Big Money and Mother Nature

THE ANNOUNCEMENTS WERE REMARKABLE for many reasons, not the least of which was their coincidence in time. Last week, Anadarko Petroleum Corp., a large, independent oil company, announced a $21 billion deal to take over two other oil and gas firms, Kerr-McGee Corp. and Western Gas Resources Inc. And then this week began with Phelps Dodge Corp., a large mining concern, announcing a $40 billion deal to take over two Canadian mining companies, Inco Ltd. and Falconbridge Ltd. Welcome to the world in which big money meets Mother Nature.

The Anadarko Deal

Here is the background on the Anadarko deal. Anadarko is proposing to pay $16.4 billion for Kerr-McGee and $4.7 billion for Western Gas. Anadarko will finance the entire acquisition with debt. Upon completion of the deal, Anadarko will more than double its annual sales. In 2005, Anadarko, which has 3,300 employees, reported $7.1 billion in sales. Revenue for Kerr-McGee last year totaled $5.93 billion, and Western Gas Resources booked $3.96 billion in 2005 sales. Together, the three companies will ring the cash register for annual revenue of $17 billion.

“We are creating a combined company with industry-leading positions in the deep-water Gulf of Mexico and the Rockies, two of the fastest-growing oil- and natural gas-producing regions in North America,” said Jim Hackett, chairman, president, and CEO of Anadarko. Despite the recent weakening in natural gas prices, Anadarko managers are looking to the longer term. They are confident that natural gas prices will regain any lost ground and remain high, due to increasing demand and flattening output across North America. Also, in all likelihood, Anadarko wants to keep itself from falling prey to other potential buyers who may covet Anadarko’s own assets and personnel. (Shell Oil Co. has been mentioned as a possible suitor.) Hold that thought while we look at another takeover proposal.

The Phelps Dodge Deal

Here is the raw data on the Phelps Dodge deal. Phelps Dodge, one of the world’s largest copper producer, is proposing to acquire Inco, one of the largest nickel mining companies in the world. In turn, Inco will sweeten an existing offer to acquire Falconbridge, another nickel mining concern already in play, and thus complete a problematic merger.

By acquiring Inco and Falconbridge, Phelps Dodge will create a diversified mining superpower whose presence will reshape the industry in a world of booming commodity prices. If this deal closes successfully, it will create the fifth-largest mining firm in the world, behind BHP Billiton, Rio Tinto, Anglo American and Brazil-based CVRD, with a market capitalization of $40 billion.

The underlying assumption behind the Phelps Dodge deal has to be that worldwide demand for basic materials will remain strong, particularly from the factories of China. Otherwise, Phelps Dodge would be acquiring assets at a post-run-up premium price and risk getting caught at or near the top of a traditional commodity cycle.

The other side of this coin is that worldwide, the basic commodity mining business has suffered from over two decades of low investment in the infrastructure needed to bring ore to the surface and process it into a useable end product. Thus, real ore deposits with real mines and processing facilities sitting on top of them are a relatively scarce item. These big holes in the ground can and do command a premium.

According to a company press release, Phelps Dodge is proposing to pay $80 (Canadian) per share for every share of Inco. Of that amount, $17.50 will be paid in cash and the rest in Phelps Dodge stock. Inco will in turn increase its offer for Falconbridge by about C$5 a share, to about C$62 per share. Phelps Dodge has announced that it will commence a US$5 billion stock repurchase program as part of the transaction. Thus, in the end, the Inco offer will be even more valuable to Falconbridge shareholders as a result of the increased value of its stock due to the Phelps Dodge bid.

Phelps Dodge officials believe that the combined entity can save about $900 million annually as a result of the three-way combination. For example, both Inco and Falconbridge operate massive nickel mines near Sudbury, Ontario. But despite the proximity of their operations, the arrangement of their mines often verged on being silly. Ore from Inco’s operations, literally a stone’s throw from Falconbridge’s sites, was routinely moved long distances by rail to Inco operations, and vice versa.

Execution Risk

Corporate mergers and large-scale asset sales are relatively routine. But three-way deals, such as we are seeing here, are uncommon, and it is an almost astonishing coincidence that we see a simultaneous confluence of events in two natural resource sectors. It makes one wonder what is driving this phase of a business cycle in the natural resource industries. Hold that thought, too.

Buying two companies at once adds what investment bankers call “execution risk” to any transaction. Imagine the difficulty involved in merging just two corporate cultures, two sets of management, two groups of employees, and two different asset bases. Now consider the difficulty entailed when there are three distinct sets of players involved in a transaction. (And in the case of the Phelps Dodge acquisition, the joinder of the three firms spans two nations.) Aside from the financial angles, the Phelps Dodge deal for Inco and Falconbridge requires governmental approvals from authorities in the U.S., Canada, and Europe, along with Phelps Dodge and Inco shareholder approval. The transaction is expected to close in September.

