A few years ago, Occidental Petroleum (OXY -0.15%) outmaneuvered Chevron by winning the $55 billion bidding war for Anadarko Petroleum. It did so with the help of Warren Buffett's Berkshire Hathaway (BRK.A -0.76%) (BRK.B -0.69%), which made a $10 billion preferred stock investment in Occidental. That investment gave the oil company the cash to close the megadeal.
Occidental Petroleum has paid a high price for that preferred stock investment. However, that burden is getting a little lighter as the oil company makes progress in redeeming the investment.
High-cost funding
Occidental Petroleum bid aggressively to snatch Anadarko Petroleum from the grasp of the much larger Chevron in 2019 to bolster its position in the oil-rich Permian Basin. Occidental offered a higher price ($76 per share compared to a $65-a-share proposal from Chevron) and a larger cash component (50% of the equity value versus 25% from Chevron) to win over Anadarko's investors.
It was able to offer more cash thanks to Warren Buffett's Berkshire Hathaway, which made a $10 billion preferred stock investment in Occidental. That investment carries an 8% dividend yield, equating to $800 million in annual investment income for Berkshire. Buffett's company also got stock warrants to buy up to 80 million shares of Occidental Petroleum at $62.50 apiece.
That already expensive funding became even more costly for Occidental Petroleum when oil prices collapsed the following year due to the pandemic. The oil company had to slash its common dividend by 98.7% and sell assets to repay the debt it incurred to buy its rival. Occidental was so strapped for cash at one point that it exercised its option to pay Buffett's company in stock instead of cash, significantly diluting existing investors.
Lifting the burden
Occidental Petroleum's financial picture has improved significantly over the last few years thanks to its aggressive debt repayment strategy and higher oil prices. It has gotten its debt down to a much more manageable level. Because of that, it's now generating significant excess free cash flow. That has allowed it to return more money to shareholders via a higher common dividend and share repurchases.
Those cash returns have triggered a clause allowing Occidental to start redeeming Berkshire's preferred investment. The company must match the excess cash returned to shareholders above $4 per share over the trailing 12 months by redeeming an equal amount of Berkshire's preferred investment (that includes paying Berkshire a 10% premium to redeem the preferred investment). Over the past year, it has made over $1.6 billion in excess cash distributions to shareholders and made a matching payment to Berkshire (including $342 million in the recently completed third quarter):
Image source: Occidental Petroleum.
As that slide shows, it has now redeemed about $1.5 billion of the preferred investment or about 15% of the total. It has also paid Berkshire $151 million in redemption premiums. Those redemptions will save the company about $120 million annually in preferred dividends.
That annual cost savings will free up more of Occidental's cash flow for the benefit of common shareholders. It can return that additional cash to those investors through higher dividends and share repurchases. Those increased cash returns will trigger additional preferred investment redemptions if the total exceeds $4 per share. Future redemptions would continue the cycle of shifting cash away from paying Berkshire's preferred dividends to benefit common shareholders.
Slowly chipping away at this legacy investment
Berkshire's preferred investment in Occidental Petroleum was crucial in enabling the oil company to win the bidding for Anadarko. However, it has come at a high cost, which is why it's great to see the company make progress in paying off this investment. The more preferred stock it redeems, the less it will have to pay Berkshire in preferred dividends. That would free up more money to create more value for common shareholders.
