At the end of last week, shares in the oil explorer and producer Occidental Petroleum (OXY, Financial) jumped after the Federal Energy Regulatory Commission approved a request from Warren Buffett (Trades, Portfolio) to increase Berkshire Hathaway’s (BRK.A, Financial) (BRK.B, Financial) position in the stock to as much as 50%.
I say that the commission approved a request from Buffett because it is unlikely that one of his portfolio managers was the one who made the request. Buffett has been incredibly vocal about his position on Occidental and his belief that the company‘s management is taking the business in the right direction.
Berkshire already owns over 20% of the oil company, although the position is significantly more when including warrants and preferred equity.
Buying the company on the cheap
It is interesting that Buffett has decided to go down this route of getting approved for a higher equity stake in Occidental. Historically, he has acquired positions in his acquisition targets in the market and then made an offer for the whole business before letting the position get too big. He has to take this course of action because when the market realizes a company might be an attractive acquisition target for Berkshire, it bids the stock up quickly to a level that might put Buffett off from increasing his position further.
However, it looks as if, in this case, Buffett believes he can continue to buy shares in the oil producer at an attractive price. At least, that's my assumption based on the situation, as it would not appear to make sense to take this route otherwise.
That brings us to the question of why Buffett might assume Occidental won't be bid up too high. The market remains skeptical that oil prices will continue to trade at elevated levels, especially with the global economy heading into stormy waters, interest rates rising and the world spending more money on the shift away from hydrocarbon energy.
At the same time, investing in oil and gas companies is still frowned upon for environmental reasons. Even though they have proven their worth over the past six months, many managers still avoid the sector in order to hasten the transition to clean energy.
This presents an opportunity for astute investors like Buffett to buy incredibly profitable and well-managed companies at discount valuations.
If Berkshire does go ahead and increase its holdings of Occidental to 50%, I think there’s a very high chance that it will make an offer for the rest of the business. But these deals could significantly impact the company even if it doesn't.
As a side note, Buffett has also built a prominent position in another oil producer, Chevron (CVX, Financial).
The illiquidity premium
One thing to note is that the more Occidental stock Berkshire acquires, the less liquid it will be. Many studies have shown that illiquid stocks tend to outperform the market because long-term holders can’t buy and sell as quickly. This reduces liquidity and the chance that investors will rush to dump the stock in a market downturn. As such, illiquid stocks tend to outperform over the long run because they don’t drop as much in market corrections.
On that basis, Buffett could benefit in either scenario. If he continues to buy the stock, he may profit from the illiquidity premium. If he makes a takeover offer for the whole business, he will benefit as the group‘s cash flow will fall back into Berkshire to be reinvested at potentially higher rates of return.
And for those investors who might think Occidental does not fit well into Berkshire, I think it is worth considering the group’s overall financial firepower. It can use its BNSF network to transport oil at a low cost wherever it needs to be, and it could also build pipelines and buy refineries to achieve vertical integration.
If Buffett does buy the rest of the business on the cheap, it might make sense if Berkshire plans a bigger expansion into hydrocarbons.
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