Occidental Petroleum (OXY -0.09%) has received more attention than pretty much any other oil and gas producing company on the market lately. That's what happens, though, when Warren Buffett buys a massive stake. Investors want to know what Buffett sees in the business and whether it is worth adding to their own portfolios.
There is quite a bit to like about Occidental right now, but one lingering question may give long-term investors significant pause. Let's look at what it looks like today, what it wants to do in the future, and whether it is an oil stock to buy.
Profitable now
Occidental's oil and gas business is looking better by the day. After taking a risky bet in 2019 to acquire Anadarko Petroleum, which required a lot of debt and special financing from Berkshire Hathaway, the recent period of high oil prices has helped to improve its financials drastically. According to management, its current operations can support its current dividend as long as domestic oil prices remain above $40, and it has been putting much of its excess cash toward debt reduction.
Its debt load peaked in the second quarter of 2020 at $37.4 billion, and has since been reduced to $20.2 billion for a debt-to-capital ratio of 43%. Management believes it no longer needs to pay down debt immediately and will pay down debt as it matures. In the interim, it plans to buy back stock. In the most recent quarter, it repurchased about $1.1 billion worth of shares.
With a relatively low break-even price, the company should be able to throw off plenty of cash. There's no guarantee that oil prices will remain as high as they are today, but prices would need to decline by more than 50% before compromising Occidental's financials.
That is based on the company's current capital spending plans, though. That could change soon as Occidental is planning a strategic pivot.
Profitable future?
Occidental's management team is planning what may be one of the most ambitious low-carbon plans among oil and gas companies. It intends to be one of the global leaders in both direct and atmospheric carbon capture and sequestration.
The company's investor presentations highlight a plan to use its current oil and gas operations as a cash-generating engine to incubate its carbon capture and sequestration plans. Occidental is uniquely positioned in this business because it has extensive assets and expertise in what is known as Enhanced Oil Recovery (EOR). EOR is a type of oil production that involves injecting CO2 into older oil and gas wells to repressurize the reservoir and extract more oil. Management believes that it can use these assets as a way to capture and transport CO2 to injection sites or to facilities that can create products from the captured carbon.
The key to this strategy is carbon capture technology and developing facilities for that very purpose. Management believes that it has developed a technology that can extract CO2 at reasonable economic levels. It is designing a Direct Air Capture (DAC) facility that will extract 500,000 tons of CO2 annually and is projected to cost $800 million to $1 billion. Ultimately, management would like to build as many as 70 of these facilities by 2035. It also projects it will cost between $300 and $425 per ton of carbon captured for the development and operation of the first facility.
The plan has some merits, and you have to applaud an oil and gas company for leveraging its strengths to develop a carbon mitigation strategy. The challenge to this whole plan is that it is based largely on a carbon market that does not yet exist.
Much of the rationale for these facilities is based on Article 6 of the Paris Climate accords, which outlines a plan to develop a global market such that we can assign a dollar value to carbon emissions. These markets have not yet been established, though.
Image source: Getty Images.
Some places have established cap-and-trade carbon markets. California has one presently, and the going rate for a ton of carbon is about $28 per ton of CO2. In Europe, its carbon trading market is priced at around 67 euros per ton.
The longer-term expectation is for Occidental to drastically reduce the cost for its facilities to the $125 to $250 per ton captured range. Also, it estimates that the voluntary capture market (companies meeting internal net zero goals) at around $30 billion by 2030. Even at those lower rates, market prices for carbon emissions will need to increase significantly to make its facilities economical.
This isn't to say that what Occidental wants to do is impossible, but many things need to go right for it to pay off.
The price today versus the potential tomorrow
To be fair to Occidental, the current capital spending on this carbon capture strategy is a minuscule part of its overall capital spending. For 2022, it only expects to spend about $275 million on developing its first DAC facility. At the same time, management teams don't create 73-slide presentations for conferences to cover 6% of capital investments unless they expect that spending to ramp up significantly in the coming years.
If anyone's looking to make a long-term investment in Occidental, it's a bet that not-yet-established global carbon markets will materialize soon at much higher prices than in the smaller active markets today. It may have a profitable cash engine to fund the development of this carbon capture business, but it doesn't make the endeavor any less risky.
Even though Occidental has the Buffett stamp of approval, I would be more comfortable knowing that a carbon trading market is established before buying this stock.
