Occidental Petroleum: Will Berkshire Buy The Whole Company?

Glancing through recent articles on Occidental (NYSE:OXY) I notice that they appear at a rate of almost one a day. I can see why. Persistent purchases of OXY shares may have pushed Berkshire Hathaway (BRK.B)(BRK.A) over the important 20% threshold by the time this article is published. Let me explain why 20% is important. Above that threshold the financials of the company whose shares are being bought are consolidated into the financials of the buyer. Occidental would in effect be treated as a subsidiary from the perspective of Berkshire’s financial reports. That’s the same as the status of Kraft Heinz (KHC), of which Berkshire owns 26.6%. This “equity” treatment more accurately reflects the position of a partial owner who can exert influence on actions of the company owned. It also greatly reduces the Federal corporate tax rate to a level lower than 7%.

It’s no wonder then that followers of Berkshire’s percentage of ownership in Occidental are hanging on every Form 4 report as ownership has crept up toward the 20% threshold. More important, however, will be the actions Buffett takes after Berkshire passes that level of ownership. Continued heavy buying above the 20% level might indicate that Buffett loves OXY to the extent that he might eventually attempt to buy the whole thing. Neal Dingmann, Managing Director for Energy at Truist, thinks so. In this June 23 client note he asserted that it was highly probable that Berkshire would buy Occidental later this year “once the company becomes investment grade.” The current flood of cash flow used to pay down debt makes a ratings upgrade in the near future a foregone conclusion and Buffet has likely already factored it into his thinking.

Dingmann also likes the fit of OXY into Berkshire. His client note put it this way: “While Berkshire Hathaway Energy is approximately 1/3 coal/gas/wind with most future focus on wind/solar, we believe OXY could fit nicely within the portfolio.” Dingmann added that the percentage of its Low Carbon Ventures was likely to move from less than five percent of its business to more than ten percent within 2 or 3 years. This accords with Buffett’s progressive but measured approach to green energy. Buffett sees the necessity but is aware of the obstacles. OXY seems to have a compatible approach.

Will a bid for the rest of OXY actually happen? There are several pros and cons having to do with OXY as an acquisition. The synergy is persuasive but one or two obstacles have the potential to be outright deal breakers. Buffett understands that a takeover must serve the interests of all parties involved. This article will look at the pros and cons in detail.

Positive Factor #1: Buffett’s Experience With Berkshire Hathaway Energy Provides A Long Term Perspective

Most of the contemporary writing about energy has to do with where the price of oil and gas will go next. Will it decline dramatically if the Saudis increase production in a big way? What if peace breaks out in Europe? These are important short term questions for the Federal Reserve and consumers experiencing high inflation, but they are not the questions being asked by energy companies. The impact of short term change in oil and gas prices isn’t as important as one might think. Oil prices are important, yes, but next month’s price, not so much. It’s the long-term demand and price of energy that is important to the oil majors.

Berkshire Hathaway Energy, which began with the acquisition of most of MidAmerican Energy in 1999, may be Buffett’s greatest success story. Beginning as a single utility it has multiplied value at an astonishing rate by organic growth as well as bolt-on acquisitions often purchased at very advantageous prices. In his 2020 Shareholder Letter Buffett described BHE as one of Berkshire’s four “Family Jewels” and reported that over the then 21 years since it was acquired BHE had increased its earnings from $122 million to $3.4 billion. At the same time BHE provided Buffett with an education in the complexities of building a grid which can transmit wind and solar energy over the long distances to large cities where that energy is needed. BHE expects to finish that task in 2030 and will return no cash to Omaha until then.

Buffett thus is perfectly placed to have a balanced and nuanced view of green energy. He has shown by his actions that he strongly supports a transition to renewable energy but he understands better than almost anyone the necessity of planning for a realistic time span. What this means is that oil and gas are going to be around for longer than most renewable energy supporters like to acknowledge. What energy prices do next isn’t very important to energy investors set against the virtual certainty that energy prices and demand for oil and gas will remain reasonably high for decades.

