Fracking and US Oil Production

• Anadarko Petroleum was considering acquisition proposals from Chevron and Occidental Petroleum (OXY) on April 11, 2019.
• Chevron's price and terms were settled, while OXY's proposal had open issues.
• Vicki Hollub, CEO of OXY, expressed confidence in reaching an agreement that night.

Context: Fracking and the Permian Basin

• The case focuses on three companies in the oil & gas exploration and production (E&P) industry.
• Fracking is the latest generation oil & gas production technology.
• The US has been a major oil consumer and producer, experiencing a production decline until the mid-2000s.
• By 2018, the US regained its position as a top oil producer due to fracking.
• Fracking involves drilling deep into shale rock, turning the drill bit horizontally, injecting high-pressure solution to fracture the rock, and extracting oil & gas.
• The Permian Basin in west Texas has become one of the largest producing oilfields due to fracking.
• OXY held the largest acreage position in the Permian Basin, followed by Chevron and ExxonMobil; Anadarko had the 7th largest position.
• Fracking has a higher breakeven point than conventional production, requiring oil prices above $50/BBL for profitability.
• Oil prices have historically been around $20.00 BBL, before increasing global demand and diminishing production drove prices up.
• Oil price volatility in the 2010s, particularly in 2016, led to financial distress for smaller enterprises due to overproduction and slower demand.

Challenges of Fracking

• Fracking requires constant cash investment due to the high depletion rate of shale oil wells.
• E&P companies must continuously drill more wells to maintain pace and growth.
• Investors are pushing for companies to return more cash to shareholders due to oil price volatility.
• Efficiency is crucial in fracking economics.
• Joint operations and consolidation of oil properties in the Permian Basin are becoming more important.
• Larger acreage allows flexibility in well locations, drilling plans, enhanced oil recovery, and cost management. Synergy in field operations offers detailed capital and cost savings.

Anadarko Petroleum

• Anadarko was established in the 1960s as a subsidiary of Panhandle Eastern, focused on developing gas discoveries in the Anadarko Basin.
• It became an independent public E&P company with $13B revenue and $23B market value in 2018.
• Anadarko's assets were primarily in US domestic oil & gas, concentrated in the Permian Basin.
• In 2016, low oil prices ($40/BBL) resulted in an operating loss for Anadarko.
• The company reduced capex, sold assets, cut dividends, and sold equity to build cash reserves.
• By 2017, oil prices recovered, and Anadarko elected to buy back $1B of its stock while reducing capex.
• In 2018, higher oil prices allowed Anadarko to increase its capex budget and repurchase $3B of stock.
• The challenge for Anadarko was to maintain growth and return cash to shareholders in a volatile oil price environment ($40-$60 a barrel).
• Projections for 2019-2025 forecast stable oil prices between $54-$55/BBL.
• Anadarko aimed to achieve future production growth [an 8% per year increase], declining capex [2.3% decrease], and growing free cash flow to reduce debt and make shareholder distributions.

Shareholder Returns and Valuation

• Anadarko underperformed its E&P peers in shareholder returns and experienced a 39.4% loss in value in late 2018.
• The share price was at the low end of valuation ranges based on projected numbers.
• Anadarko appeared to be trading at a slight discount to its peer group, but the E&P business traded at a lower multiple after adjusting for non-E&P assets.
• There was an argument that the company was undervalued in the market, but Anadarko's market price was a reasonable estimate of its stand-alone value.
• Anadarko was an attractive M&A target in 2019, needing to take the lead in consolidation or be a target.
• The company faced tight cash flow, an uncertain outlook for oil prices, mixed track records, and investor pressure.
• Projections suggested a way to sustain growth and return cash to shareholders, but their achievability was uncertain.
• The Anadarko board had to take an acquisition offer seriously.

Chevron

• Chevron is one of the last two major oil companies left in the US.
• Formed as Standard Oil of California (“SOCAL”) in 1911 after the breakup of Standard Oil.
• Chevron absorbed several major oil companies, including Gulf, Texaco and Unocal.
• Chevron has both an "upstream" (E&P) and "downstream” business (refining, marketing, petrochemicals).
• The company's global footprint generated $164B revenue in 2018.
• Anadarko was a logical fit, with opportunities to save money through a combination.
• Consolidation in the Permian Basin would yield synergy.
• Estimated annual cost savings of $1B and reduced capital spending of $1B.
• NPV of synergy for Chevron was estimated at $9B.
• On February 6, 2019, Chevron offered to acquire Anadarko for $64 per share (25% cash, the rest in Chevron stock).
• The offer was a considerable premium to Anadarko's closing price on February 5.
• Anadarko's management signed a confidentiality agreement with Chevron.