Just in terms of employees, Phelps Dodge has about 13,500 on the payroll, and the proposed acquisitions will swell the ranks with 12,000 more from Inco and 14,500 from Falconbridge. Combining the three mining companies “will vault [Phelps Dodge] into super-major status within the global mining industry,” and make it easier to raise capital and develop giant projects, said Phelps Dodge chairman and CEO Steven Whisler on Monday, June 26. “Our key driver in this transaction,” said Mr. Whisler, “is the potential for significant synergies.” Ah yes, those wonderful “synergies.”

Synergies or not, the transactions present world-class financial challenges, because in both instances, management proposes vastly to increase company debt in an environment of rising interest rates. Phelps Dodge has lined up $22 billion in financing for the deal and the related share buyback program. Simply to enable Inco to acquire Falconbridge, Phelps Dodge has agreed to buy as much as $3 billion of convertible subordinated notes issued by Inco. This cash infusion would, in turn, provide Inco with the cash it requires to buy out the Falconbridge common shares and, as one spokesman put it, to “satisfy related dissent rights, as needed.”

$22 billion is, of course, a lot of money. But Phelps Dodge is focusing, according to Mr. Whisler, on the “extremely strong cash flow [estimated at $10 billion before interest, taxes, depreciation, and amortization], which will enable us to reduce debt quickly and fund growth projects.” Let’s hope that Mr. Whisler is not whistling Dixie.

Speaking of debt, Anadarko is proposing to fund its acquisition of Kerr-McGee and Western Gas by taking on debt greater than its market value. The acquisitions will cost Anadarko $23.3 billion, including assumed debt. To pay for it, Anadarko secured a $24 billion acquisition facility from UBS, Credit Suisse, and Citigroup that it proposes to pay down using proceeds from asset sales, free cash flow, and the sale of new stock over the next 18-24 months.

Because the offer for Kerr-McGee and Western Gas is all in cash, the Anadarko shareholders do not have a vote on the matter. Thus, there is no possibility of what is called a “fiduciary out” for the company (i.e., the company cannot back out by saying the shareholders voted this down.) The proposed takeover price for the two target firms is at something of a rich premium, as well. Pre-announcement, Kerr-McGee was selling for 15 times earnings. Western Gas was selling for 21 times earnings. Anadarko, by contrast, was selling at 9 times earnings, and its market capitalization dropped by $1.7 billion on the first day of trading after the takeover announcement.

Execution Benefit

For every risk, however, there are potential benefits. According to a summary provided by Anadarko, the company expects ultimately to recover 3.8 billion barrels of oil equivalent from Kerr-McGee and Western Gas at a price of less than $12 per barrel. It would certainly be difficult to find that amount of hydrocarbon the old-fashioned way, by going out in the field, acquiring acreage, and drilling wells. By way of comparison, crude futures are currently trading above $70 per barrel.

In a series of press releases, Anadarko stated:

“Opportunities to gain access to such large, high-margin resource opportunities at such economic full-cycle costs are rare…The core assets being acquired strongly complement Anadarko’s existing properties, providing the scale and focus needed to deliver more robust, predictable, and efficient growth…Kerr-McGee’s outstanding deep-water holdings (in the Gulf of Mexico) and skill sets will elevate Anadarko into the top echelon of deep-water operators.

“Similarly, Kerr-McGee’s long-lived natural gas resource plays in Colorado and Utah, along with Western Gas Resources’ [holdings] in Wyoming, will combine with Anadarko’s assets to make us one of the largest producers in several of the most prolific basins in the Rockies.”

“There Is Nothing Left to Drill”

About a year or so ago, no less a scholar of natural resources than T. Boone Pickens said of the United States oil and gas situation, “There is nothing left to drill.” Boone was, of course, being facetious. There is always “something” left to drill.

But Boone was making an important point, summing up in just a few words the notion that exploration for natural resources in the ground is always an issue that involves many variables. Among other things, exploration involves access to new areas, the quality of the prospect, the costs of drilling and production, and the return on investment. By these criteria, the U.S. environment for significant new natural resource discoveries, and future extraction, is distinctly unfavorable.

