Oil giant Occidental Petroleum (NYSE:OXY) desperately wants to buy rival Anadarko Petroleum (NYSE:APC). It's so intent on making a deal that company executives flew out to Omaha, Nebraska last weekend to meet with super-investor Warren Buffett. They wanted his help in funding their battle with oil behemoth Chevron (NYSE:CVX) for control of Anadarko and its prime position in the oil-rich Permian Basin.
Occidental walked away from that meeting with a $10 billion commitment from Buffett's Berkshire Hathaway (NYSE:BRK.A)(NYSE:BRK.B), which gives it ammunition in its hostile fight for Anadarko. The deal, however, doesn't make much sense from Occidental's perspective. Not only is it willing to pay a high price for Buffett's support, but it has offered a significant premium to beat out Chevron. That seems excessive, since Anadarko's not the best strategic fit.
An epic battle in the oil patch
Occidental Petroleum has long admired Anadarko Petroleum, which holds an expansive position in the Permian Basin, as well as the Rockies, the Gulf of Mexico, and offshore Africa. It sees those assets as highly complementary to its portfolio, which includes a leading position in the Permian, as well as Latin America and the Middle East. That's why it has made three offers to acquire Anadarko since late March. However, instead of engaging with Occidental, Anadarko agreed to merge with Chevron in a stunning $50 billion transaction that was below what Occidental offered.
Undeterred, Occidental took its battle public, reiterating its proposal to acquire Anadarko for $76 per share, well above the $65 per share it accepted from Chevron. CEO Vicki Hollub also went on CNBC to drill down into why she believes Occidental is the right buyer for Anadarko. She stated that:
We are the right acquirer for Anadarko Petroleum because we can get the most out of the shale. We have a lot more experience [in the Permian]. We are performing really, really well, and what hasn't been talked about very much is that the upside in this deal is the shale play.
She noted that Occidental's wells in the Permian perform 74% better than Anadarko's and that it spends less money on drilling and fracking. Because of that, the company believes it can extract more value out of Anadarko's assets. That leads the company to estimate it can capture $3.5 billion in cost savings and other synergies by combining, which is well above the $2 billion Chevron believes it can deliver.
Occidental has also directly addressed the concerns analysts and investors have with the deal. While Anadarko's positions in the Gulf of Mexico and its Mozambique LNG project line up well with Chevron's expertise, these assets only comprise about 15% of the deal's value according to Hollub. As such, they're not as meaningful as it might seem.
Another issue raised by analysts is that Occidental will need to take on a significant amount of debt to close this deal. They see the company's leverage ratio zooming from less than 1 times debt-to-EBITDA up to about 2.4 times its anticipated EBITDA in 2020. The company plans to address this issue by selling $10 billion to $15 billion in assets within a year or two of closing the deal. Investors, however, worry that the company might stretch itself too thin, especially if oil prices plunge again in the meantime.
Backing from Buffett
Occidental is working to address those balance-sheet concerns by bringing Buffett on board to help fund the deal. His company, Berkshire Hathaway, has agreed to invest $10 billion into Occidental in the form of cumulative perpetual preferred stock. The preferred stock will pay Berkshire an 8% annual dividend, which works out to a hefty $800 million in cash flow per year heading from Occidental to Berkshire.
Buffett's company also will receive warrants to buy up to 80 million shares of Occidental's common stock at $62.50 apiece, which is a bit below the current price. That represents another $5 billion of potential investment in the oil company. It's also worth noting that Occidental can't redeem the preferred stock for a decade, though there's a mandatory redemption feature upon certain capital return events like a stock buyback. Meanwhile, Buffett has 11 years to exercise the warrants.
It's an excellent deal for Buffett and Berkshire since the preferred stock pays a very high rate. On top of that, Buffett picks up low-risk upside from the warrants that could pay off spectacularly if the merger delivers the benefits Occidental envisions.
This funding agreement, however, makes no sense for Occidental investors. For starters, the company would pay nearly twice the rate on the preferred stock as it would if it issued new debt to fund the deal. While they would help ease the potential leverage burden, the company is paying a high cost for Buffett's support since most analysts believe that the company could issue preferred stock in a public offering at 6%.
Further, the warrants give Warren Buffett the option to buy enough shares to dilute existing investors by 10%. As such, it transfers some of their upside potential to Berkshire Hathaway.
This battle could end badly for Occidental
Occidental Petroleum is doing everything in its power to position itself to emerge as the victor over Chevron in the fight for Anadarko. It's not only willing to pay a much higher price for the company, but it's prepared to secure expensive and potentially dilutive financing to ensure it has the firepower to compete against the big oil behemoth.
While that could be enough for it to win the bidding war, Occidental might not end up victorious in the end. The extra interest payments could hamper the company's ability to operate -- and might even put its high-yielding dividend in jeopardy -- especially if oil prices tumble. That's why its deal with Buffett doesn't make as much sense for Occidental's investors, though it certainly does for Berkshire shareholders.