The world runs on energy. Most of our energy comes from petroleum-based products such as oil and natural gas. Historically, the United States was a major oil producer but saw production levels fall off in the 1990s and early 2000s, substituting foreign sources from places such as Saudi Arabia. But in the last 10 years, oil production in the United States has soared and recently hit an all-time high. How did this happen? One word: fracking.
The innovative drilling method allowed energy producers to pull resources from previously unheard-of drilling locations, leading to booming production in places such as the Permian Basin. One company that benefited greatly from the fracking boom is Occidental Petroleum (OXY -0.15%). The long-standing energy company focused its sights on the U.S. market and has seen its profits boom in recent years with oil and natural gas prices rising.
In the last three years, shares of Occidental Petroleum produced a 518% total return for shareholders, trouncing the S&P 500's 30% total return over that same time period. Major shareholder Warren Buffett applauded the company's capital allocation strategy, buying even more shares in recent quarters.
Should you side with Buffett and take a stake in Occidental Petroleum? Let's take a deeper look and find out.
History of profitability, focus on the United States
Occidental Petroleum has a diversified portfolio of energy assets with production facilities in the United States, Latin America, and the Middle East. It is also more than just a company that pulls resources out of the ground, with midstream processing and chemical facilities to go along with resource extraction.
Unlike a lot of other energy producers, the majority of Occidental's assets are in the United States. This should be taken as a positive. Historically, it has been much riskier to have assets in places such as the Middle East due to challenges like foreign government interference and war. Less than 20% of Occidental's production capacity is outside the United States, using its full-year 2023 production guidance. Most of its assets are in the Permian Basin, Rocky Mountains, and Gulf of Mexico.
Even though oil prices make profits a bit cyclical, Occidental has been profitable for most of the last 10 years. The only time it dipped into the loss category was during the COVID-19 shutdowns (oil prices went negative, what was the company going to do?) and in late 2017 when the fracking bubble popped. Besides these one-time events, Occidental stayed in the black -- and it started generating record profits in the last few years with oil prices skyrocketing. Over the last 12 months, Occidental's operating income was $9.3 billion and free cash flow was $8.6 billion.
OXY Operating Income (TTM) data by YCharts
Why does Buffett love the stock?
Buffett loves Occidental stock, owning around 24% of the company. He bought 12.4 million shares just last quarter, adding $800 million to his stake. But why does he love it so much?
First off, it is cheap if you believe oil prices will stay relatively high. The company currently trades at an enterprise value (EV) of $84 billion, which is around 10x its trailing free cash flow (FCF). That is a ratio known as enterprise-value-to-free cash flow (EV/FCF) and is a great way to measure profitability along with the standard price-to-earnings ratio (P/E). Buffett typically buys stocks at earnings ratios around 10 or lower, so it makes sense why he likes Occidental Petroleum so much.
Besides the cheap earnings multiple, Buffett has publicly praised Occidental's conservative growth strategy. Instead of reinvesting profits into new oil production, Occidental is focused on increasing the efficiency at existing facilities and returning cash to shareholders. It has started to repurchase a lot of its outstanding shares, which increases the ownership stakes for every remaining shareholder who doesn't sell into the buyback. With a market cap of $58 billion and over $8 billion in free cash flow coming in, Occidental has an opportunity to significantly reduce its share count in the coming years. And its largest shareholder (Buffett) will be there to hold management's feet to the fire.
Don't just buy because it looks cheap
If you are bullish on oil prices, Occidental Petroleum looks like a safe buy. The stock trades cheaply and has the world's top investor as a major shareholder. But there are more reasons to have exposure to the energy sector besides a cheap EV/FCF.
Many retail investors have a lot of portfolio exposure to growth technology stocks such as Tesla, Nvidia, and Amazon. Almost every company in this sector is negatively affected by rising oil prices. Even minimally capital-intensive software-as-a-service (SaaS) companies will see rising operating expenses due to the increased energy costs at their cloud infrastructure providers. Profitability across the board will be hit at these technology companies if oil prices go higher.
For those investors with a ton of exposure to technology stocks, it isn't a crazy idea to buy some energy stocks. Companies such as Occidental Petroleum have a minimal correlation to broad market movements and can sometimes do extremely well when most other sectors are falling. Anyone who wants to add some diversification to their portfolios would be smart to buy some Occidental Petroleum shares at today's prices.