As reported here by SA News, climate resolutions have gone down at annual shareholder meetings of major oil companies as the energy crisis exceeds the climate crisis. At OXY 80% of shareholders rejected such a proposal. Remembering the recent past when climate activists actually won seats on the ExxonMobil (XOM) board, oil companies have no illusions about this. They know that unfriendly and destructive actions by both government entities and climate activists will resume once the present energy crisis abates. So far they have resisted the urge to drill and produce to the max and create oversupply that would crash prices and give their critics free rein to resume their attacks.

The war in Ukraine has provided a wake-up call to many who have felt the transition to renewables would be immediate and easy. The strategy of the major oil companies is similar to that which the Saudis have had in effect for the last several decades, regulating production so as to maintain stable prices. It goes back to the day when the always sensible Turki bin Faisal guided OPEC. What he knew, what all sensible oil producers know, and what Buffett also likely knows, is that it’s long term demand that matters. Price will take care of itself.

Positive Factor #2: Occidental CEO Vicki Hollub Might Have The Same Views As Buffett

Vicki Hollub has been the Turki bin Faisal of oil CEOs, sharing the hard truth with anyone who wanted to listen. in the May 11 OXY earnings conference call she said honestly that it’s “almost value destruction if you try to accelerate anything now.” She added that “longer-term projects just can’t get started because of the cost involved.” Translation: we have obliged the world before when oil prices were high and you’re not playing us for suckers this time. With a couple of sentences Hollub assumed leadership of the oil majors. It was just what needed to be said. Her clear thinking and leadership may have made OXY even more attractive for Buffett.

Hollub has also said that her priority uses of cash flow are in order: reducing debt, buying back shares, and increasing the dividend. So far the gusher of cash has been used largely for debt reduction which at $3.3 billion for Q1 2022 was essentially all of Occidental’s free cash flow. That was after capital expenditures of $.9 billion. For Q4 2021 the average oil price was about $79 per barrel followed by almost exactly $100 in Q1 2022 and $117 in Q2 2022. These back-of-the-envelope numbers provide pretty much all an OXY investor needs to know.

While oil prices are only part of the picture (gas prices and downstream results being important as well), they suggest somewhat higher free cash flow which would likely be accompanied by a larger debt reduction. If cash flow increases 10% and is used to pay down debt, long term debt would fall to just over $22 billion, close to Hollub’s first target of $20 billion. Meanwhile the stock is selling at about 5.5 times TTM Free Cash Flow per share (and a P/E that is roughly the same), and cash flow numbers will likely rise when the second quarter earnings report is released in August. These numbers are probably important to Buffett. He probably isn’t waiting breathlessly to see what ratings agencies do because the numbers already tell Buffett that OXY is getting its affairs in order.

To Buffett it most likely matters very little whether oil goes to $150 or $380 per barrel, to cite numbers various savants have put forward. If oil drops sharply below $100 as others believe it will, both Hollub and Buffett will probably be similarly indifferent. By the time oil and gas prices settle into whatever the new normal proves to be, Occidental will have paid down so much debt and undertaken such a major reduction in share count that prices which remain above $60 per barrel will still be highly profitable. Buffett would probably be well content if oil spent its next few years in a band with a floor around $60-70 per barrel. At that rate, after cleaning up its balance sheet, OXY would a highly profitable addition to Berkshire. It would fill out BHE with a source of energy to link up with its wind and solar assets while Occidental’s pragmatic philosophy acknowledges the need for green energy with a realistic timetable.

Potential Negative: Many Shareholders May Prefer OXY’s Strong Leverage And Resist Losing A Rising Dividend

What shareholders might think about an acquisition will play an important role in Berkshire’s decision about making a bid. The 2010 acquisition of Burlington Northern Santa Fe Railroad may provide a template. Berkshire paid a 31.5% premium for the shares of BNSF it didn’t already own but it helped that it already owned 22.6%. That pulled its average price paid per share down to a 24% premium. In the end it did something it doesn’t like to do, offering BNSF shareholders the option of receiving Berkshire shares instead of cash.

