Description

Executive Summary: Higher Oil + Structural Mindset Change Leads to Capital Returns Despite Management Credibility 

Recommendation: Long Oxy as the upside tied to their shift in capital returns post leverage target will start in 2022. Oxy’s capital return program is the last in the large cap oil & gas sector vs. peers that is early stages of ramping up. 

Price Target: 

Assuming strip pricing on the futures curve, OXY is worth $83/share based on an equally weighted average across EV/EBITDA, FCF, and DCF using current strip oil prices vs. a downside of $41/share, translating into a 1.7x R/R.  

Set-Up: 

Catalysts:

1. Cleanest exposure to get large-cap, value energy beta w/ idiosyncratic Balance Sheet Transformation happening in 2022 ~ Oxy is one of the few ways to play large, cap energy with still some additional levers to create value. Inflation is high, rates are going up and value is working. The delayed oil and gas capex cycle due to Covid plus ESG push should result in a multi-year strong period for oil prices even though the futures curve is pointing to lower energy prices in the out years, resulting in the sell-side assuming declining EPS over the next 3 years. If oil prices hold or go up ($100 oil adds $3.5bn more FCF), earnings revisions for the entire oil and gas sector will go up. 

These factors obviously help energy stocks, but EOG and Pioneer have already played out as they have reached very little financial leverage. However, post the higher bid for the Anadarko acquisition, Oxy was over-levered. This put Oxy is a position to trail EOG/PXD as capital has flown into the space. As Oxy hits the sub 2x leverage point coming into 2023, their valuable and higher growth asset base (Larger % Intl + OxyChem + Carbon Credit Management) vs. EOG/PXD can result a premium re-rating given leverage isn’t a concern.  

2. Capital Returns are Shifting Dramatically from Debt Reduction to Equity Holders via Dividends/Buybacks ~ As evidenced by almost every question during the earnings Q&A, investors are waiting for the capital returns to equity holders to begin. Why? Because OXY has a 22% FCF yield to the equity right now that is going almost 100% to debt paydown and now buybacks. 

Pro-forma for the FY 22 debt paydown, Oxy could be on the path to $12/share in FCF or $11bn in FCF, pushing FCF yield close to 22%. Isolating oil prices via the hedged position, Oxy could retire the entire stock price in 3 years. 

Oxy management has stated that they will return to “buybacks after they hit $25bn in net debt.” Oxy excludes the pref from its own Net Debt calculation given the 10-year non-call, even though I include it in my calculation. 

As of 3Q, Oxy had $32bn in gross debt and $2bn in cash. In the 4Q, there should be another $2bn roughly of debt paydown, resulting in $28n net or $3bn in remaining debt paydown. 

In FY 22, Oxy can generate $11bnbn in FCF, which reduces the $3bn paydown target and leaves $7bn for buyback potential in FY 22. 

Now including the pref, Oxy will be levered $27.5bn in Net Debt vs. $20bn in consensus EBITDA, assuming all FCF goes to debt paydown resulting in actual net leverage less than 2x. Inside 2x leverage seems to be the magic number that the rating agencies are focused on as it brings Oxy in-line with its peer group in terms of net leverage.

An additional sweetener in the long-term is the BRK preferred that is costing Oxy 8% in annual interest vs. 4.75% cost to refi this expensive paper out. On a run-rate basis, given the $10bn size of the pref, Oxy can save $325mm in annual interest expense or boost FCF 33 cents per share. There is a $500mm or 5% premium to take out the paper, but that’s after 10 years. 

3. Secular Mindset Change = Oil & Gas Industry has Found Religion on Capital Returns over Growth Capex ~ Over the last decade, the oil & has sector has been through 3 downturns (2008, 2016 and 2020). Given the increased volatility coupled with greater market focus on technology stocks (alongside declining interest rates), investors and bankers have reduced focused on the energy sector (outside of alternatives). Bankers, especially in Europe, have pulled back capital/financing while investors have moved more towards “LT secular winner.” This lack of interest has forced oil and gas management teams to shift their mindset towards what investors and bankers want: Discipline capital management and balanced returns. 

Despite high oil prices, management teams in energy remain hesitant to be overly aggressive on growth capex instead favoring capital returns and debt paydown. The mindset change is critical as historically management teams in this sector deserved a large discount for their non-rational behavior. 

With the expectation for rate hikes to battle inflation and value potentially outperforming growth, the under-owned nature of energy stocks sets up well for Oxy. As Oxy hits 2x leverage by the end of this year, the investor base available to invest in Oxy should growth. 

4. Deconsolidated 49% Western Midstream Sale could bring $5bn+ in proceeds (15% of market cap) accelerating capital returns – During peak COVID, Oxy sold back shares in WES in order to raise money and deconsolidate WES from financials. Below are the steps, Oxy took to “stand up WES” on its own. 

• Effective December 2019, employment of WES’s management team was transferred from Occidental to WES to ensure independent managerial control of WES’s strategic initiatives and day-to-day operations.

• Occidental employees who were fully dedicated and seconded to WES in December 2019 will be transferred to WES in 2020.

• Occidental will provide limited administrative services to WES for up to two years.

• The rights of WES unitholders to replace WES’s general partner under an amended limited partnership agreement were significantly expanded.

• New long-term oil and gas gathering acreage dedications covering approximately 21,000 acres in Weld County, Colorado, supported by minimum volume commitments and complemented by previously executed DJ Basin gas-processing dedications, will be put in place.

