It looks as if Warren Buffett (Trades, Portfolio) is continuing to use Berkshire Hathaway‘s (BRK.A, Financial) (BRK.B, Financial) cash to build its position in Occidental Petroleum (OXY, Financial).
According to the latest filing with the Securities and Exchange Commission, Berkshire acquired another 4.3 million shares in the oil producer on July 13, taking its stake to 19.2%.
The position is worth around $10.4 billion overall. After these deals, the ownership threshold is close to the 20% required to let Berkshire record Occidental‘s earnings with its own results, known as the equity method of accounting. The group already uses this method of accounting with its stake in Kraft Heinz (KHC, Financial), which stands at 26.6%.
However, in reality, Berkshire owns far more. It also owns $10 billion of Occidental preferred stock issued as part of its help with the acquisition of Anadarko Petroleum in 2019. This preferred stock has a dividend yield of 8%, generating $800 million a year in annual dividends for Buffett‘s conglomerate.
On top of this preferred equity, Buffett also negotiated warrants to buy another 83.9 million shares in Occidental alongside the preferred stock deal. These shares would be worth around $5 billion today.
Including these warrants, Berkshire owns around 27% of Occidental.
An acquisition in the cards?
The continued buying has supported my thesis that Buffett might be interested in acquiring all of the oil producer. Berkshire would certainly have the upper hand here as it already owns so much of the business and is a major creditor. So, it wouldn’t have to pay as much or assume as much debt as another purchaser would have to in an acquisition.
An acquisition would also allow Occidental to adopt a more aggressive growth strategy as the market is currently punishing oil companies that are in too much debt.
Still, buying a stock just because it might become a takeover target is never a good investment strategy. Takeovers are never guaranteed, and this one is still purely speculative, which means trying to guess which company might be bought out is tantamount to gambling.
So, the question is, is Occidental a good investment in its own right?
Is Occidental a good investment?
I think the company's capital allocation framework gives us a good idea of the answer to this question. During the first quarter of 2022, the corporation generated record free cash flow before working capital of over $3.3 billion. Over the past year, cash flow has been increasing as oil prices have moved higher.
In a sharp strategy shift from pre-pandemic, the company is not spending heavily to grow production. In fact, between the first quarter of 2021 and the first quarter of 2022, oil production fell marginally from 1.14 million barrels a day to 1.08 million barrels. It is not chasing acquisitions or developments where it can’t secure a suitable return.
Instead, the corporation is using its newfound wealth to reduce debt. Total long-term debt fell 12% year-over-year during the first quarter. It is also rewarding shareholders with a $3 billion share buyback plan announced earlier in the year and a quarterly dividend of $0.13 (giving a yield of around 1%). The total shareholder yield, which includes buybacks, dividends and debt repayment, sits around 13%.
It's a question of oil prices
The question of whether or not this is a good investment really depends on where oil prices go from here.
If you believe the oil market is undersupplied and oil markets will remain at current levels for the foreseeable future, then Occidental will likely be able to maintain these returns. A cash shareholder yield of 13% per annum suggests the company has the ability to outperform the market on this basis.
However, if your view is that oil prices will fall, perhaps because the war in Ukraine might wrap up sooner than expected, then the company's outlook becomes a little harder to understand.
It looks to me as if Buffett believes the market will remain in its current state of tight supply. Suppose Berkshire acquires Occidental and all of its cash flows back up to the holding company. In that case, it will be able to achieve a 13% per annum return on the investment - far better than anything it would be able to achieve elsewhere.
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