Description

Recent wells in California's San Joaquin valley have resulted in a significant development-in Kern County, one recent discovery points to 175 million to 250 million barrels of oil equivalent (MMBOE), with significant upside beyond that (their V.P. of exploration said that they have not defined the field limits, and that on a gross basis, it isn't a stretch to say that it is a 500 million barrel find).  This is the biggest on-shore discovery in several decades.  Oxy is now drilling 20 to 30 wells per year in this region, with the most attractive one-third of those prospects having expected targets of 100 to 125 MMBOE on average, and 500 MMBOE on the high side.  Oxy expects a 1 in 3 success rate.

While investors are quite familiar with the Kern County discovery, it is less known that this was the second discovery well of its type.  Oxy had a theory, based on the unique geography of California, and then successfully drilled a well.  Subsequently, they then drilled a second well in a completely different area, resulting in the Kern County discovery. 

The unique geography of California lends itself to a renewed effort at exploration.  California is a tectonically active state, and as described by their geologist, over millions of years, "there were repeated cycles of reservoir rocks coming down from the mountains and mixing with organic rich oil and gas source rock that was coming in from the proto Pacific."  Oxy has found that in areas where these tectonic plates meet fault lines, there are stocks of alternating reservoirs that have trapped hydrocarbons. 

In 1998, Oxy had 4,000 acres in California.  By 2005, they had increased that to 700,000 acres.  Today, they have over 1.3 million acres.  They believe that they are on to something.

Oxy's free cash flow yield is estimated at 10% for 2010, rising to 13% for 2011.  This compares favorably to domestic integrated oils at 6% and 9%.  What really catches the eye is that the more bullish models are forecasting very significant earnings gains, and at the current stock price, the next four years of earnings will return just over half of today's original investment.  For example, the 2010-2013 Goldman Sachs earnings forecast has Oxy earning $42.10 versus the most recent closing price of $78.42.

2010    $7.35
2011    $10.75
2012    $12.30
2013    $11.75

While the super majors have de-emphasized the United States (with the currently unfortunate exception of deep underwater drilling opportunities in the Gulf of Mexico), Oxy has maintained a strong presence in the U.S.  For example, while Oxy is producing at approximately 120% of its 2001 U.S. production levels, Exxon Mobil and Chevron net out at closer to 60% of their 2001 levels.

Also in contrast to other majors, Oxy has a solid ability to grow oil production, while many of the other majors have generally reallocated toward liquefied natural gas (LNG) opportunities.  This should allow Oxy to keep its mix weighted attractively to oil in the near term.  Currently, the U.S. accounts for 64% of Oxy's worldwide proven reserves and 53% of production.  73% of its proven reserves are in oil and 27% are in natural gas.  In 2009, Oxy produced 714,000 BOE/day.

That isn't to say that Oxy doesn't have potential with its natural gas properties.  Oxy's California shale plays have really been under the radar, despite them building their shale expertise beginning with the Elk Hills acquisition in 1998, which came with some built-in shale production.  People gave up on California, but Oxy has been very aggressive relative to its competitors at acquiring California properties.  In fact, the Oxy V.P. responsible for all of Oxy's operations in California recently stated:

"To give you an example, the Kern County discover, we might be up here talking about the shale zones of the Kern County discovery instead of the Kern County conventional part because that was how attractive it's turning out to be, but because of the attractive economics of the conventional portion, we've been spending our drilling rigs and drilling money going after the conventional portion to-date and not done as much on the shale zone..."

The company believes that California oil shale compares very favorably to what is going on elsewhere in the country.  Putting it altogether, the president of the company, Stephen Chazen, remarked that "I will say we've tried to be fairly conservative about the California outcome.  We think and we'll be disappointed really if we don't do a lot better than this.  But the numbers start to get pretty ridiculous out there in 2014 if we start to build in what we actually thought."

Oxy is the largest oil producer in Texas, producing 180,000 BOEPD (barrels of oil equivalent per day) in the Permian basin.  They continue to exploit this area, as previously uneconomic areas have begun to pay due to the combination of new horizontal drilling techniques and attractive oil prices.  They have also been aggressive with CO2 flood techniques, and utilize this technique in the Permian basis more than all other producers combined.  However, they believe that there is still a significant growth opportunity there once their new CO2 capacity comes online.

In California, Oxy produces 143,000 BOEPD, with 780 MMBOE net proved reserves (24% of Oxy's total).  They are the number one natural gas producer and the number two oil producer in the state.  Most importantly, they are the largest fee mineral owner in the state with more than one million acres.  Getting back to the California shale business, the company stated that there is a good chance that it is Oxy's biggest business unit in ten years.

Much of the area-by-area, technique-by-technique development information was detailed by the company at its recent analysts day.  This meeting occurred just two weeks ago, and included information that had never been previously disclosed, mostly on the resource potential of their properties.  It was Oxy's first analyst day in four years, and goes into significantly more detail than a typical presentation.  If you have four hours, the webcast is still online and is quite worthwhile.

A quicker read on the subject would be Steve Romick's comments in his 3/31/2010 annual report for the FPA Crescent Fund: http://www.fpafunds.com/downloads/crescent/aaa_annual_report_crescent.pdf.  Of course, the story grows more interesting with additional details, but having originally sourced this idea from his commentary, I have to admit that I probably haven't done much to improve on his basic case, other than providing supporting details.  By the way, Romick's comments are also a good read simply for the background into why the fund sold COP and bought OXY.  Given that Berkshire Hathaway likewise sold COP, without much explanation, this is a helpful review of one shareholder's dissatisfaction, and I'm guessing would mirror Buffett's reaction.