Issuing Berkshire shares was something Buffett had avoided since it worked out badly in his acquisition of General Re but it was necessary in the case of BNSF because many of its shareholders would otherwise have had to pay heavy capital gains taxes. To further accommodate long-time BNSF holders he went against a long-term reluctance to split Berkshire stock and split Berkshire B shares 50 to 1 to accommodate small scale owners. The deal was not difficult because Buffett was a friend of BNSF CEO Matt Rose and the deal was reportedly sealed by a handshake on a golf course. He could be confident that a solid management was already in place. The acquisition has worked out brilliantly and Berkshire likely has no regrets.

What Buffett might encounter with OXY shareholders includes the fact that Berkshire and Occidental have a very different shareholder base with different values, goals, and expectations. Berkshire shareholders value a conservative long term holding with solid and consistent growth. Most are satisfied that Berkshire does not pay a dividend. OXY investors, on the other hand, have been willing to accept quite a bit of risk and volatility for the prospect of a large payoff. Having been through a period of difficulty, they may reasonably expect to cash in big with the powerful leverage of a company which bet big and won big (see my recent article). Some may also hope to be rewarded by a dividend which is likely to increase regularly once the debt burden is taken care of. To institute a Berkshire dividend to placate those shareholders would very much be the tail wagging the dog unless Buffett very unexpectedly changed his mind on dividends.

There are a few ways Berkshire might get past these problems, including a structure like the partial control of Kraft Heinz, only at a much higher percentage than the 26.6% ownership of KHC. He could simply continue buying at reasonable market prices until Berkshire has effective control. When the preferred stock it owns is taken into account, it will soon own about one third of OXY. If it kept increasing his ownership percentage until it came close to 50%, Berkshire could offer a large premium on the remaining shares knowing that it would apply to only half the total shares. Something like a 30% premium might appeal to more speculative OXY owners without dragging up Berkshire’s average cost to a point which makes a deal too expensive.

Mildly disgruntled shareholders are a part of almost every acquisition. A 30% premium to the remaining shareholders should be an adequate sweetener. I wouldn’t hold my breath on Berkshire instituting a dividend.

Positive Factor #3: Getting To Know You And Like You Under Crisis Conditions

Buffett has a basic principle of buying companies that already have management in place. He emphasizes that if a company doesn’t already have good management Berkshire is not able to provide it. An example of this (and a story Buffett loves to tell) was the acquisition of Nebraska Furniture Mart, another handshake deal in which Buffett paid $55 million in a one page deal to 88-year-old founder Rose Blumkin whose children and grandchildren succeeded her in running the business.

Buffett went to war together with Vicki Hollub when she outbid Chevron (CVX) for Anadarko Petroleum and its Permian basin assets. She flew to Omaha for a one hour Sunday morning meeting with Buffett who might have helped enable her to clinch the deal with a $10 billion loan in the form of preferred stock paying 10% interest including an option to buy 80,000 shares at close to the current market price. Within a few months of the Anadarko closing the pandemic happened and oil and gas prices crashed with expiring oil futures briefly trading below zero. Hollub used her option to pay Berkshire in stock rather than cash, which Berkshire promptly sold at a loss. The oil price then turned around and Occidental, which had seemed at the brink of bankruptcy, was off to the races. OXY has risen more than six fold from the bottom to the vicinity of its present price.

Was the Buffett-Hollub relationship harmed by his selling shares near the bottom? No hard feelings at all. The Buffett-Hollub relationship has some resemblance to those Jason Bourne thrillers in which the hero and heroine are randomly brought together and must join in the common task of escaping villains while trying to save themselves and the world. In the process they learn to rely on their partner, and ultimately prevail against heavy odds. In the process they naturally become deeply bonded. When getting to know a company and its management, nothing could possibly compare to the journey Vicki Hollub and Warren Buffett took together at a moment of existential crisis full of known and unknown risks and problems to solve.

