Occidental Petroleum Stock: The Next Merger Arbitrage Play? (OXY)

Recently, Warren Buffett got permission to buy 50% of Occidental Petroleum (NYSE:OXY) stock. The news came after months of buying by the CEO of Berkshire Hathaway (BRK.A) (BRK.B). Buffett said earlier this year that OXY was a bet on “higher oil prices, and the permian basin being all it’s cracked up to be.” Since making the comments, he has gone on to acquire more than 20% of the company.

Due to his aggressive buying and kind words about OXY, Buffett is thought to be considering a full buyout of the company. OXY currently has a $66 billion market cap, and Berkshire has $101 billion in cash and short-term securities. It’s entirely possible for Berkshire to acquire 100% of OXY at the current stock price, and Buffett has been known to have been aching for a big acquisition for a long time.

It’s not clear that he actually will do the deal. Buying more shares will drive the stock price up, if the market cap hits $101 billion then OXY will be too expensive for Buffett to buy without borrowing. Buffett isn’t known for a love of leverage, so if he wants to buy Occidental Petroleum outright, he’ll probably make an offer while the price is still modest.

It’s not a foregone conclusion that Buffett will buy OXY. The deal would leave him with less cash than he likes to have, and may even require large borrowings. Still, we have to ask the question:

Is Occidental Petroleum about to become a merger arbitrage play?

If Buffett makes an offer for OXY, then the only question investors will have to ask is “will the close on these terms?” If it does, and if the offer price is higher than today’s price, then investors will lock in a substantial profit. In this article I will explore the potential for a Berkshire-Occidental acquisition and explain why I consider the stock a good value whether such a deal transpires or not.

Signs Buffett Wants to Buy Occidental Petroleum

Warren Buffett has not said that he wants to fully acquire Occidental Petroleum. In fact, a recent Wall Street Journal article explicitly said that he does not want to. According to WSJ, Buffett needed the 50% permission in order to avoid regulatory issues. However, it would be unwise to assume that Buffett isn’t going to buy OXY. Consider these two points:

1. Buffett has generally kept pretty quiet about his deals until the last minute. He spent a long time buying up BNSF stock before he finally made an offer to buy the company. By the time he finally made an offer, he already owned 23%.

2. Logically, nobody would want to announce an offer before making it, because that would give other people time to come up with competing bids.

With those two points in mind, you can see that Buffett’s not making an offer on OXY doesn’t prove that he’s not buying it. If he intended to make an offer at some point in the future, he wouldn’t say so now – that could trigger a bidding war with another interested party. So, the main signs that Buffett is interested in buying OXY – the long series of buys and the seeking of regulatory permission for more – still stand. Buffett owns 20.2% of OXY and has sought to buy up to 50% – that looks like the behavior of a buyer. It doesn’t in itself prove that Buffett is going to make an offer for OXY, but it does show that he’s behaving the way many companies do before mergers.

It’s not a foregone conclusion that a big buyer will eventually be a full owner. Therefore, we can’t consider Occidental Petroleum a merger arbitrage play today. However, there is a non-zero chance that it will become one in the future. So, anybody investing in the stock should consider the possibility of it being bought by Berkshire.

What Would Buffett Pay for OXY?

Were Berkshire to make an offer for OXY, then the offer price would be the main determinant of investors’ returns. Therefore, it makes sense to think about what Berkshire would pay for OXY.

We know that Buffett’s buys this year have been pretty much constant. The last filing was on August 8, so we don’t know if he made any buys at the recent highs (around $75). We do know that he was buying almost weekly up to the August 8 filing. So we can safely put the highs prior to that date ($70) as a floor on what Buffett thinks OXY’s intrinsic value is.

And what about a ceiling?

That’s more complicated, and will require some competitive analysis. Buffett is known for his love of moat stocks, so if we can find a durable competitive advantage for OXY, we may get an idea of what Buffett thinks it’s worth.

