Chevron, Occidental, Anadarko, and Berkshire: What Just Happened

Investors sometimes forget that oil is not quite like other common stock investments because it involves a non-renewable resource. Oil companies constantly seek replacement rates of 100% or greater because it means they are replacing what they produce. If their replacement rate is below 100%, it is producing faster than it is replacement, and eventually, the company would be left with no assets.

This is why the five supermajors are constantly playing the repurchase stock and engage in M&A course of action as a matter of strategy. They repurchase the shares to increase the price per share of the stock and then issues the same stock as currency in a subsequent merger to get its hands on the target company’s oil reserves to maintain the status quo of growing profits 6-8% over the long haul while yielding 3-5% as a formula that involves extended (sometimes even decade-long) periods of underperformance but then ultimately beats the market during several years of outperformance.

For those of you familiar with Dr. Jeremy Siegel’s research on the topic, you may know that Royal Dutch Shell was one of the top twenty investments in the entire world from 1956 through 2003, delivering almost 14% annual returns. What is less remembered is that, of those 47 years, 32 years of them were down years (as in, the January 1, XXXX price was lower than the January 1, XXXX -1 price) and only ten of the 47 years involved Royal Dutch Shell beating the S&P 500 or Dow Jones Index when that was the relevant benchmark.

In other words, if you want to own an oil stock, it better be a multi-decade commitment where the dividends will be enjoyed as they come and the stock price will be permitted to come along in its own due time because that is how the wealth gets built in this sector.

In the case of Anadarko, it had become a crown jewel in recent years because it had vastly increased its reserves from 500 million barrels of oil and oil equivalents to 2.41 billion barrels of oil and oil equivalents. It has a five-year replacement rate of 417%. For a large oil company looking to add to its portfolio, Anadarko was a dream addition because it owned all of these proven reserves in Western Texas and Eastern New Mexico and also had the possibility of having even more “unproven” reserves that could be developed in time. If Willie Sutton said he robbed banks because that’s where the money is, acquiring Anadarko made great sense because it owned assets where the American oil is.

Nevertheless, there are always a follow-up question after identification of the asset to acquire: On what terms?

In the case of Anadarko, it is a company earning $700 million in annual profits that has the capability to ramp up profits to the $1.5 billion to $2 billion range under a high triple-digit oil price scenario. Over the next decade, then, I would feel comfortable describing the earnings power of Anadarko is somewhere around $1 billion and $1.2 billion per year. With cyclical companies, these estimates of earnings power are more art than science, and I proceed with the assumption that oil prices will see some good years, average years, and bad years. To the extent things are especially good or bad, the estimate will need to be modified accordingly.

This means that when Chevron was offering $33 billion for a company with earnings power of $1.2 billion, it was paying around 27.5x earnings power. This would be on the high end of oil energy transactions, but hey, Anadarko has great Permian assets, money is still somewhat cheap, and paying a premium is always part of M&A in the public sector. I would describe the $33 billion bid as at or near the maximum price you’d want to pay for Anadarko. Chevron wasn’t getting a deal, but there was a route to making this deal look good in hindsight a decade from now.

I looked up West Texas property transactions in the 1930s. Some of these acres near the Permian Basin were selling for $2 per acre. Maybe that was the best way to get involved in all of this…

And then, Occidental, a company which I have never considered because it paid one of its former CEOs over $1 billion over a fifteen-year period that I regarded as an indicia of poor stewardship of shareholder assets, placed the call to Farnam Street in Omaha and got a $10 billion cash infusion to outbid Chevron at $38 billion. Most important for Occidental’s management that wanted to make the deal, Buffett’s cash enabled them to issue $7.56 billion or less of stock to engage in the transaction (making it an 80.1% to 19.9% cash to stock deal), an important fact because Occidental’s corporate charter requires them to hold a shareholder vote in the event that 20% of its stock must be issued in any transaction.

