Occidental Petroleum (OP/A): Valuation gap with 'growthy' E&Ps should close, as Oxy hitting its sweet spot in terms of growth and returns
Goldman Sachs July 24, 2005
We believe investors should add to positions in Occidental Petroleum (OP/A), as the company appears to be in the process of securing a substantial oil and gas resource base in the Middle East that will allow it to continue generating leading growth and returns during the current energy bull market. Access to an attractive resource base and the ability to generate superior returns on capital we think will be the key drivers that differentiate E&P-oriented companies in the years ahead. As the market gains comfort with Oxy's new opportunity set, we believe the shares can reach our $105 (+28%) "traditional" peak valuation. We believe Oxy, which trades at just 5.0X 2006E EV/DACF, should trade in-line with the 6.0X-6.5X valuation accorded other high-quality "growthy" E&P companies like EnCana (OP/A), EOG Resources (IL/A), and XTO Energy (OP/A).
OXY SHOULD CLOSE VALUATION GAP WITH ECA, EOG, AND XTO, PROVIDING 28% UPSIDE TO OUR $105 "TRADITIONAL" PEAK VALUATION
We see 28% total return upside to a $105 "traditional" peak valuation for Oxy (i.e., using 1990s cyclical valuation parameters and before considering the optionality of "super-spike" earnings/cash flow), which is 22% greater upside to traditional peak than the average large-cap domestic oil or E&P company. At $105, Oxy would be trading at 6.4X 2006E EV/DACF, within the 6.0X-6.5X range that the other high-quality "growthy" E&Ps like EnCana, EOG Resources, and XTO Energy are currently trading. In our view, investors are likely to continue placing a premium on those E&P-oriented companies that have secured an attractive resource base of opportunities that can generate leading growth and returns on capital during the current energy bull market. The fact that so many companies lack adequate resource development opportunities is driving commodity prices and industry cost inflation higher and lowering commodity price-adjusted returns on capital for industry at large. Companies that have attractive resource development opportunities we think will not only be able to grow faster but are also likely to better withstand capital cost inflation, as the pressure to pay-up via acquisitions for growth will be diminished.
KEY COMPANY-SPECIFIC CATALYSTS
(1) Re-acceleration in E&P production growth starting later this year and into 2006. In our view, new projects in Qatar, Libya, and Oman coupled with recent acquisitions in the Permian Basin positions Oxy to continue growing its E&P volumes at a 5% CAGR through 2010 as it did from 1999-2004. We believe the company is on-track to achieve its 600,000 barrel of oil equivalent per day (BOE/d) exit rate target for 2005--a point management re-affirmed on its 2Q conference call. Achievement of its 2005 exit rate would point to a resumption of 5%+ year-over-year growth in 4Q 2005. 3Q 2005 E&P volume guidance of 570,000 BOE/d appears achievable and represents 1.2% y-o-y growth. As discussed below, E&P production volumes declined 2% in 1H 2005 versus 1H 2004, which was not a surprise as 2005 has long looked to be a transition year of sorts for Oxy.
Using 1999 as the base, Oxy successfully grew E&P production on a BOE basis at a 6% CAGR through 2004, beating its 5% CAGR guidance. From a volume perspective, the company was able to meaningfully overcome the fact that the average WTI oil price rose to $41.47 per bbl in 2004 from $19.30 per bbl in 1999, resulting in a negative hit to reported production on the order of 20,000 BOE/d, or 5%, due to the negative impact higher oil prices have on volumes reported under international production sharing contracts (PSCs) (the 20,000 BOE/d estimated impact uses Oxy's current estimated sensitivity that each $1 per bbl rise in oil prices lowers E&P volumes by about 1,000 BOE/d). The fact that management still handily beat its growth guidance points to its conservatism.
(2) Securing additional Middle East growth projects. We see the addition of new projects in the Middle East as a key differentiating competitive advantage for Oxy versus almost all other domestic oil and E&P companies and even relative to many of the super majors. Recent portfolio additions in Oman (Mukhaizna development) and Libya (return to "old" contract and new exploration acreage) we view very positively and the company has hinted that there is a lot more still to come, including additional new opportunities in Libya. We believe Oxy's strong track record of delivering on growth projects enhances its relationship with Middle East governments. Our modeling of Oxy's Middle East profitability point to surprisingly strong returns on capital in excess of 25%. We believe investor concerns that Oxy may generate growth but at only "cost of capital" (or lower) returns is not supported by the facts of what it has accomplished.
(3) Liquidation of remaining Lyondell stake. Oxy has repeatedly stated that it sees further upside in the petrochemicals cycle but that it would not look to be a Lyondell shareholder through the next downturn, whenever that may be. We conclude that Oxy will look to sell its remaining stake in Lyondell (30.3 million shares plus warrants to purchase an additional 5 million shares) at some point over the next 6-18 months. If Oxy were to sell its remaining holdings by year-end 2005, which is our current assumption but may be a bit aggressive, we estimate that Oxy's balance sheet would have as much cash as debt, making the company effectively net debt free. This would be a remarkable development for a company that had been over-leveraged for much of its history.
2Q 2005 EPS BELOW EXPECTATIONS OWING TO HIGHER EXPLORATION EXPENSE AND A SLIGHTLY HIGHER TAX RATE--NOT A MATERIAL MISS
Oxy' 2Q 2005 adjusted EPS was $2.10, which was below our $2.20 forecast and the $2.24 First Call consensus projection. Reported EPS of $3.78 included a large gain on a tax settlement with the IRS plus several smaller items including a gain on the sale of 11 million Lyondell shares. Adjusted EPS was below our expectations due to higher-than-forecast exploration expense (~$0.08 share) and tax rate (~$0.03).
E&P production volumes on a BOE basis fell 3.4% year-over-year (y-o-y) in 2Q 2005 after falling 0.5% y-o-y in 1Q 2005. We believe the recent trend of lower volumes will reverse in 3Q and 4Q owing to recent acquisitions and new field additions. We note that a large portion of the negative production variance in 1H 2005 is due to the negative effect higher oil prices have on international volumes reported under PSCs. If oil prices had remained flat y-o-y, we believe oil production would have fallen only 0.8% in 2Q and would have risen 1.8% in 1Q.
UPDATING ESTIMATES
We have lowered our 2005 EPS estimate to $9.02 from $9.21 to reflect the 2Q shortfall as well as higher assumed exploration expense in 3Q per management commentary on its 2Q 2005 earnings conference call. Our 3Q and 4Q 2005 EPS estimates now stand at $2.21 ($2.33 before) and $2.57 ($2.55 before), respectively. Note, our 2H 2005 WTI oil price forecast of $53.50 per barrel (bbl) is likely to prove conservative. We have made no changes to our 2006E or 2007 (normalized) EPS forecasts of $11.50 and $4.50, respectively. Our normalized EPS estimates beyond 2007 have increased slightly due primarily to higher assumed oil production from Libya. Our normalized EPS estimates are now $4.90 ($4.85 before) for 2008, $5.30 ($5.23 before) for 2009, and $5.80 ($5.66 before) for 2010. Exhibit 1 shows our summary financial model for Oxy.
I, Arjun Murti, hereby certify that all of the views expressed in this report accurately reflect my personal views about the subject company or companies and its or their securities. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this report. |
