The Anadarko Case PDF: Oil, Gas, Fracking, and Mergers

1/27/2025 Fracking Together The 2019 Anadarko Merger* It was April 11, 2019, humid and mostly cloudy in Houston. The temperature outside hit an uncomfortable 80° by midday, but none of the lawyers, bankers and company management n...

1/27/2025 Fracking Together The 2019 Anadarko Merger* It was April 11, 2019, humid and mostly cloudy in Houston. The temperature outside hit an uncomfortable 80° by midday, but none of the lawyers, bankers and company management noticed as they milled around a large conference room inside, bracing for a long day and a difficult decision ahead. The board of directors of Anadarko Petroleum (“Anadarko”) was weighing two acquisition proposals, one from Chevron Corporation (“Chevron”) and the other from Occidental Petroleum (“OXY”). The Chevron price & terms were settled, while there were still a number of open issues in the OXY proposal, although Vicki Hollub, CEO of OXY, indicated she believed an agreement could be signed that night. The Anadarko board met telephonically that day to review the proposals, as they had over several days of negotiations, and Anadarko management had the board’s blessing to make a deal. It was likely to be a long night. Context: Fracking and the Permian Basin The Anadarko case is about three companies in the oil & gas exploration and production (“E&P”) industry. Although most of the key takeaways we will cover in class are not specific to oil & gas, deeper appreciation of the case would require some knowledge of the industry. For a general M&A course with only one class dedicated to this case, it is impractical to cover much explanatory material on the subject. In this writeup I have only included a modest amount of information about a specific area of oil & gas, fracking, which is the latest generation oil & gas production technology. And, depending on available time, I might take a few minutes at the beginning of class to elaborate further on fracking, because it is an interesting topic in today’s world. But beyond that, students will have to go to www.eia.gov or one of any number of other well-known sources of data & analysis to get additional background material on the subject of energy in general and/or oil & gas in particular. The US has always been a large consumer and producer of oil, but US market share of global crude oil production had been in substantial decline over many years until the mid 2000s. At that point the decline reversed dramatically. Exhibit 1 lists top oil producers by country as of the time of the case, 2018, and you will see that the US was back on top of the list. The reversal for the US was due to a new technology, anecdotally referred to as fracking, that allows recovery of oil trapped in underground shale rock formations that had previously been * This case writeup has been abridged from prior versions and has been prepared to facilitate class discussion in Sloan 15.445 Mergers & Buyouts. It is available only to registered students and should not be distributed outside the course. The write-up was prepared solely from outside sources, and although the important facts of the case are not in dispute, the description of people and events may not be entirely accurate. Most of the information in the write-up has been gathered from publicly available sources, primarily company filings with the SEC on EDGAR, as well as your instructor’s general knowledge of transactions and oil & gas, in which case citations have been omitted. In some cases, missing information has been filled in without further research to simplify the storyline.. 1 inaccessible using conventional drilling & production tools. Exhibit 2 illustrates the huge growth in US production over recent years as a result of fracking. The process involves: 1) drilling very deep below the surface into shale rock that contains trapped oil & gas; 2) turning the drill bit sideways underground and drilling horizontally through the rock; 3) injecting a solution of water, sand and chemicals at high pressure into the drill pipe, forcing the solution to blast through perforations in the pipe into the surrounding rock, causing the rock to fracture [hence the term “fracking”]; and 4) withdrawing the solution and allowing oil & gas that is present in the shale rock to flow through the fractures into the pipe and back up to the surface. Exhibit 3 is one of many cartoon diagrams of fracking that can be found on the internet and elsewhere. Note in Exhibit 2, the largest share of new oil production from fracking comes from the Permian Basin, a large oilfield located in west Texas. Oil had always been produced over the years in the Permian, but the advent of fracking increased its importance – it is now one of the largest producing oilfields in the world. Exhibit 4 is a list of the largest E&P companies operating in the Permian at the time of the case, ranked in terms of acreage & production. A company controls acreage by ownership, lease, mineral rights, etc, and it is the oil lying beneath that acreage that can be extracted and sold by the company. The largest Permian acreage position in the table belonged to OXY, followed by two US major oil companies, Chevron and ExxonMobil. Anadarko was listed as having the 7th largest acreage position in the Permian Basin. Although the revival of US oil production was a story of success at the time of this case, fracking technology presented serious economic and financial challenges for the E&P companies that were involved. First of all, it was an expensive way to produce oil. The breakeven point for fracking wells in terms of the price of the product sold was much higher than conventional production. Depending on the particular situation and oilfield, oil prices had to be well above $50/BBL for fracking to be profitable and justified. But crude oil is a globally traded commodity and the market price of oil is determined by factors outside any one company’s control. For several decades prior to 2004, oil prices never got much above ± $20.00. After that point, growing global demand and dimishing production from conventional sources began to drive up oil prices high enough to start the fracking revolution. Figure 1. Source: EIA. Breakeven bar added. 