Occidental Petroleum, Exxon Mobil, And The Buffett Premium

Thesis

I turned bullish on big oils around September 2021 sensing that the oil price was too compressed at that time and travels began to recover after the pandemic. As such, I see that the profitability of big oil stocks, after bleeding cash for years, was about to turn a corner. And my thesis on Exxon Mobil (NYSE:XOM) at that time was actually entitled “Exxon Mobil Has Turned A Corner“. Indeed, its profitability has enjoyed a V-shaped recovery since then (more on this in the second section immediately below). And its stock price has staged a sharp rally in tandem since then as you can see from the following chart. XOM posted a total return of more than 80% since then (when its shares were for sale at around $55), while the overall market suffered a correction of more than 12%.

Of course, I am not the only one who saw this V-shaped recovery coming. And the attractiveness of big oils has become public knowledge after Warren Buffett disclosed his large position in Occidental Petroleum (NYSE:OXY) in the first quarter of 2022. Shortly afterward, he also disclosed the addition of Chevron (CVX) to be a top 4 position in his Berkshire Hathaway equity portfolio. Buffett’s sizable position in any stock is usually both a blessing and a curse for individual investors. On the good side, it’s never a bad sign to have an endorsement from an independent thinker like Buffett. But on the bad side, Buffett’s position usually triggers a large valuation expansion to embed a “Buffett premium” in the stock.

And that is exactly what has happened to OXY as you can see from the above chart. Before Buffett disclosed his OXY position in Q1 2022, the price movement of OXY has been tracking XOM very closely. However, once the disclosure was filed, the stock price of OXY began to diverge sharply and led XOM by more than 200% in the past year.

And such Buffett premium is precisely the thesis for today. It is often a good idea to follow proven investors like Buffett, but it is always helpful to form our own views too. So that we know whether the Buffett premium is justified and what to do in case they change their thinking (without telling us first). And this is the reason why this article compares XOM and OXY: two similar big oil stocks with one in his equity portfolio and the other not.

The remainder of this article will analyze their business fundamentals and outlook. And you will see that they are both still attractive at this point. Although my conclusion is that XOM offers a larger return potential than OXY, largely due to the sizable Buffett premium embedded in OXY’s valuation now.

OXY and XOM: the V-recovery of profitability

You can see the perfect V-shape recovery of their profitability in the chart below between 2020 and the present. As aforementioned and detailed in my other articles, the recovery was catalyzed by a few key factors: extremely compressed oil prices over the past years, years of underinvestment in the oil sector, and travel recovers after the pandemic. Since then, the breakout of the Russian/Ukraine war unexpectedly and sadly added another catalyst.

To wit, the next chart compares their return on equity (“ROE”) and return on invested capital (“ROIC”). As you can see, both metrics showed a perfect V-recovery between 2020 and the present. In XOM’s case, both ROE and ROIC nosedived since the pandemic broke out to a range of negative 10% to 12% in late 2020.

And the picture for OXY was even direr. Its ROE tanked to a bottom of around -80% and ROIC plunged into the -23% range. Since then, both have recovered their profitability not only to the positive but also to above their long-term historical average as seen.

And the recovery is even better than on the surface when we examine a more fundamental metric, the return on capital employed (“ROCE”). As explained in our earlier writings, ROCE provides a much more fundamental view on profitability than ROE or ROIC because it considers the return on capital that is ACTUALLY employed (such as inventory, fixed assets, payables, et al).

The ROCE of XOM is shown in the first chart below based on its quarterly TTM financials, and the second chart below shows the ROCE for OXY. In these calculations, I’ve included the following items as capital actually employed for both XOM and OXY 1) Working capital, including payables and receivables, 2) Net Property Plant and Equipment, and 3) research and development expenses are also capitalized. In XOM’s case, we see the nosedive again since 2019 Q1, dropping from a long-term (“LT”) average of 13.7% all the way to a bottom of about 6% in 2020 when the COVID pandemic hit. Then the V-recovery started. The current ROCE as of Q2 2022 is at a remarkable level of 29.9%. Not only healthy in absolute terms but also higher than its long-term average by more than 16% (or more than 2x higher in relative terms). It is also far better than the sector average (represented by XLE) which is around 14.1%.

And the picture for OXY is almost identical. We see the nosedive again to a bottom of about 5.3%, followed by the V-recovery. The current ROCE as of Q2 2022 is also at a remarkable level of 23.8%, which is again more than 2x higher than its long-term average and also far better than the sector average.

As to be seen in the next section, as their profitability recovers to a very healthy level, decent long-term growth and solid return can be expected going forward.

OXY and XOM: projected growth rates and returns

A large part of the opportunity in oil stocks roots in the negative view of consensus estimates regarding their earnings. As you can see from the following charts, the consensus estimates are projecting the EPS of both companies to decline in the next few years. In XOM’s case, its EPS is projected to decline from $12.7 in 2022 to only about $7.5 dollars in 2025. And in OXY’s case, its EPS is projected to decline from $10.7 in 2022 to only about $2.7 dollars in 2025.

