Occidental bucked the trend among E&Ps by holding its full-year capital budget steady, amid widespread inflation (steel, labor, and fuel are major inputs for upstream firms). As previously indicated, the full-year spend will probably fall in the high end of the $3.9 to $4.3 billion range. But the firm is not immune, and its domestic operating expense guidance did creep higher by $0.50 per boe. The firmwide production outlook was similarly unchanged, although the firm inked an extension of its joint venture with Ecopetrol with an effective date of Jan. 1, 2022, which transfers some of its Permian working interest to its partner. The decrease in expected Permian volumes is offset by better-than-expected performance from other domestic assets. The extended JV, and the reallocation of capital to operated assets in the Permian, should let the firm hit the ground running, although we were already expecting mid-single-digit growth next year.

Accordingly, our fair value estimate is unchanged after incorporating these results.

Occidental Petroleum has cut the chaff from its upstream portfolio in the past few years, shedding noncore assets to focus on core holdings in the U.S. and Middle East. The portfolio was further transformed by the 2019 acquisition of Anadarko Petroleum. This transaction bolstered the firm's unconventional footprint in the Permian Basin and augmented its U.S. midstream portfolio with a stake in WES Midstream (which it subsequently reduced to 51%). It also gave the firm entry into the DJ Basin, where Anadarko was a leading operator, as well as adding assets in the Gulf of Mexico and Algeria.

This acquisition was announced in 2019 with an asking price of $57 billion (78% cash). We suspect expanding Oxy's extensive Permian Basin footprint was the primary motivation. As one of the leading operators in the play, the firm saw an opportunity to leverage its scale and experience in the basin to improve the profitability of Anadarko's Permian operations. We're skeptical that much value was unlocked, though. It's true that Oxy consistently delivers peer-leading well performance as measured by initial production rates, but that doesn't tell the whole story as its wells also decline more quickly. Even so, we rate the acquired acreage highly and believe Oxy can compete with the top Permian firms on profitability.

The Anadarko deal was a huge undertaking for Oxy, which itself had an enterprise value of about $50 billion at the time the deal was announced. The cash portion was partly financed with a $10 billion equity investment from Berkshire Hathaway along with the proceeds from the sale of Anadarko’s Mozambique assets (which Total purchased for $3.9 billion in late 2019). Despite these arrangements, the deal left Oxy with significantly higher financial leverage, preventing it from adopting shareholder-friendly capital return initiatives like peers (despite being a historical leader in this, with a peer-leading free cash yield). But the firm has turned the corner. Leverage ratios have dramatically improved and the firm has resumed dividends. Management intends to continue supplementing this with substantial share repurchases.

Historically, Oxy has done a better job of generating returns for shareholders than most upstream oil and gas producers, but this record was derailed by the downturn in global crude prices that began in late 2014. Like peers, Oxy eventually adapted to lower prices by cutting costs and is now able to generate substantial free cash flows and earn economic profits on the incremental dollars it invests, even in a $50-$60 oil price environment (WTI). However, it further delayed the potential for excess returns at the corporate level by entering into a very large and expensive corporate acquisition in 2019. The target, Anadarko Petroleum, did not itself warrant a moat and Oxy paid a substantial takeover premium. The cost of the acquisition will directly flow to invested capital while the benefit will accrue over time, as Oxy progresses the development of Anadarko's assets. We believe the firm has turned the corner and is on the cusp of consistently earning its cost of capital again, but the margin of safety is too thin to award a moat rating.

What's more, like all E&P firms, the firm is exposed to a range of potential environmental, social, and governance issues that could hurt its ability to generate strong returns. The most significant ESG exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills).

Oxy has positioned itself as a net-zero champion within the industry, credibly, and its Low Carbon Ventures unit has ambitious plans to construct between 70 and 135 direct air capture (DAC) plants in the areas in which it operates. The first of these, to be constructed in the Permian Basin region, is expected online in 2024. Unlike most peers, Oxy has adopted an explicit net-zero target including scope 3 emissions, and it aims to hit this milestone before 2050. The firm has an advantage over peers in this area because it uniquely benefits from both its chemicals business, which can supply potassium hydroxide and PVC for its plants, and from its enhanced oil recovery operations (a technology that boosts productivity in mature oil fields by injecting CO2 into the reservoir, creating a sink for the CO2 that gets captured and thus eliminating sequestration concerns).

But greenhouse gas emissions are still a threat. Consumers are becoming more averse to fossil fuels, increasing the probability of widespread substitution away from fossil fuels. The industry's poor reputation also makes value-destructive regulatory intervention more likely in the future (think fracking restrictions or carbon taxes). And while Oxy can reasonably claim it is aiming to be a better corporate citizen than most, given its extensive DAC plans, the resulting impact on oil prices would be equally painful. Such a scenario is not likely enough to be included in our base-case forecasts, but because the impact would be material, it does further erode the firm’s moat potential.

