Warren Buffett on Cyclical Businesses

CEO Mike Wirth opened the Q4 2023 review against the backdrop of the October announcement of the all-stock acquisition of Hess Corporation, including the Hess interest in the Guyana Stabroek block co-owned with ExxonMobil. Management told the call that the Company had returned a record $26.3 billion to shareholders during the year, including $16.3 billion of share repurchases and approximately $10 billion of dividends, and that the Board had authorized a $75 billion increase to the share repurchase program, with the intent to execute the program at the top of the targeted $20 billion annual range through 2024. CFO Pierre Breber walked analysts through the Hess transaction framework, indicating that the deal would close in the first half of 2024 subject to regulatory clearances, that the structure was all-stock to preserve the balance sheet and the capital return trajectory and that the synergy opportunities were concentrated in the Permian and the Bakken portfolios. He flagged that the Guyana Stabroek interest being acquired was the strategic centrepiece of the transaction, with a multi-decade production growth profile from the resource base already discovered. On the Q&A, analysts pressed on whether the all-stock structure implied that the Company viewed its own shares as overvalued. Wirth responded that the all-stock structure reflected the Company's preference for preserving the balance sheet capacity to fund the long-cycle project portfolio and the capital return trajectory simultaneously, and that the share repurchase pace would be maintained through the closing of the transaction. He also pushed back on the framing of the deal as a bet on crude prices, arguing that the Guyana resource base had been de-risked through the exploration and appraisal program and that the unit economics of the Stabroek block were among the most attractive in the global upstream portfolio. The call closed with management reaffirming the long-term framework of three percent annual production growth through 2027, anchored on the Permian unconventional, the Gulf of Mexico deepwater and the Guyana interest, and with the Company committing to maintain the multi-decade trajectory of dividend growth and to continue the share repurchase pace through the cycle.

CEO Michael Wirth opened the Q2 2020 review against the backdrop of the COVID-driven collapse in global oil demand during the second quarter, when WTI crude briefly traded at negative $37 per barrel in April. Management told the call that the Company had cut the 2020 capital program by approximately twenty percent to roughly $14 billion and that the operating expense run-rate had been reduced by approximately $1.4 billion on an annualised basis, while the common dividend had been raised for the thirty-third consecutive year. CFO Pierre Breber walked analysts through the capital allocation framework, indicating that the Company intended to defend the dividend through the downturn without issuing equity, fund the reduced capital program from operating cash flow and the balance sheet, and use the asset divestiture program to bridge the gap. He flagged that the Company's balance sheet had been built deliberately for environments like the COVID-driven collapse, with net debt at the bottom of the peer group range coming into the downturn. On the Q&A, analysts pressed on whether the Company would consider cutting the dividend as several peers had signalled. Wirth responded that the Company had committed to the dividend through the cycle and that the long-cycle project portfolio entering service through 2021 and 2022, especially the Permian unconventional and the Gulf of Mexico deepwater projects, would provide the cash flow growth to support the trajectory of dividend growth. He also pushed back on the suggestion that the Permian unconventional growth ambition should be moderated, arguing that the Company's position in the basin was the structural driver of long-term production growth. The call closed with management reaffirming the long-term framework of between three and four percent annual production growth into the mid-decade, anchored on the Permian unconventional, the Gulf of Mexico deepwater and the recently acquired Noble Energy portfolio in the Eastern Mediterranean, and committing to return essentially all of the operating cash flow net of capex to shareholders through the cycle once the price environment normalised.

Buffett wrote that Berkshire's resilience during the pandemic came from the diversity of its non-insurance operating businesses, each of which had its own demand cycle but whose aggregate cash flow was durable across most scenarios. He argued that the lesson of the period was the value of owning businesses whose balance sheets and cash flows could absorb shocks without requiring external capital, and that Berkshire's conservative capital structure was itself a competitive advantage in a crisis.

On resilience and the value of a conservative balance sheet.

Chairman and CEO John Watson opened the Q4 2014 review against the backdrop of a more than fifty percent collapse in crude prices during the second half of 2014. Management told the call that the Company was entering 2015 with the largest long-cycle project portfolio in its history, anchored on the Gorgon LNG project in Australia, the Wheatstone LNG project, the Jack/St. Malo deepwater project in the Gulf of Mexico and the Big Foot tension-leg platform, with aggregate capital commitments that would peak at approximately $35 billion during 2015 before tapering sharply through 2016 and 2017. CFO Pat Yarrington walked analysts through the capital allocation framework, indicating that the Company would fund the peak capex year from operating cash flow and the balance sheet, with the asset divestiture program contributing additional funding. She flagged that the dividend had been increased for the twenty-seventh consecutive year, that the Company intended to continue the multi-decade trajectory of dividend growth through the downturn and that share buybacks were not part of the framework given the long-cycle investment pipeline. On the Q&A, analysts pressed on whether the dividend was safe given the crude price environment and the capex burden. Watson responded that the Company had stress-tested the dividend through a $50 per barrel environment and that the balance sheet and the asset divestiture program provided the bridge through the downturn. He also argued that the long-cycle projects entering service during 2015 and 2016 were the structural drivers of cash flow growth through the back half of the decade and that pulling back on the final completion capex would have been the wrong decision under any plausible price scenario. The call closed with management reiterating the long-term objective of upstream production growth toward 3.1 million barrels of oil equivalent per day by 2017 and a return on capital employed above the peer group average through the cycle, and committing to defend the dividend through the downturn even if doing so required incremental balance-sheet leverage.