From a geological standpoint, there is not enough room between the dry holes of the American oil range to find any new deposits of oil or gas of significant size. Similarly, the most significant of the hard rock deposits of North America have been explored and fairly well defined. It is safe to say that there are few important mineral districts left to uncover in the U.S., and perhaps slightly less in Canada. Add to this the dramatically increased cost of exploration and production. Fuel costs have soared, as well as the costs for most of the basic equipment used in oil and mineral extraction. The cost of tubular goods and rock bits, for example, has skyrocketed in the past three years. And people are measuring waiting times for drilling rigs with a monthly calendar.

Sure, there is a lot of oil and gas left out there for the driller’s bit (if you can wait long enough for a delivery of drill bits), and there are significant numbers of mineralized anomalies in the Earth’s crust. But the deposits that the extraction companies will encounter will be smaller, further afield, and more expensive to develop and produce.

The Anadarko and Phelps Dodge plays certainly illustrate another point, one for which T. Boone Pickens is equally famous: that you can still “drill for reserves on Wall Street.” It was Boone who put my former employer Gulf Oil Co. into play back in 1983. The takeover that resulted, by so-called “white knight” Chevron, which swooped in to rescue Gulf from the hands of Boone, was among the first of the big takeovers within the traditional Western oil industry. So I have a certain bias when it comes to seeing oil and gas companies being taken over.

The Anadarko and Phelps Dodge deals will certainly make money for the investment bankers. This will be very good for the economies of Park Avenue, Long Island, and suburban Connecticut. And the takeover deals reward patient shareholders with a significant gain, especially the patient shareholders who took the risk of buying the variety of takeover stocks in the few days before the deal was announced (ahem!). A lot of people will sell their shares, and eventually, the tax collectors of the world will do well by this deal.

The parachute makers of the world (also known as “employment attorneys”) are probably working overtime sewing golden thread into the linings of the respective harnesses for many of the senior managers of the acquired companies. Everyone knows you cannot be too careful these days. So while the current environment in takeover land is all smiles, chuckles, camaraderie, and glowing optimism, I am sure that a good many senior employees are inspecting their ejection seats like a Blue Angels pilot just before a big air show.

To their credit, the Anadarko managers went out of their way to state that they are pleased with the potential to “acquire” the geological and other technical staff of Kerr-McGee and Western Gas. That is, Anadarko appears to want the human resource base of its takeover targets, as well as the oil and gas in the ground. Similarly, the Phelps Dodge managers have stated that layoffs of Canadian technical and production staff will be minimal.

This degree of solicitousness toward the employees is rather unusual. We used to say that the definition of an “optimist” was the geologist or engineer who brought lunch to work (as if he would be there to eat it by noon). It may truly be a reflection of management beginning to realize the severity of the shortage of human skills in the natural resource sector, after more than two decades of layoffs and declining enrollments in related earth science and engineering education programs.

The historical problem with mining and energy company takeovers is that ofttimes when one company buys another, a lot of the exploration and production people from the “other” outfit get laid off. This occurred as recently as last year when Chevron took over Unocal. And as a rule, with the merger of exploration and production departments, there tends to be less diversity of thought in the oil patch and among the rock-kickers. Fewer drilling prospects get generated in the oil and gas arena, and there is less creativity in following the mineral trend lines out in hard rock country. Considering the rising world demand for resources, and the shrunken talent pool, sooner or later it was going to become evident.

Companies that are the principal in big takeover plays almost always say something along the lines of, “Our larger size will allow us better to compete in the aggressive business climate of the modern petroleum industry.” This always a good line, and not unexpected considering the money that is in play. But it is not as if a smaller, well-managed company cannot partner up or obtain the financing it needs to pursue high-cost, risky ventures.

So the Anadarko and Phelps Dodge deals will play themselves out. We shall see what happens. Inquiring minds want to know how, when one company takes over two others, will the world be a better place? Will the combined company shoot more seismic or less? Will the combined firms drill more feet of core in the hard rocks, and drill more or fewer oil wells out in the oil patch, than the combination of the separate entities? Will the new larger entity discover and produce more stuff out of the ground than otherwise?

More on the Business Side

And now for just a few final words on the economic rationale behind the Anadarko and Phelps Dodge deals. Commentator Jim Cramer noted that “Neither deal should have ever been able to get done. But both deals reflect the playbook…that says all of these stocks must be sold because of the Fed.”

That is, the Fed has been steadily raising interest rates, causing the yield curve to turn inverted. There was, in consequence, a sell-off of natural resource stocks as people who had previously purchased shares on margin had to unload them at distressed prices. Deals that were otherwise uneconomical became possible. What this interesting coincidence of takeovers also says is that many companies involved in basic industrial activity — mining, oil and gas, infrastructure, and basic manufacturing — are relatively cheap. At Agora Financial, we have been saying this for a long time.

Until we meet again,
Byron W. King
June 27, 2006

The Daily Reckoning