Occidental Petroleum: A Bet On Higher Oil Prices

• The company has cut cost and reduced capex to enhance liquidity over the next few quarters.

• OXY has a debt wall in 2021 that must be dealt with to survive.

• We think rising oil prices driven by fundamentals in the oil market improve the prospects for the company's survival.

• Analysts have boosted estimates for free cash flow generation and yield recently.

• We rate the company a buy at current levels for investors with a high risk/reward tolerance.

Introduction

American shale peaked in February of this year, and is on a glide path lower as the drilling decline takes its toll on legacy production. As shown in the chart below, as a result of well shut-ins and drilling declines shale production reversed its trend upward, has begun a decline that we think will reduce shale production by half as we exit 2020. The dotted red line is the EIA’s estimate for the amount of the drop in June. I think they are a bit optimistic, although the current restart of legacy wells may be included in this calculation. It won’t matter as the year ages, shale is going to decline majorly as we exit this year.

We are now moving into a time that I have forecast in a number of previous articles, where certain key factors will mean the difference between survival, and value destruction as the industry consolidates. Here is a quote from one from several months ago, “A Decline In Shale Production Is Closer Than You Think.”

In this article we are going to circle back to focus on rock quality as being a driver for growth as the Permian begins to restart. This is what the rivalry between Chevron, (NYSE:CVX) and OXY back 2019 was all about from the start. Who would be the lowest cost domestic producer? The stakes were always high, OXY won the battle, and it almost killed the company. It still could as OXY looks to reschedule ~$40 bn in debt. We think much of the danger has passed for this operator however, and will discuss in this article why as oil prices rise, OXY could benefit out of proportion to other shale players.

What that means is the wells that are drilled will respond more fully, and for a longer time period than well drilled and completed in more marginal rock. This will improve EURs, and provide more cash flow per foot of interval through lower decline rates. Essentially this adds up to more oil from fewer wells, with associated cost savings to the operator, and value to shareholders

The slide above discusses how OXY has used its technology and logistics to reduce costs in Tier-1 acreage wells. Savings of millions of dollars per well are being realized, and contributes to OXY's low least lifting costs, as noted earlier in this article.

The company is delivering on promised asset management improvements, as shown in the slope of the 2020 curve. More oil is being made, sooner than in previous years on legacy Anadarko acreage. What is most likely path for oil over the next couple of quarters?

As I noted in the first graphic showing the sharp decline in shale production, we are headed in an almost “parabolic” direction for this commodity. The harsh realities of lack of investment through the capital discipline that began in early 2018, are finally beginning to affect the market’s ability to obtain new supplies. The Rystad graphic below shows the effect of the well shut-ins to this point, although with estimates for a staged recovery that has just begun.

We find no basis to challenge the Rystad numbers above as they are presented, but don’t think they give an accurate picture of the total situation affecting oil availability going forward. Where we part company from Rystad is accounting for "lost" new production from drilling.

Shale wells are in factory-mode these days. Sink a well, frac it, and hook it up to a flowline, and you've got production. There's plenty of takeaway infrastructure these days, thanks to the Energy Transfer's (NYSE: ET), and Kinder Morgan's (NYSE:KMI) of this world. What we don't have is the drilling part of this equation.

Rystad figures as noted in the chart above project that we will exit 2020 with global demand at 70 mm BOPD. That's a gap of ~5-mm BOPD.

What's the number with lost production from drilling?

As noted in the EIA-Drilling Productivity Report yesterday, U.S. shale production has continued its decline as lack of new well drilling will begin to be more pronounced as legacy wells age. The decline rate for shale wells (will vary somewhat according to source rock quality) is conservatively estimated at 60% a year.

In internal articles we have calculated the shale exit for 2020, at being between 4-5 mm BOPD. That sets up a demand vs production gap almost double what is currently factored into the Rystad graphic above.

OXY is not for the faint of heart, as many missteps have been made along the way since the acquisition. They've been pretty well documented. Here is a link to my last article on them for color on the debt. Make no mistake, this is a problem that must be solved for the company to continue going higher. A troubling note is the complete "radio silence" by the company since hiring Moelis back in early May. A bet on OXY is a bet that oil prices continue going higher as I am forecasting.

OXY has suffered along with the general market malaise in Q-1, with shares dropping almost 80% at their lows. The company has staged a resounding recovery in recent weeks, attaining over half their pre-crash valuation. This rise hasn’t escaped the analyst’s attention at BoA, moving the company to a “Buy,” today from neutral, citing the potential for the company to generate as much as $7 bn in Free Cash flow over the next year and a half. Raymond James, energy securities analyst has reiterated a “Strong Buy,” on the company citing a 9% Free cash flow yield.

If you accept my argument that oil prices are headed higher an investment in OXY could be a good way to play this bet. OXY currently is the Permian’s largest producer with daily liftings of 442K BOPD, with its lowest cost at $6.25 per BOE. As prices for oil continue to rise the company will benefit from an aggressive hedging program and higher overall production. Improved cash flow as the analyst’s mentioned above should drive the stock price higher. On an EV/EBITDA basis-6.59 the company is expensive compared to its peers, Devon Energy, (DVN)- 2.77 and Concho Resources, (CXO)-3.1. This metric alone would direct you toward those other securities.

But let's take a moment and unpack the implication of $7 bn of free cash flow over the next 6-quarters, as the BoA note suggests. We aren't privy to their calculations, but we'll take that as an expectation of rising oil prices. What would it take to generate that kind of free cash, especially since OXY is not generating free cash at present. On Q-1 revenue of $2.4 bn-including a $1.8 bn asset impairment charge, and realized prices of $45 for WTI and $7.5 bn, which absent further asset impairments put us on path to generate Operating cash flow per quarter of $2 bn+. Subtract capex of ~$1.2 bn and you can probably get close to BoA's $7 bn.

Realized prices of $60 are pretty optimistic for this time period, but can't be ruled out as we've noted in prior articles and other sources document, we are headed to a severe deficit between supply and production. I think this gives a lot of room for shares to appreciate as liquidity fears from low oil prices fade in the coming quarters.

The company is trading up today in the pre-market to over $20 per share, on strength in the oil price, and the economy restarting. In an earlier edition of this article we were recommending waiting for sub $20 prices to accumulate or start a new position. We think this moment may have passed now. As has been stated previously OXY is a bet on higher oil prices and debt restructuring. and carries considerable risk. If you accept that prices will rise, the company can be safely bought at this level, subject to reader’s own due diligence and risk tolerance.

In summary, OXY is a best of breed operator with the best acreage in the Permian. Global events could finally be turning in their favor creating an uplift for the stock.