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Is Warren Buffett’s Favorite Energy Stock Overhyped?

Over the past few years, Permian shale giant Occidental Corp.(NYSE:OXY) has become a darling of billionaire investors. Back in 2019, famous activist investor Carl Icahn bought a 2.5% stake in OXY stock before doubling down a year later by raising his stake to nearly 10% as he fought to take control of the oil producer. Icahn was campaigning for the ouster of CEO Vicki Hollub, his beef with the company being Occidental's outbidding of Chevron Corp. (NYSE:CVX) in a May 2019 deal to buy Anadarko Petroleum with $10 billion of financing from Warren Buffett. 

Unfortunately, deep in the throes of the oil price crash of 2020, OXY shares crashed spectacularly after the company cut its dividend from $0.79/share to just $0.11. Icahn started selling his OXY stake before unloading the final tranche in March 2022.

But it was not long before OXY fell across Warren Buffett's own cross hairs. Buffett started buying large quantities of OXY around the time Russia invaded Ukraine, and has consistently been building his position in the stock. 

Although Buffett has bought other oil and gas stocks in recent years, his 23.6% stake in OXY is, by far, his biggest stake in an oil and gas company with OXY now a top 10 equity holding for Berkshire Hathaway (NYSE:BRK.A). Apple Inc. (NASDAQ:AAPL) is the company's biggest holding, representing around 40% of its portfolio (excluding cash). 

That's a pretty dramatic change in Buffett's investing ethos considering that just five years ago he owned zero oil and gas stocks. So, what's with Buffett's sudden love of the energy sector, OXY in particular?

Loving Energy Stocks

For decades, Warren Buffett maintained a pretty conservative approach to investing, favoring retail and banking stocks while giving a wide berth to more volatile sectors such as tech and energy. In fact, big American banks have been Warren Buffett's favorite investment because they are part of the infrastructure of the country, a nation he continually bets on. 

As recently as late 2019, Berkshire had large stakes in four of the five biggest U.S. banks, with Wells Fargo (NYSE:WFC) remaining Buffett's top stock holding for three straight years through 2017.

But Buffett appears to have changed his investing formula quite dramatically over the past couple of years, taking new multi-billion dollar stakes in energy and computer corporations while shunning the banking sector.

After the onset of the coronavirus pandemic in early 2020, Buffett unloaded Wells Fargo, JPMorgan (NYSE:JPM), and Goldman Sachs (NYSE:GS) on the cheap, despite many stocks in the sector becoming significantly cheaper to own.

"I like banks generally, I just didn't like the proportion we had compared to the possible risk if we got the bad results that so far we haven't gotten," Buffett told investors at last year's shareholder meeting.

Instead, Buffett has recently bought huge stakes in OXY and Chevron.

Warren Buffett is not fondly referred to as the Oracle of Omaha for no good reason, having managed to repeatedly trounce the market over the decades. Indeed, Buffett's Berkshire Hathaway outperformed the S&P 500 by 9.9% per year from 1965 through 2022, generating  a staggering 3,787,464% return vs. 24,708% total return by the market.  Related: China Is Still Critical To America's Clean Energy Boom

Considering that one of Buffett's famous mantras is "risk comes from not knowing what you're doing", one can only presume the legendary investor knows exactly what he's doing by buying large stakes in oil and gas companies. And, unlike Icahn, Buffett has repeatedly said that his favorite holding period is "forever", meaning he's in it for the long haul.

There are several possible reasons why Buffett loves OXY and the energy sector in general.

First off, OXY is cheap. The stock has a PE ratio of 7.0, way lower than the average S&P 500 PE ratio of 22.2. In fact, oil and gas stocks are some of the cheapest in the business.

Last year, the energy sector turned on the afterburners and managed to top all sectors as the global energy crisis exacerbated by Russia's war in Ukraine triggered a big oil price rally. The sector has been more subdued in the current year with investors once again flocking to Big Tech and semiconductors. But the surprising finding is that energy stocks remain real cheap, both by absolute and historical standards.

Indeed, the energy sector is the cheapest of all 11 U.S. market sectors, with a current PE ratio of 6.7. In comparison, the next cheapest sector is Basic Materials with a PE valuation of 10.6 while Financials is third cheapest at a PE value of 14.1 .

Rosenberg has analyzed PE ratios by energy stocks by looking at historical data since 1990 and found that, on average, the sector ranks in just its 27th percentile historically. In contrast, the S&P 500 sits in its 71st percentile despite last year's deep selloff. Oil and gas stocks have been out of favor for so long that the sector would have to put up last year's numbers for several more years just to catch up to the rest of the market valuation wise.

The second reason is that Occidental Petroleum dividend appears safe and is committed to returning excess cash to shareholders. Ok, we concede that OXY is hardly a dividend aristocrat after that huge dividend cut of 2020. Although the company's current yield of 1.2% is nothing to write home about, the dividend is very sustainable with plenty of room for growth since the payout ratio is just 6.5% compared to the sector median at 24.1%. In its latest earnings call, Hollub assured investors that the company would distribute any excess cash from high oil prices to shareholders rather than add to capital spending plans.

"We intend to continue allocating excess free cash flow towards share repurchases," Hollub told investors in the company's post-earnings conference call.

The final reason is that Occidental Petroleum is a very profitable company. OXY has developed highly efficient drilling technologies and owns some of the most productive fields in the Permian Basin. In its latest earnings call, CEO Vicki Hollub revealed that the company has increased well productivity for seven straight years, with 2022 wells returning 205% more barrels of oil equivalent per day than they did seven years back. OXY is able to squeeze more from its existing wells without having to spend too much hence its high margins.

OXY scores highly on many profitability metrics, with an overall profitability grade of A+.

Source: Seeking Alpha

So, there you have it. It appears like Warren Buffett has done his homework since Occidental Petroleum appears like a really good long-term holding.

By Alex Kimani for Oilprice.com

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Alex Kimani

Alex Kimani is a veteran finance writer, investor, engineer and researcher for Safehaven.com.  More