gilaxy
Summary of the thesis
Western Petroleum (NYSE:OXY) has rebounded strongly over the past year, but oil prices have cooled in recent months. Although numerous factors could push oil prices further into the downtrend, the current pullback provides a good entry point for a long-term investment in a recession-resistant stock supported by a commodity super cycle.
Current performance
OXY has performed very well over the past year both fundamentally and in terms of stock appreciation. The stock is up 100% year-to-date, and recent earnings results have been quite encouraging:
income statement (10-Q)
As we can see from its most recent revenue statement, net sales grew about 80% year over year. Meanwhile, total spending increased by only about 5%. Because the company benefited from lower depreciation and interest expenses.
Overall, the company made $3.75 billion from continuing operations, which translates to $3.16 in adjusted earnings per share and $4.2 billion in FCF.
In addition, the company has paid off $4.8 billion in debt, initiated a $1.1 billion stock repurchase plan and benefited from Oxychem, which manufactures and manufactures chemicals such as PVC.
Occidental Petroleum had a great quarter compared to some of its peers in the energy industry. It’s easy to see why someone like Warren Buffett is scraping this stock from the sector. OXY excels on the cash flow front and has one of the highest ROEs and profitability of any energy company.
energy outlook
Of course, the question of whether to invest in OXY now that the stock price has gone up 100% depends largely on the outlook for the energy sector.
raw price (market observation)
As we can see in the chart above, energy companies benefited from very high oil prices in the second quarter. Oil prices have averaged around $100/barrel but have since fallen to almost $85. This is still a reasonable level for energy companies. While the third quarter won’t be as impressive, OXY will still generate excess cash flow that will help further reduce debt and increase buybacks.
However, if prices continue to go lower, so will OXY’s share price. At this point, there are a variety of different factors that could determine this.
First, the influence of OPEC, which appears determined to defend higher oil prices by keeping supply under control. But while OPEC can control supply, the demand part of the equation is out of its control, and with a global recession likely already underway, energy demand could see a sharp drop.
Commodity prices have also taken a hit after tightening monetary policy, but I still subscribe to the idea that we are entering a secular bull market in commodities.
Commodity Cycle (Stifel report)
As this chart from the Stifel report shows, the world could soon enter a new phase of rising commodity prices. For most of the last 20 years we have seen structurally falling asset prices and structurally lower interest rates. However, this has led to a general underinvestment in the extraction of natural resources such as energy,
OXY: An ideal recession game
Counterintuitive as it may seem, investing in energy can be a good hedge against a recession. Of course, lower economic activity reduces the demand for everything, but energy is one of the most important products. Eventually we could give up fancy gadgets or expensive vacations, but the machines still have to run and we still have to heat our homes.
In that regard, energy is a good recessionary investment. In this sector, however, the best energy companies will be those that can generate strong cash flows and tolerate the debt burden, and this is where OXY stands out:
|
OXY |
CVX |
XOM |
SO |
|
|
EBITDA margin |
55.98% |
22.94% |
19.64% |
38.07% |
|
return on equity |
47.84% |
20.24% |
23.05% |
24.68% |
|
Leveraged FCF Margin |
32.89% |
11.72% |
10.51% |
18.74% |
|
Debt/Free Cash Flow |
4.18 |
4.28 |
4.91 |
4.90 |
|
Long-term debt/total capital |
44.09% |
12.72% |
17.08% |
27.10% |
Source: Search for Alpha
Above, we can compare OXY to some of its main competitors using various metrics. As we can see, OXY is way ahead in terms of margins and ROE. This is an FCF machine, and it’s easy to see why Warren Buffett likes the stock.
However, the company has a significant amount of long-term debt, about double or even triple that of its peers. But when we look at debt versus free cash flow, OXY comes out on top once again. In addition, the company has made a clear commitment to reducing debt.
All in all, OXY stands out as one of the most profitable companies in the industry, and that will come in very handy as the economy contracts and margins tighten.
risks
It’s important to note that the bull thesis has some risks here. First off, there are numerous catalysts that could lead to lower prices. These include, among other things, the market entry of Iranian supplies, an end to the Russia-Ukraine conflict and the release of further strategic reserves.
Furthermore, continued Fed tightening could threaten to trigger deflation again. Nonetheless, I still believe oil producers are well positioned to thrive over the long term.
Bring away
Oil has had a tremendous run in 2022 and the current pullback gives us a good opportunity to enter the market. Within the sector, OXY offers a very compelling ROE, and with Buffett’s cachet, I believe more investors will jump in when oil picks up steam again.
