According to biblical tradition, Belshazzar, king of the Neo-Babylonian Empire, one day saw mysterious handwriting. He summoned the prophet Daniel, who interpreted the writing as an ominous warning from a higher power. This is where we get the phrase, the “writing’s on the wall.” And for Occidental Petroleum (NYSE:OXY) and OXY stock, you can either heed the warning or ignore it altogether.
Fundamentally, I believe the present environment offers overwhelming evidence that the oil industry will incur a paradigm shift. I’m not necessarily suggesting that OXY stock and its ilk are headed straight to zero. But just like the airliners, oil is a market that’s now too small to fit all players. Something has to give, which is why I don’t recommend getting too exposed to this sector.
Nevertheless, Occidental presents an interesting case. Against traditional analytical methodologies, OXY stock is indeed undervalued. As InvestorPlace contributor Mark Hake, CFA noted, several analysts have directed their audience to consider the upside opportunity in Occidental. Specifically, many cite a favorable free cash flow (FCF) yield as powerful evidence.
Are they onto something? Let’s take a deeper look.
OXY Stock Is Undervalued but It Depends on Your Framework
From Hake’s write-up, “SunTrust Robinson Humphrey analyst Neal Dingmann was very bullish on OXY stock. He likes the company’s ability to produce large amounts of free cash flow, especially if the price of oil rises.” Further, Hake explains the justification for buying Occidental under this premise.
Its free cash flow could rise to nearly $4 billion in 2021, according to Barron’s. Since OXY has a market value of $15.1 billion now, that would give it an FCF yield of 26%. That is huge. A normal FCF yield would be below 10%.
Indeed, it would be huge given how the company’s FCF yield has declined in recent years. Moreover, against a handful of similar comparisons based on Gurufocus.com – Concho Resources (NYSE:CXO), Continental Resources (NYSE:CLR), and Marathon Oil (NYSE:MRO) – Occidental does look undervalued on paper.
In 2019, FCF yield (based on enterprise value) for CLR was 16.5%, indicating an overvalued state. CXO’s FCF yield was 5.9%, which is roughly fairly valued. On the other hand, MRO’s and OXY’s yields were 1.3% and 0.9%, respectively, indicating undervalued opportunities.
Coincidentally, I used a mathematical model comparing MRO with retail gasoline demand to suggest that, based on my framework, Marathon may offer upside as an undervalued play.
However, I’m not jumping on OXY stock because the premise could be wrong. As I wrote regarding Marathon, “…if we can somehow avoid serious repercussions from this [novel coronavirus] resurgence, perhaps MRO stock could win out.”
But the problem is that the resurgence may be much worse than we thought. As well, other headwinds have sprouted up, posing deep fundamental challenges to the oil industry. Thus, OXY stock is undervalued only if you assume that none of the harbingers will come to pass.
Anxiety Is Piling Up for the Markets
Earlier this month, President Donald Trump wore a mask publicly for the first time. Recently, he endorsed their wear, encouraging every American – including young ones – to do their part. Needless to say, it was a dramatic shift from earlier policies and rhetoric.
More critically, the President stated that the Covid-19 pandemic could get worse before it gets better. He characterized the crisis as “big fires,” when earlier he stated that rising coronavirus cases were just “embers.”
In any other circumstance, this abrupt shift would discombobulate voters. But they don’t have time to be confused because we have yet another brewing crisis. On Wednesday, the Trump administration ordered China to close its consulate in Houston, Texas by Friday.
Obviously, this ratchets up geopolitical tensions between the world’s top two economies. Moreover, it’s a political chess match that has high stakes for our country. Substantially weakened by the coronavirus, our economy is nowhere near robust enough to engage in Cold War-style tactics against China.
To be fair, President Trump must respond to startling allegations of Chinese espionage, along with longstanding accusations of intellectual property theft. However, the timing couldn’t be worse for an asset like OXY stock.
Invariably, a protracted conflict with China will negatively impact consumer sentiment. Since so much of our economy depends on consumer spending – and all the associated activities to get them spending – any pain here could quickly snowball.
Trade It, Don’t Marry It
If you must, you could win temporarily by trading OXY stock. Despite the ugly headwinds, Occidental is still undervalued from a comparative perspective.
In addition, I noticed that of the four oil stocks compared above, OXY’s FCF yield had the strongest correlation to oil prices (West Texas Intermediate). Theoretically, this suggests that any upside movements in the oil price will have a disproportionately greater impact for Occidental.
But if you take that approach, all I can say is to not be greedy. Because the fundamentals are so ugly, I believe the inputs into traditional stock analyses are skewed. And if that’s the case, the output would likely be skewed as well.
I wish I could say something better about the oil industry. Frankly, I liked the sector prior to the pandemic. But in our current situation, you just have to read the writing on the wall.
A former senior business analyst for Sony Electronics, Josh Enomoto has helped broker major contracts with Fortune Global 500 companies. Over the past several years, he has delivered unique, critical insights for the investment markets, as well as various other industries including legal, construction management, and healthcare. As of this writing, he did not hold a position in any of the aforementioned securities.