It’s been a heated debate as to whether oil prices will ever recover given that some are assuming that peak oil demand arrived as early as last year. Some believe that we are now on a secular downward trajectory as dependence on green energy continues to grow. Additionally, oil price wars by varying countries and subdued demand caused by coronavirus have created a perfect storm of secular and cyclical pressures to oil prices. Although, there are base case predictions that as global economies recover and global transportation resumes, so will the price of oil, at least over the medium term. As a potential tail-event, there’s also the possibility that oil & gas investment curtails so significantly that oil production falls below supply for long enough of a period that oil prices experience an upside super-cycle. Who knows for sure where we are headed next but Mr. Buffett represents a good bellwether to follow.
Warren Buffett has a long, interesting track record in the oil & gas subsector from E&Ps, to midstream pipeline assets, to refineries, to integrated majors. He understands the industry as a whole quite well and has made incredible returns, particularly on PetroChina (NYSE:PTR) (a 7-bagger; CAGR of 52%) and Phillips 66 (NYSE:PSX) (a 2.5x bagger; 20+% CAGR), pitted against the challenged performance on his ConocoPhillips (NYSE:COP) position (which he would add to his position near the 2009 cycle bottom and later fully recuperate his position).
In 2019, Buffett structured a $10 billion preferred stock deal with Occidental Petroleum (OXY) to help finance the acquisition of Anadarko, which has put immense pressure on the company’s capital structure. Moving into 2020, Buffett has accumulated Suncor Energy (SU) for a total of ~1.3% shares outstanding and we similarly view shares as quite attractive. In order to eliminate the risk of oil price volatility and generate alpha, we think going short OXY and long SU presents an attractive pair trade.
Why Sell Occidental?
In late September, Bloomberg published an article stating that Occidental Petroleum will now be paying Buffett cash as opposed to shares, which signaled “confidence” by the company’s management team. Unfortunately, that cannot be further from the truth. In Buffett’s original preferred financing deal with Occidental Petroleum to bridge the financing gap for the Anadarko acquisition, Buffett is being paid 8% with a convertible option to receive payment through the form of common shares or cash dividends. At the time, we viewed this transaction as a sweetheart deal in favor of Buffett. Major shareholders, including Carl Icahn, also claimed that the deal was structured to the detriment of Occidental’s overall capital structure and the common equity. Icahn was so disappointed, perhaps infuriated, with the deal that he went to public media stating that Occidental’s CEO was “taken to the cleaners” and the deal was akin to “stealing candy from a baby.” Surely, Mr. Icahn would be proven correct as shares tumbled by nearly 30% since the agreement was finalized. Then, COVID-19 reared its ugly head, which collapsed crude oil prices and simultaneously sent OXY’s shares off a cliff.
As many investors are already aware, OXY’s shares were already overpriced prior to the acquisition of Anadarko. However, layering in this additional financial leverage, plus the existing operating leverage, in combination with a decline in oil prices, created a perfect storm for the enterprise value decline impact on the equity. The Wall Street Journal then provided the narrative that the ultimate collapse in the market capitalization transformed what appeared to be a friendly preferred stock deal into toxic financing, or what the publication referred to as a “Death-Spiral Deal.” As the transaction was originally structured, Buffett would be required repayment in a fixed dollar amount. With a market capitalization of $40+ billion, OXY’s C-suite agreed to those terms because they essentially had the option to pay out in the form of modestly dilutive common shares or cash. Prior to COVID-19, both options seemed reasonably fair for both parties. However, with currently excessive leverage, poor cash flows, and waning working capital, OXY has been pinned against a wall and has still hoped to pay Buffett with its shares (now an attractive alternative to desperately needed cash). However, Buffett is more interested in protecting his own position rather than other shareholders. Therefore, Buffett does not want to own common shares but has sought out cash instead.
With about $200 million in preferred cash dividends being sent to Mr. Buffett, that’s detrimental to an exploration & production company that is cash strapped and increasingly reliant on external sources of capital. For context, OXY’s free cash flow [FCF] has rapidly deteriorated since the acquisition of Anadarko and its cash and equivalents has reached new lows:
Its existing working capital deficit is also due to the maturity of long-term debt, which management is partially addressing through limited FCF but more so through asset sales. Within the next 24 months, OXY will have to hurdle an incredibly high maturity wall of about $12 billion. Its debt-to-capital ratio of 62% will not be taken lightly by creditors either, as $9.5 billion of asset impairment charges have forced its debt-to-capital ratio towards ~62%.
OXY’s other leverage and debt coverage ratios calculated by banks and bondholders are about 2.5x-3x higher than the E&P industry median. Therefore, creditors will be demanding significant debt reduction prior to these refinancing transactions or require higher risk premiums. Today, OXY is paying a weighted average interest rate of ~4% on its debt. With about $12 billion set to mature against total debt outstanding of $38 billion, nearly one-third of the debt stack will need to be refinanced. Those transitions could add about $300-400 million of incremental net interest expenses, which represents about 47% and 19% of FY21 and FY22 EBIT, respectively. Beyond 2022, certain bond issues are now selling below par that have resulted in longer-term yields ranging from 7-11%.
