We are decreasing our fair value estimate for Occidental to $53 per share (from $57). About a quarter of the decrease reflects the declining market value of Occidental's equity investment in Western Midstream since our last update. The remainder was driven by guidance for slightly higher capital spending and slightly less production growth in 2023 than we were previously modeling, along with higher unit operating costs. We have also reduced our near-term revenue forecasts for the chemicals segment by about $200 million per year, given concerns about the broader economy and the potential impact on OxyChem's construction and agriculture end-markets.

The firmwide budget has been set at $5.2 billion-$5.6 billion for 2023, which is 29% higher than the firm's actual 2022 capital outflow (rather than 20%, as we incorrectly stated in our Feb. 27 note). That year-on-year increase is at the high end of the peer group but not egregious, given the current inflationary environment. We suspect the bulk of supplier cost increases reflect 2022 surges in steel and labor costs, that were not fully incorporated in E&P budgets last year as legacy contracts protected prices for at least part of the period. In any case, Occidental's oil and gas spending will only rise by about 12% in 2023, and management attributes that to 15% cost inflation partially offset by efficiency gains. The rest of the 2023 budget hike reflects chemical plant construction and expansion (supporting a 2026 revenue boost) and low carbon ventures investment. Overall, incorporating the new budget lowers our fair value slightly because we were only modeling 10% oil and gas inflation.

The slower growth outlook also weighs on our fair value estimate, as we were previously forecasting a year-on-year volume increase of just over 5%. Management expects full-year production to be 2% higher than the 2022 average, but 4% lower than the fourth quarter.

Occidental is one of the world's largest independent oil and gas producers. It has a diverse asset base, with upstream operations spread across the U.S., Middle East, and North Africa. It also has a significant consolidated midstream business, which provides gathering, processing, and transport services to the upstream segment, and it separately holds a 51% equity interest in WES Midstream (a remnant of the 2019 acquisition of Anadarko Petroleum). The portfolio also includes a chemicals business, which produces caustic soda (a widely used industrial alkali) and PVC (a construction material). The latter segment benefits from low energy and ethylene costs and profitability is determined by the strength of the broader economy.

The $57 billion Anadarko deal was a huge undertaking for Oxy, which itself had an enterprise value of about $50 billion at the time. 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). But these arrangements still left Oxy with a huge debt burden at an inopportune moment, right before the pandemic. To its credit, management was able to steady the ship by severely cutting back on capital spending, selling assets, refinancing short-term maturities, and temporarily suspending its dividend. And the firm took full advantage of the subsequent rebound in commodity prices, generating enough cash to fully repair the balance sheet and pave the way for capital returns (via buybacks and its restored, growing dividend).

The midstream segment also includes Oxy Low Carbon Ventures, which partners with third parties to implement carbon capture, storage, and utilization projects. This activity differentiates Oxy from most peers, which merely focus on curtailing their own emissions. Oxy's experience sequestering CO2 for enhanced oil recovery potentially enables it to go further, and management has ambitious plans to develop a network of point-source and direct air capture facilities that should help Oxy get to net zero by 2050 and generate incremental revenue as well.

The upstream oil and gas industry realized fairly recently that investors are more interested in consistent and stable returns than they are in breakneck production growth, and most firms are now committed to conservative capital programs with low reinvestment rates and generous shareholder distributions. But a handful of producers were doing this long before the rest of the industry hopped on the bandwagon, and Oxy was one of them. The firm generated substantial excess returns on invested capital from 2008-14.

However, this track record was upended by the collapse in global crude prices at the end of 2014, and economic profits evaporated the following year. Like peers, Oxy eventually adapted to lower prices by improving efficiency and using new technology to reduce costs. But just when profitability was recovering, it jumped into a very large and expensive corporate acquisition in 2019, which took several years to digest. The target, Anadarko Petroleum, did not itself warrant a moat and Oxy paid a substantial takeover premium. We believe the firm has turned the corner and is on the cusp of consistently earning its cost of capital once again, but the margin of safety is too thin to award a moat rating at this time.

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).

Oxy has positioned itself as a net-zero champion within the industry, credibly, and its Low Carbon Ventures unit has ambitious plans to construct between 70 and 135 direct air capture, or DAC, plants in the areas in which it operates. The first of these, to be constructed in the Permian Basin region, is expected online in 2024. Unlike most peers, Oxy has adopted an explicit net-zero target including scope 3 emissions, and it aims to hit this milestone before 2050. The firm has an advantage over peers in this area because it uniquely benefits from both its chemicals business, which can supply potassium hydroxide and PVC for its plants, and from its enhanced oil recovery operations (a technology that boosts productivity in mature oil fields by injecting CO2 into the reservoir, creating a sink for the CO2 that gets captured and thus eliminating sequestration concerns).

But greenhouse gas emissions are still a threat. Consumers are becoming more averse to fossil fuels, increasing the probability of widespread substitution away from fossil fuels. The industry's poor reputation also makes value-destructive regulatory intervention more likely in the future (think fracking restrictions or carbon taxes). And while Oxy can reasonably claim it is aiming to be a better corporate citizen than most, given its extensive carbon capture plans, the resulting impact of such interventions on oil prices would be equally painful. Such a scenario is 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 that 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, though unlikely, 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.

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 2023 and 2024 will average $78/bbl and $73/bbl, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $3.20 per thousand cubic feet and $3.90/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 $53 per share. This corresponds to enterprise value/EBITDA multiples of 4.6 times and 5 times for 2023 and 2024, respectively. Our production forecast for 2023 is 1.18 million barrels of oil equivalent per day, which is consistent with guidance. That drives 2023 EBITDA to $16 billion, and we expect cash flow per share to reach $12.64 in the same period. Our 2023 estimates for production, EBITDA, and cash flow per share are 1.19 mmboe/d, $15.5 billion, and $12.24, respectively.

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. In the past President Joe Biden has hinted at legislation withholding future oil and gas permits, which could hurt Oxy's growth in the Gulf.

Due to the volatility of oil markets at this time, we assign a very high uncertainty rating.

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.

Now that its debt goals are essentially checked off, we expect the firm will meet or exceed the standard for capital returns that its peers have recently set, and it has more than enough free cash potential to do so, even with much weaker commodity prices.