Occidental has a fair number of mutual fund and institutional clients, including T. Rowe Price, who know how to use calculators and know that paying $38 billion for Anadarko would hinder wealth creation. Even if oil rose to $100 per barrel, it would still take Occidental twenty-one years to get its money back that it is laying out for this deal, and by that point, over a third of Anadarko’s entire reserves would be depleted.

There is no margin of safety in that. Also, if oil were to be cheap and average a price of $60 per barrel, it would take over 40 years for Anadarko to recoup its investment. In other words, if 1986 through 2000 oil pricing were to reappear for the next generation, Occidental shareholders would be especially screwed. Welcome to the world of “negative margin of safety” investing inhabited by people who cannot apply any of the precepts taught by Benjamin Graham.

But do you know who can apply those precepts? Graham’s most famous student, Warren Buffett, who swooped in and executed one of the most favorable deals involving major American companies in recent memory.

In exchange for giving Occidental $10 billion in cash on short-term notice, Berkshire gets to collect $800 annual dividends through 2029 (and extending indefinitely beyond that time period until Occidental redeems the preferred stock that it issued Buffett, which it will almost surely do as soon as it is able on the grounds that it should be able to find cheaper than 8% financing from some other source at that time).

In addition, Berkshire will also have the opportunity to purchase up to 80 million, or approximately 10% of the company, at a price of $62.50 at any point within a year of the redemption of the preferred stock. In other words, in 2030 (likely, though possibly later), Berkshire will get to see what price Occidental is selling at, and to the extent that Occidental trades above $62.50, it will be able to pay $5 billion and then capture the price increase instantly in a practically riskless manner.

For the next eleven years, Occidental executives and employees will dutifully show up to work and put forth their best efforts to increase the intrinsic value of the firm, which may be reflected in the changing price of the company, and to the extent that the price rises, Berkshire’s CEO will get to step in a time machine back to 2019 and pay those prices for a substantial stake in the company. It’s proof that you don’t need a ski mask and a pistol to commit robbery.

My best quote throughout all of this comes from Chevron’s CEO Michael Wirth: “Winning in any environment doesn’t mean winning at any cost. Cost and capital discipline always matter, and we will not dilute our returns or erode value for our shareholders for the sake of doing a deal.” Considering Chevron gets a $1 billion break-up fee for not raising its bid, the path of discipline might be even easier to follow.

He is absolutely spot on. For those who have substantial money invested into Chevron, I would feel relieved from this quote of the man helming the wheel. Warren Buffett once offered the vague and ambiguous remark at an old Berkshire meeting that reading through annual reports can tell you a lot about the guys running the show.

I apply that precept by looking for management teams that focus on per share gains in value. If you read the annual report of Nike or Autozone, you will see they are fanatic about the wealth attributable to each share. Well, that’s how you build wealth, and those companies are following the correct North Star. Chevron, too, frequently includes charts showing the dividend and earnings represented by each share.

Guess what entity doesn’t talk about per share changes in value? Occidental. The company’s CEO, Vicki Hollub, is engaged in empire-building. She wants to Occidental to be in the same conversation with Exxon, Chevron, and Conoco and Phillips 66 in terms of size, so she wants to see Occidental sprawl accordingly.

The problem with this approach is that the cost of building an empire is steep. 19.9% of Occidental’s shares will be issued. The debt load, which is already substantial, is now tacking on Berkshire’s $10 billion preferred shares that will require quarterly payments of $200 million.

Every day Hollub wakes up between now and 2029, she’ll owe Warren Buffett $2.1 million. And then, for the grand finale, she’ll have to give Berkshire back its $10 billion and surrender ten percent of her company to Berkshire. And that’s the best case scenario. If she doesn’t have to repay the debt and give up a tenth of the company to Berkshire in 2029-2030, it means that Occidental can’t get financing cheaper than 8% on $10 billion and/or the stock is trading at less than $62.50. Good luck with that.

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