on so much leverage to force the deal through, we believe management deserves credit for steadying the ship afterward. The firm reacted quickly at the outset of the pandemic, dramatically curtailing its 2020 spending plans and slashing the ordinary dividend. And despite the historically weak market for oil and natural gas assets the firm was still able to execute numerous divestitures (and we were surprised by the size of the proceeds in several cases). It also refinanced several near-term debt maturities, giving it a longer runway to continue deleveraging. The balance sheet still lags the group but looks much healthier, and our free cash flow yield projection indicates the firm will soon be better positioned than most peers to deliver robust capital returns (even though it started from behind in this regard).