2 The volatility of crude oil prices in the 2010s is evident from Figure 1. There have been periods, e.g. 2016 in particular, where overproduction, slower global oil demand and other factors drove crude prices down below breakeven for fracking, and a number of smaller enterprises, including some private equity-backed companies with relatively high debt leverage, wound up in financial distess as a result. Here are some data on quarterly oilfield bankruptcy filings over that period. Figure 2 Source: Haynes Boone Oil Patch Bankruptcy Monitor® Jan 2022 Another issue with fracking is the constant cash investment required. The rate of depletion from a shale oil well can be extremely high in the first couple of years after it has first been put into production, and E&P companies end up like hamsters on a wheel, having to drill more wells to keep pace, with growth requiring constant reinvestment of cash flow. Around the time of the case, given the volatility and uncertainty of oil prices, market investors had begun to push back against the levels of constant reinvestment among oil and gas producers with assets & operations in places like the Permian Basin, pushing companies to return more cash to shareholders; and companies were forced to respond. 1 The marginal economics of fracking wells puts a very large premium on efficiency. The need for efficiency in turn puts a premium on joint operations and consolidation of oil properties where possible in places like the Permian Basin. Larger contiguous acreage gives an E&P company flexibility in terms of well locations & drilling plans, the lateral length of wells, enhanced oil recovery programs, supply chain management and overhead costs, etc. So there is a lot of potential synergy in putting two separate field operations together. And these are the types of syngery, i.e. detailed capital & cost savings on a well-by-well, field-by-field, vender-by-vender basis, that are not hard to estimate and more certain to be achieved than, for example, synergy from revenue enhancements or brand positioning strategy in a case like Gatorade. 2 1 See for example Deckelbaum et. al, “4Q18 E&P Recap; Free Cash isn’t Free”, Cowen Equity Research, 3/11/19. 2 I have included an appendix at the very end of this abridged version of the case writeup which summarizes a few financial takeaways applicable to the estimation of synergy value in an oilfield like the Permian Basin. 3 Anadarko Petroleum Anadarko was first set up in the 1960s as a subsidiary of Panhandle Eastern, a large gas pipeline company headquartered in Houston, TX. The goal was to develop new gas discoveries in the Anadarko Basin, which straddles Oklahoma and the Texas Panhandle. It was later spun out of Panhandle Eastern and ultimately grew into an independent public E&P company with $13B revenue and $23B market value in 2018. Anadarko’s principal assets & operations were from US domestic oil & gas, primarily in areas where fracking dominates production, and mostly concentrated in the Permian Basin.3 Anadarko also had with some other oil & gas and related energy assets. 4 Anadarko was large enough and well enough capitalized that even with oil price volatility and an uncertain future outlook, financial distress and the threat of bankruptcy were fairly remote considerations. But the company faced the same challenges as any other company pursuing a fracking business. That is evident from the three year summary of financial information for Anadarko shown in Exhibit 5. In 2016, the company was only able to sell its oil at an avg price of $40/BBL, which resulted in an operating loss. The company cut capex from prior year, sold assets, cut its dividend and sold equity, in order to avoid adding additional debt leverage and to build cash on its balance sheet for future flexibility. In 2017, the avg sale price of oil got back above $50 and cash flow recovered somewhat near breakeven. Anadarko elected under pressure to buy back $1B of its stock, but reduced capex net of asset sales to add more cash to the balance sheet. 2018 was a better year for oil prices, so Anadarko was able to generate enough cash flow to restore a larger capex budget. At the same time, the company took $3B cash off its balance sheet to appease shareholders and repurchase stock. After all of that, oil prices in early 2019 had seesawed back below $50 again.5 The challenge for Anadarko in the future was to hope for some upside but meanwhile find a sustainable way to both maintain growth and return cash to shareholders in an environment of volatile oil prices fluctuating in a likely range $40 and $60 a barrel. Anadarko was not unique among mid-size E&P companies operating in the Permian Basin looking for solutions for that going forward. Projections. Anadarko projections for 2019-2025 are shown in Exhibit 6 [and in an Excel spreadsheet file posted on Canvas]. Oil prices in the projections were forecast to remain roughly flat between $54-$55/BBL over the five years, consistent with forward pricing in the 3 For interested students I have posted a description of Anadarko’s US domestic oilfield assets on Canvas. 