Occidental Petroleum (OXY -0.15%) has struck a deal to acquire privately held oil and natural gas producer CrownRock for $12 billion. The deal will bolster its position in the oil-rich Permian Basin. It will also increase the company's cash flow, giving it more fuel to pay dividends.

The deal is the latest in a wave of mergers in the oil patch as Occidental looks to keep pace with larger rivals ExxonMobil (XOM -2.78%) and Chevron (CVX 0.37%). However, there's one notable difference between this purchase and the deals made by its peers -- a difference that could haunt the energy company in the future.

Drilling down into the deal

Occidental Petroleum is acquiring CrownRock in a cash-and-stock deal. CrownRock controls more than 94,000 acres in the Midland Basin side of the Permian, where it produces about 170,000 barrels of oil equivalent per day (BOE/d) of high-margin oil. Occidental's management expects the purchase will increase its free cash flow by $1 billion next year, assuming oil averages $70 a barrel, which is right around the current price.

In addition, CrownRock holds 1,700 untapped drilling locations, including 750 that are profitable to drill at sub-$40 oil. This will increase Occidental's sub-$40 drillable inventory by 25%.

The transaction will increase Occidental's scale in the Permian Basin, enabling it to leverage its operations to reduce costs. The combination of all these factors is giving Occidental the fuel and confidence to increase its dividend by 22%.

Following the leaders

This purchase follows the announcements of similar needle-moving deals by ExxonMobil and Chevron. ExxonMobil is acquiring Pioneer Natural Resources for $64.5 billion (including the assumption of debt), while Chevron is buying Hess for $60 billion (including the assumption of its debt). Those oil giants likewise expect their deals to increase their scale, enabling them to produce oil and natural gas more efficiently and cost-effectively. The acquisitions should also enhance their free cash flows over the long term. For example, Chevron expects its Hess acquisition and high-return capital program to more than double its free cash flow by 2027.

The Occidental acquisition is most similar to ExxonMobil's deal. Pioneer Natural Resources is the leading producer in the Permian's Midland Basin (whereas the Hess deal adds the Bakken and Guyana to Chevron's portfolio). That greater scale will give ExxonMobil more opportunities to leverage technology to become an even more efficient operator, which should reduce costs. Occidental should see similar benefits from its scale-enhancing acquisition of CrownRock.

Levering up again

There's one key difference between these megadeals. 

ExxonMobil and Chevron are both making all-stock acquisitions. The only debt they're taking on is what they're assuming from the acquired companies (which is 8% of the total value of ExxonMobil's deal and 12% of Chevron's transaction value).

Occidental's deal has a completely different financing structure. It's only using $1.7 billion of stock to fund its $12 billion deal. To fund the rest, it's issuing $9.1 billion of new debt and assuming $1.2 billion of CrownRock's existing debt. In short, it's taking on debt to fund 86% of the transaction's value.

However, Occidental does plan to pay off the bulk of this debt quickly. Along with the increased free cash flow from the deal, it's planning to launch a new asset sale program to raise between $4.5 billion and $6 billion in cash. That should enable Occidental to repay at least $4.5 billion of the debt it's taking on in the deal within the next year.

The strategy is eerily similar to Occidental's funding plan in 2019 when it beat out Chevron to buy Anadarko Petroleum for $55 billion. The company struck a side deal with TotalEnergies to sell $8.8 billion of Anadarko's assets, which was part of its plan to sell between $10 billion and $15 billion of assets over 24 months. Those proceeds, along with free cash flow and expected deal synergies, were part of its plan to pay off a large portion of the debt it took on to acquire Anadarko.

Unfortunately, that strategy didn't work out as well as planned. Government regulators blocked part of the TotalEnergies transaction, and oil prices collapsed the following year due to the pandemic, impacting Occidental's free cash flow and asset sales strategy. While it survived, it was a challenging time for the oil company and its investors. Hopefully, management's decision to make another debt-fueled acquisition won't come back to bite it again.

A high-risk, high-reward deal

Occidental Petroleum is the latest oil company to make a splashy deal. Its $12 billion acquisition of CrownRock will enhance its position in the Permian Basin while boosting its free cash flow by $1 billion. However, it's taking on a lot of debt to get this deal done, which has burned it in the past. While it has a plan to pay off a big chunk of that debt within a year, an unexpected decline in oil prices could foil that plan and weigh on its stock price. That downside risk makes Occidental a less appealing oil stock right now.