Occidental Petroleum: A cash flow tidal wave hits the balance sheet (NYSE: OXY)
(Note: This article originally appeared in the May 11, 2022 newsletter and has been updated with current information as needed.)
Western Petroleum Corporation (NYSE: OXY) acquired Anadarko Petroleum and then had to endure first an OPEC price war followed by coronavirus demand destruction. The next surprise, the war in Ukraine, finally gave this company what it needed to recover from the acquisition (i.e. high commodity prices).
This company, like so many others, needs to “get back on track”. This industry is known for its low visibility. Therefore, the challenges will be doing all that needs to be done while commodity prices remain high. The return on investment for shareholders could be quite significant from current prices if management is successful.
The biggest consideration has to be that cash flow before working capital changes jumped hugely, topping $4 billion in one quarter. The main (if not the only important) reason why changes in working capital were negative is that higher raw material prices made the same sales volumes much more expensive. Therefore, accounts receivable would eat up working capital.
Another industry competitor, ExxonMobil (XOM), set the stage for earnings forecasts by saying earnings will take a big jump in the second quarter. Occidental Petroleum is not as diverse. But upstream operations will bring in a great quarter of much-needed cash. It doesn’t take many of those great quarters to make the acquisition look good.
It’s not going to happen every quarter. At some point, there will be a cyclical downturn to reverse what just happened. Before that, there should be a time when prices stabilize or reach a slightly lower equilibrium until supply exceeds demand to cause the next cyclical downturn. This means that operating cash flow from continuing operations will increase even if prices no longer strengthen. Hopefully this time around the industry is experiencing something approaching a normal “good time” that lasts a year or two longer than last time in 2018.
For a company like Occidental (where management plans have gone off the rails), this is a chance of redemption in the eyes of the market. The market clearly sent the stock to a price level that indicated very little confidence in management’s ability to navigate the future. It obviously didn’t happen that way, of course. But the market clearly still has its doubts.
This stock is far from the levels reached before the pandemic. This is partly due to the unknowns of the pandemic and the effect of delaying the company’s deleveraging plans. Supposedly, when executives make an acquisition (and consider getting out of debt), they include a “cushion” in case the worst happens. However, the market may have feared that fiscal 2020 was beyond anything management could have anticipated. It may be true.
But most directions, including this one, will try to fix what they can. The latest pricing environment is a very welcome change from the environment that hosted the acquisition. The risk is that this environment will not last long enough or that very low prices in the next pullback will last too long. Therefore, the stock price rally may be muted until the market sees a decline in debt.
On the other hand, management paid off a lot of debt in the first quarter. As a result, management is on track to hit a $20 billion debt target much sooner than anyone could have imagined 2 years ago. Lower debt also allows the dividend restoration to start much earlier than expected by the market.
Occidental didn’t do anything different from much of the industry.
Cenovus Energy (CVE) acquired half of the ConocoPhillips (COP) partnership it did not own using both common stock and debt. Management by all accounts took full advantage of the business (probably much more than the stock market wanted because the market did the common dump).
Even though management had a plan to deleverage the balance sheet and, by all accounts, executed it well, the stock market kept the stock in the niche for a long time after the balance sheet repaired.
The market didn’t care about details like better cash flow from increased production. Only now, after the company has acquired additional refining capacity, has the market begun to allow the stock to break out of the niche.
Cash flow has improved despite the challenges presented by this industry. But as noted above, the market really didn’t notice this stock until relatively recently, despite a huge improvement in cash flow since the acquisition.
The point of all this is that Occidental used a strategy that is actually quite common throughout the industry. What was not common was the OPEC price war followed by the destruction of coronavirus demand afterwards. The significant cash flow demonstrated by the company finally shows a demonstration to the market of the advantages of this acquisition.
With Cenovus, the improvement in cash flow was much more significant (in percentage). Still, Mr. Market kept the stock in the niche for several years as cash flow improved. Occidental will do just fine if cash flow doubles at different price points from acquisition.
This means that for Occidental, now is the time to prove to the market that future financial performance per share will exceed pre-acquisition results. It is not uncommon for a major acquisition to take a few years to achieve management’s goals. High commodity selling prices can provide more cash to accelerate the optimization process while paying down debt.
It’s clear that Occidental has another quarter of significant debt reduction “in the bag” unless some other unexpected event occurs. After that it is less clear for the market.
On the other hand, the company must generate a sustainable profitability higher than the period preceding the acquisition. This is where many major acquisitions fall short of management’s expectations. Therefore, market doubts about future earnings are reasonable.
If management hits its acquisition targets, the stock price will likely continue to hit at least former highs. Generally, management makes any acquisition to do better in the next business cycle. Whether management has had enough time to optimize operations while assimilating this important acquisition remains an open question for the market.
Warren Buffet continues to buy stocks because the industry is exceptionally cheap. Price-to-earnings ratios crashed during the coronavirus demand destruction and really haven’t recovered yet in a cyclical fashion. There is a lot of pessimism in this story due to what happened between 2015 and 2020.
But this industry is much better prepared for the low visibility than it was in 2015. The pessimism is likely still overblown as Mr Market expects the past to continue. Yet the speculative actions and money lending that rushed (in the past) continue to be absent due to the severe speculative losses that followed. This absence is likely to last.
At least now, it looks like this stock has at least a speculative chance of breaking past the former highs of the last cycle. How much more than that depends on the evaluation of the performance of the acquired properties.
Reducing debt to $20 billion will do much to restore market confidence in the company’s balance sheet. The next step is probably to get quarterly earnings above $3 per share. Stay tuned to see how the management performs in the future. It looks like the company is now back on track with the original plan.