Buffett's Occidental Endgame
Buffett's Occidental Endgame
Occidental Petroleum is not likely to be acquired by Berkshire Hathaway but Warren Buffett is happy to continue buying shares under $60. What's next?
“We will not be making any offer for control of Occidental. But we love the shares we have. And we may or may not own more in the future. But we certainly have warrants, which we got as part of the original deal, on a very sustainable amount of stock, at around $59 a share. And those warrants last a long time. I’m glad we have them.”
Warren Buffett surprised many shareholders at the Berkshire Hathaway annual meeting earlier this month when he said that he will not make an offer for control of Occidental Petroleum. Mr. Buffett expressed confidence in Vicki Hollub, Occidental’s CEO, and the economics of the company’s Permian Basin reserves but he seemed satisfied to play a passive role with a substantial minority interest.
When Berkshire’s stake in the oil company closed in on the 20% milestone in July 2022, I was skeptical that Mr. Buffett would want Occidental to become a wholly owned subsidiary. Among the factors I cited were political risks, flexibility, and Berkshire’s advantageous position due to investments in preferred stock and warrants. However, I left open the possibility of an acquisition since I have been surprised by similar situations in the past, most notably the acquisition of BNSF in 2010.
While Mr. Buffett’s statement during the annual meeting seems definitive, I would say that we can never completely exclude the possibility of an acquisition. While we cannot predict the future with certainty, we can observe what’s happening in the present. Due to Berkshire’s large interest in Occidental, all activity in the stock must be reported to the SEC within two business days following the transaction. This week, Berkshire reported purchasing 5,623,014 shares of Occidental stock for $327.2 million between May 11 and May 18, as shown in the following exhibit:
Berkshire currently owns 217,330,133 shares of Occidental common stock with a cost of $11.66 billion, or $53.66 per share. At the close of trading on May 18, Berkshire’s position was worth $12.66 billion, representing an unrealized gain of $1 billion. Based on Occidental’s latest share count, Berkshire owns 24.4% of the company.
This article takes a look at Berkshire’s overall exposure to Occidental Petroleum including the preferred stock and warrants, Berkshire’s investment in Chevron, and what Warren Buffett’s next move in the oil and gas industry might be.
In August 2019, Berkshire invested $10 billion in Occidental Series A preferred stock which pays a 8% dividend. The preferred stock contains a mandatory redemption provision requiring Occidental to redeem the preferred stock at a 10% premium to face value on a dollar-for-dollar basis for every dollar distributed to common shareholders above $4 per share on a trailing twelve month basis. This was triggered during the first quarter, as discussed in Occidental’s first quarter 10-Q report:
In March 2023, Occidental triggered the mandatory redemption provision. Occidental accrued redemptions of preferred stock with a face value of $647 million, and an additional $65 million premium. To the extent Occidental's trailing 12-month distributions to common shareholders remains above $4.00 per share, Occidental is required to continue to match any common shareholder distributions with preferred stock redemptions. Of the $712 million mandatory redemptions accrued as of March 31, 2023, $551 million of preferred stock redemptions, inclusive of a 10% premium, were settled in cash subsequent to March 31, 2023 but before the date of this filing.
According to Berkshire’s latest Form 4 filing, the company owns 93,532 shares of preferred stock with face value of $100,000 per share, indicating a preferred stock position of $9.35 billion. It is likely that further mandatory redemptions of preferred stock will occur, depriving Berkshire of a security paying dividends at the rate of 8% per annum but with the consolation of receiving a 10% premium to face value. The entire preferred stock position is optionally redeemable by Occidental starting in August 2029 at a 5% premium to face value.
In connection with Berkshire’s preferred stock investment, Occidental granted warrants for 83.86 million common shares at an exercise price of $59.62. The warrant expires one year after the preferred stock is redeemed and gives Berkshire the opportunity to allocate an additional $5 billion toward the common stock. Although I see no incentive to exercise the warrant before expiration, Berkshire would own 33.8% of Occidental’s common stock if the warrant was exercised in full today.
Since Berkshire owns in excess of 20% of Occidental common stock, the investment is now accounted for under the equity method which I explained in some detail last year when Berkshire’s stake was approaching 20%. However, due to the timing of financial results, Occidental’s results are reflected in Berkshire’s financials with a one quarter lag. Berkshire’s 20% position also provides a modest tax advantage. The dividends received deduction rises from 50% to 65% for investments in 20% positions.
