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Falling commodity prices led Occidental Petroleum Corporation (OXY) to report lower second quarter earnings this year against the comparable period last year, as did most other exploration and production companies hit by declining realizations on natural gas and oil. However, Occidental Petroleum reported a better quarter than most, amid its second consecutive quarter of record production and a focus on oil that saw a less significant decline in realizations than natural gas.

Permian Basin Costs Relative to Realizations, A Factor

Occidental Petroleum's daily production, currently reported at 766,000 boe, continues to rise on the strength of domestic production, which increased by 9% over the second quarter of 2011. Oxy attributed its decreased earnings, despite the production increases primarily on lower product prices, as well as higher operating costs. Higher operating costs, combined with lower realizations, are hurting E&Ps across the board, even on relatively low cost plays such as the Permian Basin. The Permian accounts for 55% of Oxy's domestic oil production, 53% of its domestic natural gas liquids production, and 18% of its natural gas production, so any cost changes here have an outsized impact on Oxy's revenues.

In these situations, sometimes outside the box thinking is required. Competitor Clayton Williams Energy (CWEI), which produces primarily from the Permian and Eagle Ford, is attempting to control drilling costs through various measures, such as using its own rigs and negotiating with providers, as is Oxy. Clayton Williams also purchases casing and tubing according to the market, not according to its supply needs, something few other companies are releasing publicly as a strategy.

With Devon Energy (DVN) giving estimated ultimate recovery of 570,000 boe per well on the liquids-rich Cline Shale at a cost of $6.5 million, it would take further slides in oil prices and more severe cost inflation to discourage producers from the Permian, but as the natural gas price depression is showing, wide fluctuations are not always easy to predict. I believe that Oxy and its peers may need to put stronger pressure on contractors to keep costs reigned in before escalation becomes a problem, as is now happening on the Bakken.

New CFO, A Positive Sign

Oxy is adding a new face to its executive management team, announcing the appointment of Cynthia L. Walker as Executive Vice President and Chief Financial Officer effective August 6. Previously, a managing director at Goldman Sachs (GS), she oversaw energy transactions as part of the Goldman Sachs Global Natural Resources Group. In a statement, Oxy President and CEO Stephen Chazen noted Walker's "experience in mergers and acquisitions and finance…with a specific focus on the upstream oil and gas industry. As a result of her background in these areas, she is tailor made to serve as our CFO."

I think Walker's appointment is a significant talent acquisition for Oxy, which claims a strong leadership team, but could use deeper mergers and acquisitions experience like that Walker is bringing to the table. Although it counts the 2005 acquisition of Vintage Petroleum among its successes, Occidental's 2009 acquisition of the Phibro oil and gas trading operation from Citigroup (C) was not so successful.

Phibro caused an earnings surprise with a mark to market loss in the second quarter of 2010, shortly after its acquisition, with Chazen going so far as to inform investors on Oxy's quarterly conference call "you can't say that his [the unit's] trading results in the quarter were anything but lousy." The experience on both sides of the transaction that Walker is offering will help Oxy avoid another similar debacle. I think Walker's appointment might be an indication that Oxy will be pursuing further growth through acquisition on a short time horizon.

Possible Mexican JV

Oxy is in the beginning stages of a joint venture with Mexican chemicals manufacturer Mexichem SAB, another step in Mexico's plans to open its oil and gas sector to foreign investment. The joint venture under discussion would provide Mexichem with Oxy produced vinyl chloride monomer or VCM, which Mexichem would purchase under a long-term supply contract. The companies would share the costs of building the cracker for supplying VCM production and also make a joint investment in Mexico's state oil company Petroleos Mexicanos, which would guarantee a supply of raw materials "at competitive rates."

Since Oxy would not be producing oil or gas from Mexico's nationalized resources and it appears likely that the cracker would be built on U.S. soil, the risk to Oxy in this deal is minimal compared to the risks its competition is taking to get into the recently opened Mexican oil and gas market. Exxon Mobil (XOM) is allegedly showing interest in the possibility of drilling for Mexican oil and gas assets, although in order to encourage major participation correspondingly major changes in Mexico's business acumen, and even its Constitution, may be necessary.

Outlook

Oxy is trading around $89, with a price to book of 1.8, and a forward price to earnings of 10.2. This is a slight premium over most of its peer group influenced by Oxy's strong earnings and record production as analysts look forward to a natural gas price rebound. Exxon Mobile is trading at an even larger premium, around $88 with a price to book of 2.5, and a forward price to earnings of 9.9. By comparison, Devon is trading around $59, with a price to book of 1.1, and a forward price to earnings of 8.7. Clayton Williams is trading around $49, with a price to book of 1.5, and a forward price to earnings of 7.6, while Marathon is trading around $27, with a price to book of 1.1, and a forward price to earnings of 7.6.

Oxy's relatively low dividend and payout ratio compared to its peer group is causing some analysts to predict a dividend increase in the near future. Given Oxy's history of reliable increases, I don't think that this prediction is far off the mark. With a stronger cash balance than most of its peers, driven in part by better earnings, Oxy's dividend yield seems low. Competitor Devon has a current yield of 1.25%, while Marathon Oil (MRO) is doing slightly better with a current yield around 2.5%. However, increased dividend or not, Oxy is a strong value play.

Source: Occidental Petroleum: Now A Strong Value Play