In mid-June, the price of West Texas Intermediate (WTI) crude oil topped $120 per barrel.
Since then, $30 has been shaved off the commodity’s price, a steep decline of 25% in less than a month.
As you would expect, share prices of oil producers have followed crude oil prices downward.
For Warren Buffett, this sell-off has represented an opportunity to resume aggressively purchasing shares of Occidental Petroleum (NYSE: OXY).
For context, Occidental Petroleum shares dropped from over $70 in early June to around $60 in mid-July.
Buffett’s Berkshire Hathaway (NYSE: BRK-A) used that share price decline to scoop up another 4.3 million shares of Occidental Petroleum.
Berkshire now owns a shade under 20% of Occidental Petroleum’s total shares, making Berkshire by far the largest shareholder of the company.
On top of that, Berkshire also owns $10 billion worth of Occidental Petroleum’s 8% preferred shares and 84 million warrants that can be used to purchase more Occidental Petroleum shares at $59.62.
Factor in those warrants, and Berkshire owns roughly one-third of Occidental Petroleum.
Buffett clearly loves Occidental Petroleum – but should we?
To answer that question, we must consider Occidental Petroleum’s current market valuation versus the cash that the business generates.
The stock market is currently valuing Occidental Petroleum’s business as being worth $88 billion.
In the first quarter of 2022, the company generated $3.3 billion in free cash flow.
Free cash flow is the holy grail of investors.
It’s excess cash a business has generated that can be returned to investors through dividends or share repurchases or be used to strengthen the company’s balance sheet.
There is nothing Buffett cares more about.
At that $3.3 billion in first quarter free cash flow run-rate, Occidental Petroleum could generate $13.2 billion in free cash flow this year.
Against Occidental Petroleum’s $88 billion market valuation, that equates to a 15% free cash flow yield ($13.2 billion / $88 billion = 15%).
As an investor, I’ll take a company that generates a 15% free cash flow yield every day of the week.
There just aren’t many opportunities like that around.
What I also really like about Occidental Petroleum is what the company is doing with its free cash flow.
In the first quarter, Occidental Petroleum used the entirety of the $3.3 billion in excess cash to repay debts. This disciplined behavior reflects management’s ongoing focus on taking Occidental Petroleum’s overleveraged business and turning it into an investment-grade company.
Occidental Petroleum’s total debt has been chopped in half since the end of 2019.
I like the valuation based on free cash flow, and I love what management is doing with that cash.
But there’s a catch…
Since Occidental Petroleum is a commodity producer, its long-term cash flow generation will always be dictated by the price of the commodity it produces. In Occidental Petroleum’s case, we’re talking oil and, to a lesser extent, natural gas.
Every $1 per barrel change in WTI crude oil changes Occidental Petroleum’s cash flow by $205 million.
Likewise, every $0.50 change in natural gas prices has a $205 million impact.
So being bullish on Occidental Petroleum essentially means being bullish on these commodities.
Buffett clearly has a bullish view on oil these days.
I’ve written before about how he suddenly started buying oil producers hand over fist in the first quarter of 2022.
Personally, I agree with Buffett that there are supply challenges in the global oil market.
But I’m forever cautious about buying oil producers when oil prices are near triple digits.
Still, Occidental is a good value, and if you don’t have some oil exposure in your portfolio, I think Occidental Petroleum is worth buying today.
But if you already have good exposure to this sector, I think we are going to be able to get a crack at this stock at an even better price down the road.
For now, I’m giving Occidental Petroleum a valuation ranking of “Slightly Undervalued.”
Valuation Rating: Slightly Undervalued
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