Occidental Petroleum has a number of competitive advantages, including:

• A $40 breakeven WTI Crude price. This compares favorably to $45 for Chevron (CVX) and $41 for Exxon (XOM).

• Extensive assets in the Permian Basin, one of the world’s most productive fields.

• Geographic proximity to huge markets like California and Texas, an advantage as it saves on transportation/midstream costs.

• No refining operations. Refining operations are less profitable when oil prices are high, because their input costs are higher. This hurts the big oil conglomerates like Exxon, which have extensive refining operations, but helps companies like OXY, which simply sell oil.

This is a mighty list of competitive advantages for OXY. Taking all of this into account, it stands to reason that Buffett thinks Occidental Petroleum is worth more than it is today.

How much exactly does he think it’s worth?

That’s impossible to say for sure, but consider this:

• OXY stock has $12.12 in free cash flow per share according to Seeking Alpha Quant. That’s more than it had in 2011, when the stock peaked at $109.

• If you assume 10% FCF growth over 5 years, followed by no growth forever, and discount at 8%, you get a DCF model that values the stock at $187.

So we’ve got a range of $109 to $187 using different approaches. It seems like Buffett wouldn’t value a stock at the very top of its range of possible valuations, being a value investor. But it’s quite possible that he thinks OXY is worth at least $109. If so, an eventual offer coming in at $100+ is a real possibility.

The Matter of Oil Prices

The big risk to Occidental Petroleum, as with most oil stocks, is oil prices going lower. Yes, OXY has a low breakeven price, but it does need oil to hold certain levels to achieve certain business outcomes. For example:

• It needs oil above $40 to breakeven.

• It needs oil somewhere above $90 to achieve positive growth from the second quarter levels.

On the surface, it looks like Occidental’s third quarter earnings will decline sequentially. Oil prices were lower in the third quarter, so earnings should go down, right?

Not so fast. Occidental’s third quarter revenue is likely to be lower than its second quarter revenue, but earnings are a different matter. You see, OXY has been paying off debt all year long. In the most recent quarter, OXY paid off $4.8 billion worth of debt – 19% of the total! If that $4.8 billion in debt was yielding 4%, then it carried $192 million in annual interest expenses. In the second quarter, interest expense was $114 million, down from $391 million in Q1. $114 million is $456 million on an annual basis. If the $4.8 billion in debt repayment occurred late in the quarter, then we could see the interest expense come down even more. Interest is a cost taken off of net income, so the lower that debt goes, the higher the earnings. This provides OXY with a buffer against the earnings impact of lower oil prices.

Warren Buffett has called Occidental Petroleum a bet on higher oil prices. Evidently, he thinks oil prices will rise or at least stay at today’s relatively high levels. But with massive debt reduction, there is less of a “need” for higher oil prices. So it’s quite possible that OXY is a good value even if oil prices don’t budge and Buffett never makes an offer.

The Bottom Line

The bottom line on Occidental Petroleum is that it’s a wildly profitable oil company that’s improving its balance sheet and making big gains. Whether Buffett buys it or not, it’s a great value.

At today’s prices, OXY trades at a mere 9 times adjusted earnings, 7 times GAAP earnings, and 4.3 times operating cash flow. It’s extremely cheap. So investors have much more to like here than just a potential Buffett buyout. With all the debt it’s repaying, OXY doesn’t even need rising oil prices to produce medium-term earnings growth. It’s reducing its interest expenses by hundreds of millions of dollars on an annualized basis – that alone can produce earnings growth. If Buffett does buy OXY, the offer price could potentially be $100 or higher, given the company’s valuation and the fact that Buffett bought its stock aggressively near today’s prices. If Buffett buys, there’s potential to lock in some quick profits and invest them elsewhere. If he doesn’t, there’s potential for long-term gains well exceeding the amount that he would have offered. In any case, Buffett already owns 20.2% of the float, and is known for extremely long holding periods. For this reason, investors can bank on a large percentage of OXY’s shares never being sold, which will put upward pressure on the stock price. On the whole, I’m very excited about Occidental Petroleum stock.