WES makes up 15% of Oxy’s market cap (assuming no premium for the shares) and trades at 9x EBITDA on a stand-alone basis. With investors constantly skeptical of Vicki and management, Oxy should sell WES in order to reach $25bn net debt target.  

In terms of valuation, deconsolidated WES is a below the line item that is worth about $5.5bn in EV across the 49% stake and the GP ownership. If we back out the $600mm of FCF in FY 22, we get to about $8bn in FCF or $8.50 in FCF per share. Monetizing the below the line midstream asset creates a “core” FCF yield closer to 31%. 

5. Oxy Low Carbon Ventures (OCLV) Analyst Day in Early 2022 – Oxy has 40 years in the carbon management business. It’s a bit of a moonshot technology around a regulatory arbitrage (ESG), but could add a lot of value if successful. There is only one carbon capture project (multi-billion dollars invested) out of Iceland named Orca (JV known as Climeworks ~ $100mm raised ~ at multi-billion dollar valuation potentially) that went live in Sept 2021, further validating Oxy’s strategy.  

Oxy should be able to provide additional color at the investor day regarding, CO2 net reduction potential, financing, partnerships and potential government support. 

At a similar valuation to Iceland, OLCV could be worth $2 to $3bn ($2-3/share) if funded externally given path to commercial distribution. 

Business Overview

Oxy consists of 3 Segments: 1) Oil and Gas 2) Midstream Business and 3) OxyChem 

•  Oil and Gas (73% of 3Q21 Sales) – Upstream asset base consists of unconvential resources in the Permian Basis, DJ, Gulf of Mexico, MENA, and LATAM. Oxy is one of the largest players in the Permian w 3mm acres or 14% of total production (297 Mbbl/day) offset with $1.2bn in capex. Second largest is the DJ Rockies (293 Mboe/day). In third is GoM at 130 Mboe/day. 

• Midstream & Marketing (10% of 3Q21 Sales) – Consists of the retained marketing business of 670 Mbo/day Midland to Gulf Coast Pipeline capacity and 450 Mbo/day capacity rights in export terminal alongside Permian EOR infrastructure, power plants and a recently deconsolidated WES stake. OLCV sits within the midstream segment as well. 

• Chemicals (21% of 3Q21 Sales) – Oxychem owns manufacturing plants at 24 sits producing vinyl chloride monomer (VCM), which is sold to Orbia under a 20 year agreement that is then converted into PVC. The goal is to be the lowest cost producer to maximize cash flow. Oxychem is currently operating at record profits. EBIT is currently sitting at $1.25bn. Oxychem shouldn’t command a specialty chemical multiple, but could sit somewhere near chemical peers at 7-8x for non-specialty players.  

Valuation & Risk/Reward

Risk/Reward – Oxy offers a 1.7x R/R using an equal probability weighted average across EV/EBITDA FCF and DCF. 

EV/EBITDA ($83/share) ~ 

The closest peers on current year 2021 numbers trade at 7.5x EV/EBITDA. Rolling that forward to ’22 and taking a discount for CEO credibility, we value Oxy at 6x EBITDA.  

FCF Method ($91/share) ~ Given the higher financial gearing of Oxy currently vs. its peers, it makes sense that the FCF valuation yields the highest. Peers are at 8x FCF Multiple on ’22. Assuming a 1x discount to peers, Oxy post deleveraging could trade at these levels resulting in 75% upside. However, Oxy post deleverage could trade at a premium for the first time in a long time given it has 

1. the most “recovery growth” in international markets vs. oil and gas peers coupled with 

2. exposure to midstream (WES trades at 9x EBITDA), 

3. Higher multiple chemicals (7-8x EBITDA) vs. O&G 

4. and carbon capture venture business 

DCF Method ($77/share) ~ DCF target for Oxy using FY ’22 ending balance sheet ($30bn net debt including pref). As we can see from the chart to the right, the sell-side community penalizes Oxy via it’s WACC for having higher leverage than other peers. FY 22 is the inflection year for FCF debt paydown with $10bbn+ potentially. 

Downside Valuation ($41/share) ~ 29% downside 

• EV/EBITDA ($43/share) ~ Assuming 2023 EBITDA and then take a 15% discount for lower oil. Then we assume 5.5x EBITDA, which gives no benefit to midstream and chemicals multiple uplift. 

• FCF ($40/share) ~ Assuming 2023 FCF, which is $7.85 (vs. $13/share FY ’22) due to declining oil price futures, we take an additional 15% discount and apply a 6x FCF multiple. This gets us to $40/share or -31% downside

Downside Risks

• Oil Price Volatility ~ The curve right now is in backwardation, saying that prices should come down. If this occurs, it will be hard for oil and gas stocks to outperform for a long period. Worry is that Saudi’s and EM producers will flood the market for profit potential.

• Low Management Credibility ~ Vicki Hollub (CEO) was the brain child behind the topping bid for Anadarko. This deal hasn’t been viewed favorably, resulting in a management discount at Oxy. CEO ouster would be a positive.

• Deleveraging Target ~ If Oxy went for growth capex over promising to return capital to shareholders that would be a negative. 

• Interest Rates ~ Lower interest rates and shift back into tech would be bad for Oxy and value stocks.

• Carbon Ventures Business ~ If the regulatory market doesn’t open for this arbitrage, then investors would pull back on the incremental duration provided by this growth opportunity.

Catalyst

Buyback ramping

IG upgrade

Takeout of Pref

Potential M&A w Berkshire