Vicki Hollub was in most ways the senior partner, and her ability to marshal her oil engineer background while learning crisis management and the ins and outs of finance and dealmaking must have greatly impressed Buffett. They are also now in accord as to the value of Occidental. As reported in this SA News piece on March 28 Hollub purchased 14,191 shares of OXY at an average price of $56.24, close to the amount Buffett had been paying. More interesting is the fact that she bought a chunk of her own stock rather than diversifying her holdings, bringing her personal stake to almost $30 million. That sort of confidence shown by a CEO is something that probably impresses Buffett.

Vicki Hollub would clearly be at the center of any deal, which would be the acquisition of Hollub as much as the acquisition of OXY. It’s interesting that Buffett’s current deal acquiring Alleghany Corporation (Y) was made particularly attractive by the fact that its new CEO Joe Brandon is an old friend who had previously run Berkshire subsidiary Gen Re and was forced to leave under SEC pressure involving sham transactions with AIG of which he was eventually fully exonerated. Brandon had previously been considered a potential successor to Ajit Jain, being ten years younger. Bringing him back greatly adds to the depth of management on the insurance side of Berkshire and may ultimately restore his position as Jain’s heir apparent.

What Hollub brings is the same sort of depth at BHE plus a knowledge of the drilling and production side now fortified with the financial experience learned while outmaneuvering Chevron and bringing Occidental back from the brink. With Greg Abel, who now is Vice Chairman in charge of Berkshire’s non-insurance businesses, named to eventually replace Buffett as CEO, Hollub would be a candidate to assume many of his responsibilities. It’s worth adding that Abel himself was clearly an important talent acquisition, coming to Berkshire with the acquisition of CalEnergy which acquired MidAmerican Energy and took its name. Both the company and the individual proved to be game changers. Buffett likely sees Hollub the same way.

The Deciding Factor: What Does Vicki Hollub Want?

Buffett does not make hostile acquisitions. The CEO has to be receptive to the idea of becoming a subsidiary of a very large company. For Vicki Hollub, who spent her career climbing from oil engineer to become the first woman to be CEO of a major integrated oil company, being absorbed into Berkshire Hathaway, even as a star presiding over a large area, might be difficult. One could hardly blame her for wanting to remain at a company she reinvented on a large scale (Anadarko’s holdings were almost the size of OXY’s), led it through recovery from near bankruptcy, and emerged a winner with huge cash flow and great overall results. In some ways those achievements seem larger with Occidental as a freestanding business than as a part of Berkshire.

On the other side of the argument Berkshire’s resources mean the end of worries about debt and credit ratings as well as the likely opportunity to add assets under her management which greatly expand the level of assets she currently manages with OXY. It may or may not be a tough choice for her. While Hollub has been a hard nosed business leader nothing in her history suggests that she is driven by personal ego.

Buffett is a gentleman and is very unlikely to impose his preferred action upon an unwilling acquisition candidate. The one thing to be sure of is that Buffett would honor Hollub’s decision. While the most important factor is unknown and unknowable, my best guess is that Buffett will continue buying OXY shares at prices he is comfortable with for now. It is likely that he would stop buying at a point slightly below 50%, the point above which an owner can make decisions without the approval of other shareholders. If he chose to exceed that amount, he would probably proceed to outright merger, but only with CEO Hollub on board.

Long story short, I wouldn’t buy Occidental as a bet that Buffett will buy the whole thing and pay a large premium. He may. Me may not. The odds are too hard to calculate, and much of it is in the hands of an individual who has kept any views about a Berkshire acquisition to herself. I do own OXY, however, for the very good reason that it has fabulous current cash flow, is rapidly paying down debt, and will be profitable even if the price of oil falls a bit. I regard it as a long term investment. On this basis I may add to my position in the near future.