Getting back to the recent analyst meeting, both four years ago and again now, OXY projected sustainable oil and gas production growth of 5% to 8% (last five years has been a 7.9% annual compounded growth rate), although this time they mentioned that growth could exceed 9%, depending on exploration success and asset development.  Oxy also targets maintaining top quartile financial returns versus their industry peers.  That means targeting ROI of 15% after-tax for U.S. assets, and 20% or more after-tax for international projects.  Finally, they have emphasized increasing the dividend, which is currently 1.88%.  These projections are based entirely on their existing properties, and not from any future acquisitions or projects.

How does Oxy historically deal with cash flows?  Mostly, they put it back in the business.  Here is Oxy's cash flow reinvestment record from 2004 to 2008:

• 50% reinvested back into the business via capital spending
• 20% acquisitions
• 10% common dividend
• 10% debt reduction
• 10% stock buybacks

This analysis has focused on the U.S. properties, but Oxy has many promising international areas of opportunity, beyond their already established Latin American and Middle East business.  Indeed, with half of their production coming from international, it is worth reviewing further.  For example, in Latin America (Columbia, Bolivia, and Argentina), production is expected to go from 79,000 BOE/day in 2010 to 100,000 in 2014.  In the Middle East, the outlook goes from 286,000 BOE/day in 2010 to 370,000 barrels in 2014. 

They have an impressive record of technological success, and those successes have established their credibility above many of their competitors.  With the evolution of unconventional techniques, oil companies are beginning to distinguish themselves based on their track records for getting results from innovative approaches.  In one case, Oxy built an enormous steam generator, using mineral-tainted water from the desert aquifer, utilizing the steam heat to vastly increase production from a slow field.  As a result of these successes, here are some potential openings that Oxy is well positioned for:

• Abu Dhabi has numerous expiring contracts in 2014, making more than 1.5 million barrels per day available.
• Oman, where Oxy has delivered better than its competitors' efforts at enhanced oil recovery.
• Iraq's 115 million barrels of proven reserves: Oxy is part of the consortium that will develop Iraq's giant Zubair oil field, and they plan to participate in the Kurdish regions.

In a nutshell, Oxy sees itself as an "improved recovery" company.  That emphasis is important in understanding its operations and E&P activities.

Oxy also has a midstream business, with significant and growing fee income.  Most of the money comes from gas processing.  When they process their own gas, it doesn't show up as profit in this segment, but is rather passed back to the oil company and shows up as higher prices gained.  The five year outlook for the midstream business is to grow it to $1 billion EBIT in five years.

Their chemicals business, is basically a vinyls business, and has a five year average EBIT of $688 million, and generates a lot of free cash.  This business has ramped up its exports, which benefit tremendously from the low price of natural gas in the U.S.  They expect average annual EBIT of $700 million over the next five years.  This could decline in the event of higher natural gas prices, but that would be fine, as higher natural gas prices would tremendously benefit their core E&P business.

Oxy comes across as shareholder oriented.  They outline their approach as "So for every dollar you retain, how much did you give back to the shareholders in stock market value?"  They seem very focused on avoiding negative surprises.  They keep conservative accounting, as shown through their emphasis on proven reserves.  They also mention their awareness of the importance of health, environmental and safety issues, as another way of avoiding negative surprises.

Sometime into the third hour of the analyst day presentation (fortunately, a transcript is available on their website), Oxy's president makes some interesting comments on the topic of negative surprises and how their competitors present their information.  It reminded me of when Buffett mentioned a few years ago that it was outrageous that a major oil company did not make a single mention in its annual report about its reserve replacement costs. 

Oxy's president made a similar deprecating comment about some industry competitors in his discussion of conservative accounting.  Regarding proven reserves, DD&A (Depletion, Depreciation and Amortization) rates, keeping those DD&A rates tied to their actual spending, and how that comes through the income statement as they amortize PP&E (Property, Plant, and Equipment), Stephen Chazen showed a list comparing Oxy to twelve competitors: "Some of these are very well known companies with 40% of their PP&E not being currently amortized.  I don't know what the earnings of such a company would mean."

Oxy management is aware of the importance of growing dividends to a large class of its shareholders.  However, they are not purely financial engineers, and evoke a lot of skepticism about oil companies that issue "liquidating" dividends due to their inability to actually grow their business.  There goal is to produce returns on investment much higher than could be accomplished through share repurchases, so their emphasis is on reinvesting in the business.  This will undoubtedly continue as long as Oxy's returns on invested capital are significantly in excess of their cost of capital.

Regarding valuation, Oxy is trading at multiples that are generally in-line, if not at a slight premium to its peer group.  It generally trades at a discount to the major oil companies and in-line with large cap E&P's.  However, due to its growth profile, it looks quite compelling on longer-term multiples.  For example, based on 2010 estimates (again, referencing Goldman Sachs estimates), it trades at a P/E of 10.8x and EV/EBITDA of 4.5x.  Looking forward to 2012, those multiples decline to a P/E of 6.5x, and an EV/EBITDA of 2.9x.

Granted, any investment in an oil company will be dependent on energy prices for its outcome.  Oxy has plentiful natural gas opportunities, but their projections are not based on any near term recovery in natural gas prices.  Instead, their emphasis on oil production, when combined with their California and Middle East growth prospects, provides some compelling forward multiples for the long-term investor.

Disclaimer: This is not meant to be a buy or sell recommendation, and my firm frequently has both long and short positions in many of the securities mentioned. 

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