Finally, spills are mainly a concern for firms operating offshore. Offshore activity is not the main focus for Oxy, but it does have operations in the Gulf of Mexico that it inherited from Anadarko. So, though the probability is very remote, a devastating accident like the BP Macondo disaster in 2010 could have a material adverse impact (that could be forced to cover cleanup costs and perhaps face other legal repercussions). Spills also occur from time to time during long-haul transit over land, and Occidental could be vulnerable there as well, since it has substantial midstream operations. Again, though unlikely, there is a small chance that the firm could end up on the hook for an event like the Kalamazoo River (Michigan) spill, which also occurred in 2010.

Our primary valuation tool is our net asset value forecast. This bottom-up model projects cash flows from future drilling on a single-well basis and aggregates across the company's inventory, discounting at the corporate weighted average cost of capital. Cash flows from current (base) production are included with a hyperbolic decline rate assumption. Our valuation also includes the mark-to-market present value of the company’s hedging program. We assume oil (WTI) prices in 2022 and 2023 will average $99/bbl and $85/bbl, respectively. In the same periods, natural gas (Henry Hub) prices are expected to average $7.20 per thousand cubic feet and $5.90/mcf. Terminal prices are defined by our long-term midcycle price estimates (currently $60/bbl Brent, $55/bbl WTI, and $3.30/mcf natural gas).

Based on this methodology, our fair value estimate is $44 per share. This corresponds to enterprise value/EBITDA multiples of 3.3 times and 4 times for 2022 and 2023, respectively. Our production forecast for 2022 is 1.14 million barrels of oil equivalent per day, which is consistent with guidance. That drives 2022 EBITDA to $24.9 billion, and we expect cash flow per share to reach $19.26 in the same period. Our 2023 estimates for production, EBITDA, and cash flow per share are 1.2 mmboe/d, $19.7 billion, and $15.09, respectively.

As with most E&P firms, a deteriorating outlook for oil and natural gas prices would pressure this firm’s profitability, reduce cash flows, and drive up financial leverage. An increase to federal taxes, or a revocation of the intangible drilling deduction that U.S. firms enjoy, could also affect profitability and reduce our fair value estimates.

Material ESG exposures create additional risk for E&P investors. In this industry, the most significant exposures are greenhouse gas emissions (both from extraction operations and downstream consumption), and other emissions, effluents, and waste (primarily oil spills). In addition to the reputational threat, these issues could force climate-conscious consumers away from fossil fuels in greater numbers, resulting in long-term demand erosion. Climate concerns could also trigger regulatory interventions, such as fracking bans, drilling permit suspensions, and perhaps even direct taxes on carbon emissions.

Finally, as an offshore producer in the U.S., Oxy has an additional vulnerability. The firm's drilling campaign in the Gulf of Mexico requires ongoing approvals from the Department of the Interior. As this entity is controlled by the executive branch of the U.S. government, it can suspend permitting activity without congressional approval. President Biden is likely to enact legislation withholding future oil and gas permits, which could hurt Oxy's growth in the Gulf.

Due to the volatility of oil markets at this time, we assign a very high uncertainty rating.

Our Standard capital allocation rating reflects Oxy's recently improved balance sheet, fair investment strategy, and appropriate distributions.

Vicki Hollub, a 35-year industry veteran who previously led Oxy's operations in North and South America, succeeded Stephen Chazen in early 2016. Hollub presided over the widely criticized 2019 acquisition of Anadarko Petroleum for $55 billion. This transaction forced Oxy to take on substantially more leverage than we were comfortable with, leaving it with very little wiggle room if commodity prices were to deteriorate. Less than a year after the deal closed, that's exactly what has happened due to the COVID-19 outbreak. As a result, Occidental was forced to cut its dividend and sell assets to ensure it can meet its looming debt obligations. While the acquisition may have made sense when it was first being considered, we think it was a mistake to enter into a bidding war with Chevron, as Oxy ended up overpaying. In addition, the deal was carefully structured to circumvent a shareholder vote, utilizing a large loan from Berkshire Hathaway with potentially expensive warrants attached (to minimize the equity component of the consideration being offered).

While we think it was a mistake to take on so much leverage to force the deal through, we believe management deserves credit for steadying the ship afterward. The firm reacted quickly at the outset of the pandemic, dramatically curtailing its 2020 spending plans and slashing the ordinary dividend. And despite the historically weak market for oil and natural gas assets the firm was still able to execute numerous divestitures (and we were surprised by the size of the proceeds in several cases). It also refinanced several near-term debt maturities, giving it a longer runway to continue deleveraging.

Now that its debt goals are essentially checked off, we expect the firm will meet or exceed the standard for capital returns that its peers have recently set, and it has more than enough free cash potential to do so, even with much weaker commodity prices.