To The Moon

While energy stocks such as Occidental Petroleum and Chevron have crushed the broader markets in 2022, is it worth investing in them?

Warren Buffett viewed the recent decline in oil prices as an opportunity to increase exposure to energy company Occidental Petroleum ‌$Occidental(OXY)$‌(NYSE: OXY). In a regulatory filing on June 22,  ‌$Berkshire Hathaway(BRK.B)$‌(NYSE: BRK.B) declared it purchased 9.6 million shares of Occidental Petroleum for approximately $529 million.

Due to rising oil prices, energy companies such as Occidental Petroleum have delivered outsized gains to investors since the bear market of 2020. As a result, OXY stock has increased from $10 in November 2020 to a multi-year high of $70 in June 2022. It’s currently trading at $56, which is 20% below its 52-week high. In the last year, OXY stock has surged 80% compared to the 9% decline of the S&P 500 index.

Buffett, also known as the Oracle of Omaha, bought the dip in Occidental Petroleum, and Berkshire Hathaway now owns 152.7 million shares in the energy giant. Historically, Buffett has shied away from cyclical stocks. But in the last year, Berkshire Hathaway has accelerated investments in the energy sector. In fact, Chevron (NYSE: CVX) is among Berkshire’s largest holdings, and accounted for 7.2% of its total portfolio at the end of Q1.

Why is Warren Buffett bullish on OXY and Chevron in 2022?

In Q1 of 2022, $Occidental(OXY)$‌increased free cash flows by more than 100% to $3.3 billion, allowing the company to lower its debt significantly. At the start of 2022, Occidental Petroleum emphasized it aims to repay debt amounting to $5 billion this year, and improve shareholder wealth by increasing dividend payouts and focusing on share buybacks.

In 2021, Occidental Petroleum paid annual dividends of $0.04 per share, which has since increased to $0.52 per share this year.

Despite its market-beating returns, OXY stock is trading at an attractive valuation. In the last 12 months, its levered cash flow stood at $9 billion, suggesting the stock is valued at 6x trailing cash flows. Analysts covering Occidental Petroleum remain bullish and expect the stock to surge by 40% in the next year.

 ‌$Chevron(CVX)$‌is one of the largest integrated energy companies globally. Chevron reported a net loss of $5.5 billion in 2020 due to depressed oil prices. But it ended 2021 with earnings of $15.6 billion, suggesting fluctuations in commodity prices impact the company’s key metrics.

While Chevron is part of a cyclical industry, it has managed to increase dividends for 35 consecutive years. Chevron offers investors a forward yield of almost 4% at its current price. In the March quarter, Chevron reported earnings of $6.5 billion or $3.36 per share.

The company’s free cash flow surged to over $6 billion for the third quarter in a row. Its robust cash flows allowed Chevron to lower its debt and return $4 billion to shareholders via dividends and repurchases.

The bottom-line

Rising crude oil prices have acted as a massive tailwind for energy companies in the last 18 months. While companies across sectors are wrestling with the double whammy of inflation and rising interest rates, energy heavyweights, including Chevron, are well-positioned to expand profit margins significantly.

However, I believe investing in energy companies carries significant risk due to their cyclical nature. Yes, they have outpaced the broader markets in 2022, but they have delivered less-than-impressive returns over the long term.

For example, in the last ten years, shares of Occidental Petroleum and Chevron have returned 8.3% and 114.4%, respectively, compared to the S&P 500 returns of 243%. When you invest in cyclical stocks, it’s essential to time the market, which is a challenging proposition. Instead, it’s better to invest in companies that generate cash flows across business cycles.