Warren Buffett and Charlie Munger both expressed bullish sentiments about oil in general and Occidental in particular at the annual meeting earlier this month:
CHARLIE MUNGER: There’s a lot of oil down there that nobody knows how to produce. And they’ve been working at it for, like, 50 years. But they worked at the existing shale production for about 50 years before they figured it out. And it was weirdly complicated when they finally were able to do it. There’s only one type of sand that works.
WARREN BUFFETT: Can you imagine a horizontal pipe, you know, maybe a mile and a half or something? It’s just so different than what you think about.
CHARLIE MUNGER: It goes laterally for three miles, two miles down. How in the hell do you drill two or three miles laterally, when you’re already two or three miles under the Earth? They have mastered a lot of very tricky technology to be able to get any oil out of these wells at all.
WARREN BUFFETT: And we love the position with Occidental. And we love having Vicki run it. And they’ve been —
CHARLIE MUNGER: And there’s a lot more oil down there, if anybody can figure out another magic trick. That’s all we need is another magic trick.
If there is a negative side to the story, it is that shale deposits of the type that Occidental is producing in the Permian Basin deplete very quickly compared to traditional oil wells which can produce for many years or even for decades. As Charlie Munger said at the meeting, technology has been able to tap into reserves that were long thought to be inaccessible or uneconomical to produce.
In addition to the Occidental investment, Berkshire Hathaway has a large holding in Chevron common stock. As of March 31, Berkshire reported owning 132,407,595 shares of Chevron which are currently worth $20.6 billion. Chevron is a much larger company than Occidental with a market capitalization of nearly $300 billion so Berkshire’s stake falls well under the 10% level where it must file Form 4s within two business days of a transaction. As a result, Warren Buffett’s activity in Chevron goes under the radar between quarterly 13-F filings. He transacts in the stock frequently:
From Berkshire’s perspective, it is more difficult to transact in Occidental due to both the smaller market capitalization of the company and the fast reporting requirement that exposes Mr. Buffett’s decisions very quickly. In contrast, Chevron has the liquidity for large transactions and it can be done without immediate disclosure.
It is notable that Mr. Buffett’s sale of Chevron stock in the first quarter was about $6 billion, far in excess of recent purchases of Occidental common stock. Shareholders and market commentators should be cognizant of Berkshire’s activity in both Occidental and Chevron before jumping to conclusions. Berkshire’s net exposure to oil depends on both positions, not just the Occidental position in isolation.
Many years of observing Warren Buffett has convinced me that he’s a straight shooter. If he says that he’s not making any offer for control of Occidental, then that is no doubt his current intention. Occidental stock declined on news of Mr. Buffett’s statement and brought it below the $60 range where he has been a buyer of the stock, so now he is adding to the position. A less ethical investor might have thrown cold water on talk of an acquisition knowing that the stock would decline so he could buy more, but we can safely rule out such a cynical thought in this case.
So, what’s next?
My expectation is that Mr. Buffett will continue purchasing common stock under $60, which is approximately the strike price of Berkshire’s warrants. If Occidental continues to redeem the preferred stock, the common is a sensible destination for the proceeds. However, there are practical limits to how much can be purchased given the size of Occidental and the presence of the warrants.
I do not think that Mr. Buffett will do anything to raise Berkshire’s ownership of Occidental above 50%. Doing so would trigger the consolidation of Occidental into Berkshire’s financials because Occidental would become a controlled company. If we listen to Mr. Buffett’s statement at the annual meeting, he said that Berkshire would not make any offer for control of Occidental. It seems reasonable to assume that he will not acquire stock, even on the open market, that would result in getting close to 50% ownership once the effect of exercising the warrant is taken into account.
Should investors attempt to “coat tail” Warren Buffett and buy shares of Occidental below $60? As I wrote in February, I never recommend blind coat tailing. However, there is nothing wrong with studying a company owned by a super-investor and gaining your own conviction in the idea. In this case, investors also have the benefit of knowing what Mr. Buffett is doing within a few days of his trades. That assurance is not available to those who rely on 13-Fs for clues.
Like the cat who learned a lesson after jumping on a hot stove, I long ago concluded that oil investments are not within my circle of competence. I remain content owning interests in the oil industry via Berkshire Hathaway with Mr. Buffett calling the shots.
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I wonder, if the price of oil takes a plunge in the future for whatever reason, will a Berkshire-backed OXY go shopping for distressed oil/gas related companies?