By Brian Tracz
Oil is still in a long-term secular growth trend. A slump in oil prices is the best time for investors to enter the exploration and production (E&P) sector, given this sector's uniquely direct exposure to commodity prices. Occidental Petroleum (OXY) has been hit harder than its peers in the recent plunge from January 2012 prices. This is a perfect entry-point for Occidental shares. The present share price of around $77 presents an exceptional opportunity, with a reasonable price target over the next year of around $115. About 60% of Occidental's oil production tracks world oil prices, and the remaining 40% tracks the WTI domestic index. Even though its liquids holdings closely track these indices, Occidental shares have taken a deeper plunge than these indices. Occidental's competitive finances and cost structure don't merit the extent of the recent drop.
Floundering Oil Prices …
The price for Brent crude is less than $100, down from its January 2012 high of $125. Additionally, the price of WTI crude is around mid-$80s, down from its January 2012 price of $110. This comes amid sluggish job reports in the United States, where job creation was less than 50% of 150,000-person target. Additionally, the U.S. dollar is becoming increasingly stronger as the Euro becomes increasingly weaker, adding friction for oil exports. Finally, Saudi Arabia's oil production is nearing its historic record. Saudi Aramco is exceeding 10 million barrels per day after Ali Naimi, the oil minister of Saudi Arabia, promised to deliver lower prices and higher production.
In all, oil prices are sluggish right now, and this is leading to a slump in exploration and production (E&P) stocks. The Energy Select Sector ETF (XLE) peaked in earlier in 2012 at $76, but it is presently trading at $62, the lowest in its persistent slide since then.
… Favor Strong Fundamentals …
But I still support a strong 3-year projection for an increase in oil prices to their January 2012 highs and beyond, assuming no resolution to the Euro crisis that initiates a world-wide recession à la Lehman. Oil is in a long-term bullish trend because depletion rates are very high, even for the most well-off oil-producing nations like Saudi Arabia and Oman. Additionally, global demand will be reaching higher levels, pending the development of rural China and India and an economic recovery for Europe. Thus, exploration and production will be vital parts of the upstream operations for the oil industry at large as more wells are dug to recover more oil.
Occidental is well-positioned to exploit this trend. Occidental Petroleum is heavily biased to liquids-its total production is about 70% liquids. Occidental Petroleum is expected to have a second quarter 2012 production rate of 763 MBoe/d, with domestic volumes increasing by 7 MBoe/d. Occidental also has one of the lowest cost structures in the E&P universe and a clear financial and managerial strategy. Occidental reported an excellent net margin of 28% for the first quarter 2012, higher than both Devon Energy (DVN) and Noble Energy (NBL)-these had net margins around 18%. The reason: Occidental has successfully developed its holdings in order to maximize margins and lower total cost. For instance, though it increased its acreage on the Bakken shale to 277,000 acres from 204,000 acres, management has not hesitated to reduce its rig count on the shale. Instead of drilling wells that produce exclusively gas, the company derives much of its gas from wells that are primarily liquids producers. Additionally, it readily sells unproductive holdings. In all, Occidental's management intelligently identifies ways to improve net margin.
… and Undervaluation
To boot, Occidental Petroleum shares have undergone a steep slide in the past few months. The 52-week range for Occidental Petroleum shares is $66 to $110. With the present share price of around $79, prices are trading in the lower half of this range (the $66 figure represents the share price when oil stocks hit their bottom in October 2011).
Occidental's trailing P/E is 9.4, compared to Hess (HES) and Devon , which have a P/E at 11. Occidental's consensus forward P/E estimate is almost identical to its trailing P/E of 9.4, reflecting the Street's shared opinion that Occidental's past performance is no fluke. Additionally, the P/E range for Occidental shares in 2011 was 8.0 to 14.2, so shares are trading toward the lower end of this metric, indicating possible overselling or undervaluation.
Occidental's price/cash flow ratio is about 6.25, lower than the S&P US BMI energy sector index value of 7.6, again suggesting lower valuation relative to the broader energy market.
Occidental and ConocoPhillips (COP) make an intriguing comparison. They both boast P/E lower than 10, which is below the sector average of around 14 (according to the S&P US BMI energy sector index). They both maintain a certain level of downstream operations, though ConocoPhillips recently spun-off its mid-stream refining operations as Phillips66 (PSX). Both are interesting investment opportunities. However, my general thesis still stands that Occidental has competitively minimized its cost structure. Indeed, ConocoPhillips' net margin is 5%, one-fifth that of Occidental, partially due to the fact that ConocoPhillips is restructuring in the wake of its spin-off and reassessing ways to inexpensively extract profit from its assets. In addition to its low cost structure, as I have mentioned, Occidental is most directly exposed to liquids prices, more so than nearly any of its peers.
Risks and Conclusion
Occidental's exposure to oil prices is both a blessing and a curse. If oil does indeed increase in price to expected levels, then Occidental shares offer a way of playing the increase with a company with high margins and undervaluation. However, there is the persistent anxiety that WTI crude prices might linger in the sub-$90 range. Most of the forces that would cause low price point are extra-market forces, as mentioned above. Thus, despite the strong past and projected performance of Occidental, I recommend following news on the Eurozone debacle. The failing of the Euro-or Greece's withdrawal from it-are some of the most imminent possible causes of a worldwide recession. In that case, I would not advise a short-term investment in the energy sector generally, much less in a company like Occidental with large exposure to oil.
While this is the major risk to my thesis, I nevertheless await the downward trending WTI and Brent crude indices to bottom-out, at which point there will be a favorable entry point for Occidental shares. Note that for every $1 fluctuation in the price of crude, domestic oil profits at Occidental are affected by about $35 million. Occidental shares are uniquely positioned, given a recovery in oil prices, to make the most of this price rise.