In my view, such a negative forecast represents a severe underestimate of their earning and growth potential.

In contrast to the above pessimistic consensus estimates, I see healthy growth in the next few years as detailed in the next table. I see their cash flow to further expand for a variety of fundamental reasons as detailed in our earlier writings. These reasons include:

• I see high oil prices persist as the Russia-Ukraine war drags on. Sadly, according to the so-called Lindy’s Law, the longer a war has dragged on, the larger its chance of dragging on longer.
• I see the current shortage in the oil and gas industry as structural and a result of years of underinvestment. There is no quick fix and it will need a long-term solution, and both XOM and OXY will play in the solution.
• Finally, the current U.S. natural gas inventory in underground storage is not only below the average but also toward the lower end of the 5-year range. As winter approaches, the heating problem, especially in many European countries, would provide an immediate and strong tailwind for both given their large natural gas reserve and production capacity.

Looking further out, with the cash generated by the above positive tailwinds, both XOM and OXY will be able to ramp up their reinvestment rates. The combination of reinvestment recovery and the above-mentioned ROCE recovery would provide a potent recipe to fuel organic growth, as projected in the following table. In this projection, dividends are assumed to grow at the same rates as earnings, and dividends are not reinvested.

In both cases, a reinvestment rate of 10% is assumed. Under this assumption, the long-term organic growth rate will be about 3.0% per annum for XOM (10% ROCE x 29.9% reinvestment rates) and about 2.4% for OXY. Then I think it is easily justifiable to add an inflation escalator (projected to be 3.5% on average) as the oil price has been outpacing overall inflation by a good margin in the past. I consider a 3.5% inflation escalator to be very conservative. For example, average inflation has been 3.9% CAGR on average in the past 50 years. But oil price has risen at a pace of 5.9% CAGR, beating inflation by a whole 2%. Even with the very conservative inflation escalator, the nominal growth rate – the growth rate we commonly quote – would be 6.5 for XOM and 5.9% for OXY.

As for the valuation, the projection assumes a 10x PE multiple for both XOM and OXY. For reference, XOM’s historical average is about 15x PE, and OXY’s average PE is about 10.5x.

As can be seen, under these rather conservative assumptions, XOM is projected to deliver a handsome total return of more than 164% in the next 3~5 years. And OXY is projected to deliver a quite healthy return of more than 131% – lower than XOM by a good amount largely thanks to the Buffett premium embedded in its valuation now.

OXY and XOM: financial strength and cash

The above investment returns are further supported by the dividends and also their strong financial strength, especially in the case of XOM. In both cases, the cash dividends are projected to be a good portion of the total return potential.

In terms of financial strength, currently, OXY has about $1.36 billion of cash on its ledger and XOM about $18.86 billion, translating into $1.47 per share for OXY and about $5.53 dollars per share for XOM, respectively. As a result, their PE adjusted for cash is even lower as seen in the second chart below (only about 9.9x for XOM and about 6.4x for OXY).

Also note that both of them also have some debt, but the debt for XOM is much lower in relative terms than OXY because of XOM’s larger cash position and also its larger size. The net debt for OXY is about $22 billion. And the net debt for XOM is about $28 billion, only about $6B above OXY, yet XOM’s operating cash flow is about 5x of OXY’s and market cap about 6.3x of OXY’s. As result, XOM is much less leveraged than OXY and we will discuss the implications next.

Final thoughts and risks

To recap, I see the current consensus as a severe underestimation of XOM and OXY’s earnings power and growth potential. And I further speculate that Warren Buffett probably holds the same view given his large positions in oil stocks. Consensus estimates project an EPS contraction in the next few years, yet I see healthy growth in the 5% to 6% range. Such discrepancy creates a severe mispricing and hence a large return potential in the next few years (more than 130% for OXY and more than 160% for XOM based on my projections).

All told, my overall feeling is that both XOM and OXY’s are good investment opportunities with healthy return potential. And the returns are further supported by the generous dividends, which are projected to be a good portion of the total return potential in both cases. Although I feel XOM is better in relative terms under the current conditions, especially for more conservative investors, due to the current Buffett premium embedded in OXY and also the following risks.

Finally, risks. First, in the case of OXY, the stock now trades with a hefty Buffett premium embedded. And such premium is a large reason why OXY’s total return potential is projected to be about 30% lower than XOM. At the same time, OXY also depends on leveraging more heavily than XOM and is therefore sensitive to interest rate change. As shown in the second last chart above, OXY’s total debt to equity ratio is about 84%, more than 3x higher than XOM’s 25%. Overall, OXY is also in a weak financial position than XOM as reflected in its lower Altman Z-score (1.7 vs 4.0). As a general rule of thumb, for manufacturing businesses, an Altman Z-score above 3 indicates solid financial positioning (and close to zero signals nonnegligible bankruptcy risks). Buffett’s large stake in OXY might add some financial strength to OXY to make up the gap, although such effects are hard to quantify. Lastly, also note that OXY has also suffered much larger volatility in the past (its beta is about 2x higher than XOM as seen).