The latest inflation figures for September are eagerly awaited. On October 13, this data point was released showing that the inflation rate was 8.2% for September. The mainstream news outlets will tell you to run for the hills, because inflation is once again getting stronger. However, I think it makes sense to step back and look at the general trend.
US inflation peaked in June 2022 at 9.1%. In July it fell to 8.5% and in August it was 8.3%. In September, the downward trend continued with the 8.2% reported, although this figure was still higher than analysts’ forecast of 8.1%. This is a key point to realize because inflation is not just about absolute data, it is also about inflation expectations. If companies expect high inflation, they will likely raise prices, which can actually lead to even higher inflation. It’s a dangerous part of human psychology and a tactic Federal Reserve Chairman Jerome Powell has warned against.
If we dive into the granular makeup of the inflation numbers, we can see that this is governed by the CPI, or consumer price index. It is essentially a basket of everyday goods and products whose prices are compared to historical levels. For example, the energy portion of this index rose 19.8% in September, which was extremely high but lower than the rate of 23.8% in August. This increase is mainly attributable to the increase in gas, electricity and petroleum prices. Much of these increases were due to the psychology of fear rather than supply and demand.
The fact that energy prices drive a significant portion of inflation is fascinating. In light of this, I want to take a closer look at a stock
warren buffet (Trades, Portfolio) has bought aggressively over the past two quarters: Occidental Petroleum (OXY, Financial). With inflation driving the energy, is that how Buffett fights inflation?
Buffett bought this stock
Buffett was relatively conservative during the pandemic market crash, and many people said he had “lost touch.” However, Buffett bought stocks aggressively in 2022 as the rest of the market scared. In particular, Berkshire Hathaway (BRK.A) (BRK.B) continuously loaded shares of Occidental Petroleum during the second and third quarters of 2022. Buffett paid an average price of between $58 and $61 per share during his shopping spree, based on the average prices during the transaction dates. Berkshire now owns more than 278 million shares of Occidental worth nearly $19 billion. Buffett owns 29.87% of all outstanding shares of the company, so I think it’s safe to say he’s extremely bullish on the stock. There are rumors that he may even acquire the entire company.
Occidental Petroleum is an oil and gas exploration and production company, so it benefits directly from rising oil prices. The West Texas Oil Index is currently trading at around $88 a barrel, down from June’s high of $120 a barrel, but still above the pre-pandemic level of $59 a barrel. In addition, the global energy uncertainty caused by the Russian-Ukrainian war also caused the market to remain on high alert.
Occidental Petroleum operates in three business segments; Oil and Gas, Chemical and Intermediate Marketing. Its flagship oil and gas segment manages exploration and production operations globally. Oil companies tend to calculate an average cost of producing oil, say ~$40 per barrel, and they make a profit if they can achieve an average selling price above that level. With oil prices above $88 at the time of writing, the company is poised for huge profits.
The company is also well diversified internationally with US facilities spread across New Mexico, Texas and Colorado and global operations in the Middle East and North Africa. Its business is also diversified through product types ranging from petroleum to natural gas and natural gas liquids (NGLs). This is particularly important given the recent explosions of the Nordstream gas pipeline that connects Russia to Europe. US gas could be a key answer to this supply problem.
Occidental has the advantage of a mix of production types that includes both long-cycle and short-cycle operations. With inflation still at high rates, it is important to identify companies that have already invested in exploration. In this case, Occidental is a prime candidate because it has many “long cycle” operations around the Gulf of Mexico that are already producing oil.
The company develops a mix of short-cycle and long-cycle opportunities, which provide diversification in production. Occidental also owns other parts of the oil and gas production chain through its investments in pipeline companies such as Western Midstream Partners (WE S, Financial). Its OxyChem chemical business adds further product diversification as it uses waste from fuel production to create and sell chemicals.
Finances and cash flow
Occidental Petroleum generated strong financial results for the second quarter of fiscal 2022. The company generated revenue of $10.74 billion, which beat analyst consensus estimates of $963 million. Overall earnings per share were $3.47 for the second quarter, which beat analysts’ estimates of $0.47 per share.
By segment, the company’s Oil & Gas segment generated pre-tax income of $4.1 billion, up sharply from the $2.9 billion generated in the same quarter last year.
The chemicals segment generated a record pre-tax profit of $800 million, which was boosted by higher product demand. However, ironically, this has been partially offset by higher energy costs, which increase production input costs.
The Midstream marketing segment generated pre-tax profit of $264 million. This includes a healthy $96 million gain from certain derivative hedges.
Occidental generated a monster free cash flow of $4.2 billion (before working capital) in the second quarter, which was a record for the company.
At Berkshire Hathaway’s 2022 shareholder meeting, Buffett said identifying companies with “low capex” or low pricing power is key to fighting inflation. In this regard, Occidental incurred capital expenditures of $972 million in the quarter, which is manageable given the strong cash flow. Occidental also has temporary pricing power thanks to rising oil prices.
Occidental strategically used its excess cash flow to reduce debt. The company repaid $4.8 billion in debt, or 19% of outstanding debt. The company has $1.36 billion in cash and short-term investments, which is strong given current profitability. The company also pays a dividend of 0.76%, which is better than nothing, although I expected more for an oil company that is currently raking the dough.
In order to account for the company’s debt, I will use the enterprise value to EBITDA ratio to value Occidental as opposed to the price to earnings ratio. The stock trades at an enterprise value to EBITDA ratio of 3.99, which is 45% cheaper than its five-year average rate above 7.
Occidental trades at a mid-range enterprise value to EBITDA ratio (red line), which is roughly in the middle of the pack compared to other companies in the sector. For example, Exxon Mobil (XOM, Financial) trades at a higher enterprise value to EBITDA ratio of 5.82.
Occidental Petroleum proved to be an extremely successful investment and an ideal hedge against inflation as oil prices soared. The company’s shares were bought aggressively by Buffett, whose investment firm now owns nearly a third of the company. The stock isn’t exactly cheap, but it appears to be fairly valued, and given the global energy uncertainty, I think there could be additional upside potential.