Chairman Dave O'Reilly opened the Q4 2008 review against the exceptional backdrop of a year in which crude oil had spiked above $145 in July and then collapsed below $35 by December. Management told the call that the full-year earnings would set a record for Chevron, with the upstream earnings benefiting from the first-half spike and the downstream refining business having produced record margins in the first half before swinging to losses in the fourth quarter as demand collapsed. CFO Steve Crow walked analysts through the capital program, indicating that the Company had actually increased the capital budget during the year to $22.9 billion to advance the Gorgon LNG project in Australia, the Tahiti deepwater project in the Gulf of Mexico and the Chuandongbei sour-gas project in China. He flagged that the Company had bought back approximately $3.5 billion of common stock during the year, that the dividend had been increased for the twenty-first consecutive year and that the balance sheet was positioned to support the long-cycle capital program through any plausible near-term price environment. On the Q&A, analysts pressed on whether the collapse in crude prices would force a rethink of the long-cycle capital allocation framework. O'Reilly responded that the Company had built the project portfolio specifically to deliver returns through the cycle and that the deepwater and LNG projects in the pipeline were expected to earn double-digit returns even at substantially lower long-run crude prices than the 2008 average. He also defended the buyback pace, arguing that the Company's strong operating cash flow permitted both the long-cycle investment and the shareholder returns. The call closed with management reaffirming the long-term framework of organic production growth of one to two percent per year through the next decade, anchored on the deepwater and LNG portfolio, and with the Company committing to continue the multi-decade trajectory of annual dividend increases even in a low-price environment.

Buffett publicly acknowledged that he had made an error in buying a large position in ConocoPhillips near the top of the oil price, and that the position had been reduced at a loss. He used the admission to make the broader point that mistakes of timing on commodity-sensitive businesses are a recurring hazard, and that the discipline of staying within the circle of competence applies to industries whose economics depend on a commodity price one cannot forecast.

On the ConocoPhillips error.

Chairman Ken Derr opened the Q4 1998 review against the backdrop of an oil price that had collapsed below $12 per barrel during the Asian financial crisis and that was pressuring the entire integrated peer group. Management told the call that Chevron had responded to the downturn by accelerating the cost-reduction program announced in 1997, taking a further $250 million of operating expense out of the run-rate during 1998 and pushing the upstream unit operating cost trajectory toward the lower end of the peer group range. CFO Mike Smith walked analysts through the upstream production trajectory, indicating that the company was tracking toward approximately 1.55 million barrels of oil equivalent per day for the year, with the deepwater Gulf of Mexico portfolio ramping through 1999. He flagged that the downstream business had absorbed the worst refining margin environment in a decade, with the benchmark West Coast crack spread compressing by roughly thirty percent year over year. On the Q&A, analysts pressed on whether the downturn would force a rethink of the long-term capital allocation framework. Derr responded that the Company's capital spending would actually be increased modestly into 1999, anchored on the deepwater portfolio and on international upstream projects in Kazakhstan and West Africa, and that the operating expense reduction was being executed without compromising the long-cycle upstream project pipeline. The call closed with management reiterating the long-term framework of between two and three percent annual production growth, competitive returns on capital employed through the cycle, and a commitment to defend the common dividend through downturns rather than to cut it, citing the multi-decade track record of dividend growth as the most important signal of the franchise's quality.

Buffett wrote that during a banking recession, the reported earnings of banks are not to be trusted at face value, because loan-loss provisions lag the deterioration of the underlying credits. He argued that a bank's economic earnings in a downturn are far below its reported earnings, and that the reverse is true in recovery. The lesson generalizes: accounting reflects what has already happened, while economic value depends on what the business will distribute in the future.

On bank accounting during the 1990 recession, with Wells Fargo in view.

Buffett argued that a business that must continuously reinvest to stay competitive — a textile mill, an airline — reports earnings that are economically fictional for the owner, because the cash never reaches the owner; it is consumed by the business itself. The test is whether a dollar of retained earnings eventually produces more than a dollar of market value. If not, the business is destroying capital regardless of what its income statement says.

Connecting owner earnings to the retained-earnings test.

Buffett explained that the textile business had been a chronic disappointment despite capable management. The problem was structural: the industry's economics — commodity output, intense competition, heavy reinvestment merely to stay even — overwhelmed the efforts of honest operators. He closed the operation rather than continue pouring capital into a business that could not earn an adequate return, framing it as a lesson that a bad business is not redeemed by good people.

On closing the original Berkshire textile mills; the founding mistake of the Berkshire name.