Occidental Petroleum Corporation (NYSE: OXY) took full advantage of financial leverage through the acquisition of Anadarko. At first, it looked like fiscal 2020 was an unmitigated disaster, as oil prices plunged into negative territory.When Oil Breaks $100, It Looks Absolutely Brilliant a barrel. Now is the time to take the long view knowing that this industry is volatile and has poor visibility. The long-term outlook is excellent as the industry continues to make incredible technological advancements to drive down costs and bring more square footage into the Tier 1 sector. This makes the acquisition more valuable over time, as each new well drilled will yield more oil (and other products) than was anticipated at the time of the acquisition.
Admittedly, technological advancements and operational improvements (and cost reductions) are a race against time value for money. Large companies often face this problem because many large acquisitions take time to show the benefits of the acquisition. But soaring commodity prices in the last fiscal year have given the company a big boost, with years of progress at a time.
Now, the company doesn’t need that much money in the future to make this acquisition a success. Technology appears poised to provide a substantial boost in profitability in the future. Management has just announced the acquisition of Carbon Engineering Ltd. Occidental already has one of the largest secondary recovery operations in the U.S. in the Permian Basin. As unconventional wells age, large amounts of carbon dioxide will be required to produce more oil through secondary recovery. Management is clearly already thinking about this (the acquisition should further increase the value of the Anadarko acquisition as more oil will be drilled).
Still, favorable commodity prices always help. At the moment, the price doesn’t seem to be functioning as expected. Instead, they performed better. The more this happens early in the deleveraging process, the more likely the company will be able to demonstrate to shareholders the advantages of an acquisition.
Large acquisitions typically take five to seven years to fully realize the benefits. That could be frustrating for shareholders who were hoping to see all the results yesterday. But it could also mean a very competitive company in the future, with competitive advantages that were not available before the merger.
The most obvious improvement is the good results.
New well performance continues to at least (and likely exceed) rising costs elsewhere in the upstream system. This progress brings more acreage into the Tier 1 field than originally envisioned at the time of the merger. It also makes the acquisition more valuable over time.
Investors often wonder why company results don’t reflect the progress they can see. The reason is that given production there is still a cost while drilling. These costs don’t go away just because the newest wells are much better.
This means the reported results are a mix of new and established production. It will take time to drill enough wells the “new way” so that there are enough wells to report lower costs (and thus increased profitability) company-wide.
This is another basin where well performance is improving. Elsewhere, management mentioned (for example) that wells are getting longer (where needed or desired). Some things increase profitability and increase costs.
Contrary to this, wells are being drilled faster than I could have imagined, and completions (speed and design) have advanced beyond my expectations.
The real open question is whether the company can beat the competition over time. Management has clearly pulled off some top-notch results. But then again, they already had that before the acquisition. The question remains whether management can translate these gains into higher profitability going forward (above current reported levels).
I personally think they have a better chance of showing this in DJ Basin since Occidental Petroleum is a better operator than Anadarko. So the profitability improvement is likely to show up where Occidental didn’t really have significant exposure prior to the merger.
implicit progress strategy
The message throughout the second quarter seems to be that the benefits of consolidation and leverage will be margin expansion across commodity prices throughout the business cycle.
A side issue is that as North America’s ability to export natural gas to the world increases, so does its upside potential. Management has mentioned in several places that oil accounts for about 51% of total production. That would imply some upside potential as North American gas prices (and associated liquids) join fairly strong world market prices.
Some other considerations are that the chemicals sector provides plastic raw materials that are extremely important to the green revolution. Future demand for raw materials such as ethane and propane looks very good. That could mean better prices in the future than in the past.
Paying down debt and preferred stock would also have benefits. Currently, preferred stock retirement is the priority, while debt is retired on an opportunistic basis.
Management appears on track to retire about a quarter of its preferred stock this fiscal year. That’s a far cry from the speed at which debt was paid down in the previous fiscal year. But that’s enough to lower the cost of preferred stock for the next fiscal year.
Again, if this continues (all ratings will be upgraded), rating upgrades have the potential to reduce future debt costs if refinancing is preferred over debt repayment.
Occidental still needs some reasonable pricing to make progress on deleveraging. For now, current markets seem to indicate that commodity prices will help the deleveraging process. Technological advances will also reduce pressure on leverage ratios in the form of improved corporate profitability.
There is always the danger of another cyclical recession. But the longer the downturn goes on, the better the company will be financially able to ride out the downturn. Typically, the first few years are critical to the deleveraging process. That’s why the COVID-19 challenge in fiscal 2020 is worrisome.
Now, after the FY2022 benefit, things look much better. The company could still use some nice future commodity prices. But this question is no longer as necessary as it used to be (especially after 2020).
The proposed benefits of a merger with Anadarko appear to be on track to be significant enough to show up to shareholders in the near future. But the overall question of leveraged benefits versus risk (which in this case predominates) remains an open question.