(Bloomberg) -- Famed investor Warren Buffett is steadily snowballing a stake in Occidental Petroleum Corp. in what could end up being his biggest-ever acquisition. His Berkshire Hathaway Inc. on Friday won approval to buy as much as 50% of the shares. Some investors believe it’s a step toward a full takeover, which may end up costing more than $50 billion.
Here’s why Occidental is attractive to Berkshire:
Inflation looks to be the mega-trend for the first half of the 2020s and crude oil is one of the best natural hedges out there. Russia’s invasion of Ukraine and a lack of investment in new oilfields over the past five years have hit supplies, leading to stagnant production profiles everywhere from OPEC to US shale. Meanwhile, demand for fossil fuels has been strong coming out of the pandemic even as governments push for a switch to clean energy.
With investments across the energy sector from utilities to solar power, Buffett claims to be a realist in the debate around fossil fuels. “People that are on the extremes of both sides are a little nuts,” he said at a Berkshire shareholder meeting in 2021.
Buffett first invested in Occidental in 2019 when the oil company was in a bidding war with Chevron Corp. to buy its crosstown Houston rival, Anadarko. Occidental CEO Vicki Hollub flew to Omaha, Nebraska, on the company’s Gulfstream V and convinced Buffett to add $10 billion to her war chest. It was enough to swing the deal and Chevron pulled out soon after. In exchange, Buffett got preferred shares yielding 8% annually plus warrants to buy more common stock at $59.62 apiece. Today, with Occidental at $71.29, those warrants would turn a profit of more than $900 million if exercised.
Initially the Anadarko deal was a disaster because it loaded up Occidental’s balance sheet with more than $30 billion of additional debt right before the pandemic. Occidental’s market value went from $50 billion before the 2019 transaction to less than $9 billion toward the end of 2020 as oil prices crashed.
But on the flip side, this created a good value play for Buffett. When crude turned around late last year and was supercharged by Russia’s invasion of Ukraine, Occidental was best-placed to benefit. The stock is the best performer in the S&P 500 this year, up more than 140% compared with the index’s 11% decline.
“Oxy started this year heavily indebted with massive oil exposure,” said Bill Smead, who manages $4.8 billion at Smead Capital Management Inc. and is a top 20 shareholder in Occidental. Soaring crude prices mean “they’re now paying off that debt and gushing cash. It’s the best of all worlds.”
Too much cash has been Berkshire’s biggest investing challenge over the past few years. The conglomerate had about $105 billion on hand at the end of June. It is expected to generate about $8 billion in free cash flow each quarter for the next five years, according to Greggory Warren of Morningstar Research Services LLC. Inflation at the highest in 40 years is a great incentive to put that money to work.
Occidental would work better as a subsidiary of Berkshire than a stock holding “given the volatility that exists in the energy/commodity markets,” Warren said. “This could end up, though, evolving into a slow-motion takeover where Berkshire buys up to the stakes that FERC allows it to acquire until it can acquire Oxy whole.”
Occidental is not only one of the biggest producers in the Permian Basin, the largest US oilfield, but it also has one of the lowest costs with an oil price of just $40 a barrel needed to sustain its dividend. West Texas Intermediate currently trades at about $90 a barrel. Hollub has reined in the “drill-baby-drill” mentality that characterized shale for the first decade of its lifespan and is now prioritizing profits over production. Free cash flow hit a record $4.2 billion in the second quarter.
The Anadarko purchase may have been expensive, but it allowed Occidental to lift its land holdings in the Permian to 2.8 million acres, 14 times the size of New York City’s five boroughs combined. It also added steady, cash-flowing assets in the Gulf of Mexico and Algeria.
Buffett has a good personal relationship with Hollub, which began at the 2019 meeting in Omaha, brokered by Bank of America Corp. CEO Brian Moynihan. This year, the veteran investor praised Hollub after reading a transcript of Occidental’s Feb. 25 earnings conference call in which she pledged financial discipline even as oil prices were rising.
“I read every word, and said this is exactly what I would be doing,” Buffett told CNBC’s Becky Quick in “Squawk Box” in March. “She’s running the company the right way.”
Inflation Reduction Act
The oil industry mostly criticized the Inflation Reduction Act that President Joe Biden signed into law this month. The $437 billion legislation “discourages needed investment in oil and gas” and offers “the wrong policies at the wrong time,” the American Petroleum Institute said.
But Hollub was surprisingly upbeat, calling the bill “very positive.” That may have something to do with its expansion of tax credits for carbon capture, of which Occidental is a leading proponent. The company has plans to build the world’s biggest direct air capture plant which will command a tax credit of as much as $180 for each ton of carbon sucked out of the air.
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