Occidental Petroleum Stock: The Next Merger Arbitrage Game? (OXY)

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Paul Morigi

Recently, Warren Buffett got permission to buy 50% of western oil (NYSE: OXY) Inventory. The news came after months of purchase by the CEO of Berkshire Hathaway (BRK.A) (BRK.B). Buffet said earlier this year that OXY was betting on “higher oil prices, and the Permian Basin being all it’s supposed to be.” Since making those comments, he has acquired more than 20% of the company.

Because of his aggressive buying and kind words about OXY, Buffett is reportedly considering a full takeover of the company. OXY currently has a market capitalization of $66 billion and Berkshire has $101 billion in cash and short-term securities. It is entirely possible for Berkshire to acquire 100% of OXY at the current share price, and Buffett is known to have long dreamed of a big acquisition.

It’s not clear that he’ll actually do the trick. Buying more shares will drive up the stock price, if the market cap hits $101 billion, then OXY will be too expensive for Buffett to buy without borrowing. Buffett isn’t known for his love of leverage, so if he wants to buy Occidental Petroleum outright, he’ll likely bid while the price is still modest.

It’s not a foregone conclusion that Buffett will buy OXY. The deal would leave him with less money than he would like to have and might even require significant borrowing. You still have to ask yourself:

Is Occidental Petroleum about to become a player in merger arbitrage?

If Buffett makes an offer for OXY, then the only question investors will have to ask is “will the closing be on those terms?” If so, and if the bid price is higher than today’s price, investors will see a substantial profit. In this article, I will explore the potential for an acquisition of West Berkshire and explain why I view the stock as good value whether or not such a deal goes through.

Signs that Buffett wants to buy Occidental Petroleum

Warren Buffett has not said he wants to fully acquire Occidental Petroleum. In fact, a recent Wall Street Journal article explicitly said he doesn’t. According to WSJ, Buffett needed the 50% clearance in order to avoid regulatory issues. However, it would be unwise to assume Buffett won’t buy OXY. Consider these two points:

  1. Buffett generally kept quiet about his deals until the last minute. He spent a lot of time buying BNSF stock before finally making an offer to buy the company. By the time he finally made an offer, he already owned 23%.

  2. Logically, no one would want to announce an offer before making it, as that would give other people time to come up with competing offers.

With those two points in mind, you can see Buffett not bidding on OXY doesn’t prove he’s not buying it. If he intended to make a bid at some point in the future, he wouldn’t say so now – it could spark a bidding war with another interested party. So the main signs that Buffett is interested in buying OXY — the long streak of buys and the demand for regulatory clearance for more — still stand. Buffett owns 20.2% of OXY and has been looking to buy up to 50% – that sounds like buyer behavior. That in itself doesn’t prove that Buffett is going to bid for OXY, but it does show that he’s behaving like many companies did before the mergers.

It is not a foregone conclusion that a large buyer will end up being a full owner. Therefore, we cannot view Occidental Petroleum as a merger arbitrage game today. However, there is a non-zero chance that he will become one in the future. So anyone investing in the stock should consider the possibility of it being bought by Berkshire.

What would Buffett pay for OXY?

If Berkshire made an offer on OXY, the bid price would be the primary determinant of investor returns. Therefore, it makes sense to think about what Berkshire would pay for OXY.

We know that Buffett’s purchases this year have been pretty much constant. The last deposit was on August 8, so we don’t know if he’s been buying at the recent highs (around $75). We know he was buying almost every week until the August 8 filing. So we can safely put the highs before that date ($70) as a floor on what Buffett thinks is OXY’s intrinsic value.

And what about a ceiling?

It is more complicated and will require a competitive analysis. Buffett is known for his love of the moat in stocks, so if we can find a sustainable competitive advantage for OXY, we can get a sense of what Buffett thinks it’s worth.