Certain Deal Terms

• Negotiations included proposed language on fiduciary outs and termination fees.
• Buyers want to avoid target sellers abandoning deals for superior offers.
• Language was negotiated in the merger agreement to prohibit target companies from soliciting further interest from other potential bidders.
• A fiduciary out allows the target company to break a merger agreement for a superior unsolicited proposal.
• Chevron pushed to limit the fiduciary out, but was unsuccessful.
• A merger agreement is a contract, and if one side terminates for a superior proposal, the other can collect damages.
• Common for buyers to receive a termination fee if the target seller abandons the agreement.
• A breakup fee protects against losing a deal to a bidder paying only a small increment more.
• A typical breakup fee equals about 3% of a deal's value.
• Chevron demanded a $1B fee.
• From target seller's perspective, a breakup fee is used to induce multiple bidders to make strong opening bids.
• Anadarko was willing to offer Chevron a breakup fee if the price offered was fair and adequate.

Occidental Petroleum (“OXY”)

• OXY is a California company with a colorful history, and in the 1950's Armand Hammer assumed the role of CEO.
• OXY diversified into various areas other than E&P, including petrochemicals and midstream processing + pipeline assets in both the western US as well as in the Middle East.
• OXY has considerable investments in unconventional oil shale reserves and production.
• OXY had $18B revenue in 2018, lead by CEO Vicki Holub.
• OXY had a strong motivation to acquire Anadarko.
• Large synergy potential in the Permian Basin, presuming overlapping and contiguous land.
• Potential overlaps in some other fracking locations in the US as well.
• OXY believed it could generate annual cost savings of $2B and reduce annual capital spending by $1.5B.
• OXY's estimated synergies pencil out a lot higher than Chevron's, resulting in an NPV of $15B.
• OXY did not have financial experience of Chevron, but the opportunity to sell off some of its assets and operations after a merger could be helpful in mitigating the acquisition costs.

OXY's Offer and Subsequent Negotiations

• OXY approached Anadarko unsuccessfully on more than one occasion in the past about a possible transaction.
• Vicki Hollub, CEO of OXY, presented Anadarko with an acquisition offer for $76 per share, with 25% or $19 of the price paid in cash and the rest in OXY stock.
• Chevron decided not to respond with a bid increase.
• Anadarko's board decided to suspend discussions with Chevron, sign a confidentiality agreement with OXY, and enter discussions to see if an acceptable deal with OXY was possible.
• Negotiations between Anadarko and OXY became more complex than negotiations with Chevron.
• Unlike Chevron, because of the relative sizes of Anadarko and OXY, Anadarko shareholders would end up owning pro forma 37% of the combined companies.
• Under its offer, OXY would be issuing about 437M new shares of stock
• OXY did not have enough common shares authorized in its charter to issue that much stock, so OXY shareholders would have to agree to a charter amendment to increase the number of authorized shares.
• OXY shareholders would also have to vote up or down on the merger as well, obviously a risk.
• Anadarko explored several creative ways to force more cash and less stock in the transaction to avoid requiring a vote, but OXY pushed back because it was limited by the financing it had lined up at that point
• OXY compromised and came back with another proposal comprised of 40% cash and the rest in OXY stock, avoiding the need for a shareholder vote on a charter amendment, but a shareholder vote would still be required.
• Anadarko believed, for good reason, that OXY could raise enough financing to add even more cash and eliminate the voting requirement altogether, but it would probably take several weeks for OXY to line up the money.
• OXY lowered its offer price to Anadarko from $76 to $72 per share & Anadarko immediately re-engaged Chevron.
• Chevron agreed to raise its offer to an advertised value of $65 per share, comprised of 25% cash and the rest in Chevron stock.
• Chevron threatened to withdraw its offer entirely if Anadarko did not go ahead and sign the agreement on their deal at $65 per share
• OXY hastily increased its offer back to an advertised value of $76 per share, with 40% or $30.40 in cash and the rest in stock.
• The board wanted a final decision made by that evening, and planned to sign a merger agreement and announce a deal between OXY + Chevron the next morning before markets opened.

Appendix: Oil & Gas Synergy Value

• Deal synergies are estimated in terms of annual pre-tax cash flows, but the benefits from consolidation in an oilfield are different.
• Consolidation benefits will logically dissipate as cash flow from assets that are acquired and operations end
• Companies like OXY + Chevron need to build a model that calculates the NPV over a finite time horizon vs. using a perpetuity terminal value.
• Use synergies on field operations for 8-10 years, discounted at a tax rate of 8-10%.
• When valuing oil + exploration companies like Anadarko, the sample of relatable companies trade at multiple that ranges an average of 5x EBITDA range.
• It makes no sense for cash savings to make that the cost savings are valued more highly than cash flow from the core assets themselves; therefore the consolidation benefits should be ~4.5x tax synergy.
• Capital savings can be thought of as a rough equivalent to expense savings versus a reduction of investment & would be worth more because some of the tax shield lost from reducing capex vs. expenses doesn't come until later in the future.

Explore the reason for reversal in US oil production trends. Understand fracking process and its steps. Learn about the largest share of new oil production from the Permian Basin.