While OXY remains a relatively low-cost operator and has engaged in further expense reductions, so long as WTI crude oil prices remain beneath the $40 handle, the company will generate limited FCF. As management seeks to deleverage, such efforts appear to have longer term consequences as well. Most oil & gas E&Ps currently sell for between 4x and 9x EV/EBITDAX depending on a slew of factors such as reserves, production scale, the cost profile, hedges, etc. Management recently earmarked the sale of its Colombian assets to Carlyle Group Inc. for $825 million, according to Reuters. These projects understandably carry much more geographical risk, but if this divestment serves as any indication of future transactions, then shareholders should be concerned, if not outright shaken. One SA analyst, Michael Boyd, recently estimated that the assets were sold for 3x EBITDAX (and about $225 to $275 million in operating cash flow). We can also count that as highly distressed as it ran about one full turn beneath the lower bound of the broader industry’s EBITDAX valuation range.
All in all, OXY’s mismanagement, highly leveraged capital structure, and poorly handled divestitures pose significant risks to shareholders today and in the future. To boot, total shares outstanding have increased by more than 75 million after the Anadarko deal has closed due to Buffett’s deal, resulting in nearly 10% dilution to the common equity in only one year. We would suggest that the common stock be avoided and/or sold.
Why Buy Suncor?
Similar to most other integrated oil & gas companies, Suncor Energy is trending near its COVID-19 March lows. While Suncor is also a low-cost producer, it maintains a long-standing history of generating consistent free cash flows, except for one period during 2016:
What’s the secret? The Canadian oil sands, although they do require a significant upfront capital outlay, these projects often carry long lives with slow decline rates. In other words, this structure allows for a roll down of capex while slow depletion results in substantial cash generation. Suncor has stated that its proven reserve base has the potential to last for at least the next 11+ years. Additionally, its oil/gas mix composition derives significant profitability as it often leans very heavily towards oil. Conversely, unconventional shale plays typically have quite steep decline rates during the first couple years of production with varying mix compositions, occasionally leaning heavily towards gas instead of oil, which results in substantially lower profitability.
Suncor is further diversified by owning logistical networks via pipelines and railcars and storage, as well as refineries and marketing channel which are funneled into wholesale and retail distribution. When looking at the cost profile, Suncor ranks within the top integrated majors from a cash flow breakeven perspective. According to Suncor’s Q2 2020 earnings call presentation, page 5 demonstrates how the company essentially covers all of its costs between WTI pricing of $25/bbl and $35/bbl.
Presently, WTI remains around $39/bbl, which covers the company’s sustaining capital and dividend. In the conditions that pricing stays lower for longer, investors can continue collecting their dividends without any significant risk of the payout being cut.
Not only does Suncor have an incredibly well diversified business model and low cost structure, but it also carries a relatively strong balance sheet. Although the company has incurred approximately $3.4 billion in net debt in the last few quarters, its financial leverage remains markedly low. Its leverage and debt coverage have landed the company well within the investment-grade category. According to Moody’s Investors Service, the analyst updated its research note in early April during the depths of the oil price rout stating:
The affirmation and stable outlook reflects Suncor’s durable integrated oil sands asset base that can withstand a prolonged downturn in oil prices…In a prolonged downturn, we would expect Suncor to protect the balance sheet and reduce negative free cash flow.”
Since then, spot prices have recovered by more than 50%. Regardless of whether oil prices remain excessively low for a prolonged period, Suncor would be adversely impacted but most industry peers would be challenged to an even greater degree. Alternatively, if oil prices rebound further, Suncor will realize better pricing along with its production scale and would return towards historical FCF generating levels. Given the currently low oil price environment, it’s pointless to attempt measuring these companies based on FCF multiples. As a proxy, however, observe how Suncor current trades for rock-bottom multiples based on TBV and TTM cash from operations.
That being said, if oil prices rebound back toward pre-COVID levels by 2022 or 2023, Suncor would effectively be selling for approximately 10x mid-cycle FCF today. That’s far better than many other oil & gas companies I’ve come across in my research process and that may set up Suncor for outperformance over the long term. Rounding things out, Berkshire Hathaway (BRK.A) (BRK.B) has been increasing its position throughout 2020 and now owns ~1.3% of Suncor. That move is, at least, a decent vote of confidence from a firm that understands the various oil & gas industries and valuations.
Last but not least, also keep in mind that OXY carries a significantly higher beta than SU, so that should be a consideration when creating a pair trade. OXY’s shares are much more volatile relative to SU, particularly when oil prices change:
Altogether, we think going long Suncor Energy and shorting Occidental Petroleum presents a net neutral oil bet with the potential to generate healthy alpha. The fact of the matter is that Suncor will be alive and well for decades to come, which is underpinned by its low production costs, sizable oil sands reserve base, ancillary businesses, and healthy credit profile. Conversely, Occidental has good scale and production costs, except bad management and a deteriorating capital structure represent overwhelming risks to current and prospective shareholders. By placing equal weight bets on each company, investors essentially neutralize the direction of oil pricing. If one is more bullish or bearish on oil prices, then overweight your allocation accordingly. If you have any thoughts or questions, please comment below.
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Disclosure: I am/we are long SU. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: I am long SU. I may initiate a short position within OXY at any time within the next 72 hours.