Occidental Petroleum has a number of competitive advantages, including:

  • An equilibrium WTI crude price of $40. This compares favorably to $45 for Chevron (CVX) and $41 for Exxon (XOM).

  • Extensive assets in the Permian Basin, one of the most productive fields in the world.

  • Geographic proximity to huge markets like California and Texas, an advantage as it saves on transport/intermediary costs.

  • No refining operation. Refining operations are less profitable when oil prices are high because their input costs are higher. This hurts big oil conglomerates like Exxon, which have vast refining operations, but helps companies like OXY, which simply sell oil.

This is a long list of competitive advantages for OXY. Given all of this, it stands to reason that Buffett thinks Occidental Petroleum is worth more than it is today.

How much does he think it’s worth exactly?

It’s impossible to say for sure, but consider this:

  • OXY stock has $12.12 free cash flow per share according to Seeking Alpha Quant. That’s more than in 2011, when the stock peaked at $109.

  • If you assume 10% growth in FCF over 5 years, followed by no growth forever, and an 8% discount, you get a DCF model that values ​​the stock at $187.

So we have a range of $109 to $187 using different approaches. It seems like Buffett wouldn’t value a stock at the top of his range of possible valuations, being a value investor. But it’s entirely possible that he thinks OXY is worth at least $109. If so, an eventual offer of $100 and up is a real possibility.

The question of oil prices

The big risk for Occidental Petroleum, like most oil stocks, is falling oil prices. Yes, OXY has a low equilibrium price, but it needs oil to maintain certain levels in order to achieve certain trading results. For instance:

  • It needs oil above $40 to break even.

  • It needs Oil somewhere above $90 to achieve positive growth from Q2 levels.

At first glance, it looks like Occidental’s third-quarter earnings will decline sequentially. Oil prices were lower in the third quarter, so earnings should fall, right?

Not so fast. Occidental’s third-quarter revenue will likely be lower than the second quarter, but earnings are another matter. You see, OXY has paid off its debts all year. In the last quarter, OXY paid off $4.8 billion in debt, or 19% of the total! If that $4.8 billion debt was earning 4%, then it was carrying $192 million in annual interest. In the second quarter, interest expense was $114 million, down from $391 million in the first quarter. $114 million is $456 million on an annual basis. If the $4.8 billion debt repayment occurs late in the quarter, we could see interest expense fall even further. Interest is a cost taken from net income, so the lower the debt, the higher the income. This provides OXY with some protection against the earnings impact of lower oil prices.

Warren Buffett called Occidental Petroleum a bet on rising oil prices. Clearly, he thinks oil prices will rise or at least stay at today’s relatively high levels. But with massive debt reduction, there is less “need” for higher oil prices. So it’s entirely possible that OXY could be a good value even if oil prices don’t move and Buffett never bids.

The essential

The bottom line about Occidental Petroleum is that it is an extremely profitable oil company that is improving its balance sheet and making big gains. Whether Buffett buys it or not, it’s excellent value for money.

At today’s prices, OXY trades at just 9 times adjusted earnings, 7 times GAAP earnings and 4.3 times operating cash flow. It is extremely cheap. So investors have a lot more to love here than just a potential Buffett takeover. With all the debt it’s paying down, OXY doesn’t even need higher oil prices to generate medium-term earnings growth. It cuts its interest expense by hundreds of millions of dollars on an annualized basis – that alone can produce earnings growth. If Buffett buys OXY, the bid price could potentially be $100 or more, given the company’s valuation and the fact that Buffett has been aggressively buying its shares near today’s prices. If Buffett buys, it is possible to make quick profits and invest them elsewhere. If he doesn’t, there is the potential for long-term gains far exceeding the amount he would have offered. Either way, Buffett already owns 20.2% of the float and is known for his extremely long holding periods. For this reason, investors can bet that a large percentage of OXY’s stock will never be sold, which will put upward pressure on the stock price. Overall, I’m very excited about Occidental Petroleum’s stock.

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