4 The other assets of Anadarko included: 1) offshore oil & gas production in the Gulf of Mexico; 2) oil & gas exploration & production in Algeria and elsewhere in Africa; 3) a liquified natural gas (“LNG”) export facility under development and not yet completed in Mozambique; and 4) a majority interest in Western Midstream Partners (“WES”), which owned and operated oil & gas gathering, pipelines, storage and processing facilities (“midstream operations”) in the western US, servicing both Anadarko as well as third party oil & gas producers in that area. In this abridged version of the case writeup, I will not get into Anadarko’s other assets and options, except as mentioned later in the case in connection with their fit with assets and operations of Chevron and OXY. 5 These prices and the ones shown in exhibits are prices for what is called West Texas Intermediate (WTI) crude oil, which is the standard benchmark for US oil prices but not necessarily the same as Anadarko’s average sale price. Note that after falling below $50 in early 2019, prices crept into to the $60s for a short period around the time of the case, then fell back to the low to mid-$50s, where they were generally expected to stay. 4 market at the time.6 The projections were robust. They reflect what appears to be a belief and commitment from Anadarko mangement that they could squeeze enough efficiency out of capex and oilfield operations to achieve a magical trifecta: 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. There was presumably good analysis and evidence to support the projections, but there was also some risk that numbers like that would be hard to achieve. Shareholder Returns and Valuation. In terms of shareholder returns, Anadarko modestly underperformed its E&P peers on average for several years leading up to the case, as shown in Exhibit 7. The problem was exacerbated by a 39.4% loss in Anadarko value over the last five months of 2018. Exhibit 8 summarizes the analysis of bankers involved in the case.7 By that analysis, the company’s share price appears to be at the low end of the range of valuations based on projected numbers, implying a share price recovery might be expected in the period ahead, which is not surprising given Anadarko’s robust projections. Exhibit 9 is a separate table of comparable company EV/EBITDA multiples for the latest twelve months as of April. As that table indicates, Anadarko appeared to be trading at only a small discount to its peer group. That said, after adjusting for one of the company’s non-E&P assets, it would appear that the remaining Anadarko E&P business was actually trading at a multiple toward the bottom of the peer group range. 8 Taken altogether, there may be an argument that the company was undervalued in the market. That said, it probably makes sense for us to use Anadarko’s market price as a reasonable estimate of the company’s stand-alone value, as we have in other cases. As you can imagine, by 2019 the pieces were in place for a mid-size oil & gas company like Anadarko to become an attractive M&A targets. There were significant synergy gains to be had from consolidation in oilfields like the Permian Basin. But if Anadarko was not willing or able to take the lead in that consolidation, market investors might be better offer with the company as a target of consolidation. With tight cash flow, an uncertain outlook for oil prices, mixed track records, and increasing pressure from investors, all of these companies were at a disadvantage in the market. Anadarko’s projections suggested a way forward that might sustain growth and at the same time allow shareholders to harvest some of the investment in fracking, but the projections might end up being hard to achieve. Perhaps there was no urgency, And the Anadarko board & management team might not have been seeking an acquisition offer, but it should have and would have to take a reasonable offer seriously if it came across the transom. And that is what happened in early 2019. 6 Anadarko also produced projections for an upside scenario, which are included in Exhibit 8 but not in the Canvas spreadsheet. In the upside scenario, oil prices are forecast to increase modestly to $64.50 (WTI) – the company referred to the upside forecast as “Wall Street consensus pricing”. Although Anadarko’s bankers undoubtedly ran a DCF on the upside scenario, the results were not disclosed and don’t appear to have been used in their opinions. 7 There is an Excel spreadsheet file posted on Canvas, with a simple DCF model and a suggested exit multiple and discount rate consistent with the banker analysis. Interested students may want to try their hand at a DCF analysis to get a feel for the numbers – I get to the ballpark but cannot quite replicate the results of either banker – higher than Goldman and lower than Evercore. The two bankers themselves got fairly different results. One of the complications was due to the difficulty valuing one of Anadarko’s non-E&P assets – its majority interest in a mid- stream pipeline, processing & storage business, WES. We won’t have time to focus on that issue in this case. 8 A number of analysts at the time took the position that…. 5 Chevron Along with ExxonMobil, Chevron is one of the last two major oil companies left in the US. It was originally part of Standard Oil, and became Standard Oil of California (“SOCAL”) in 1911 after the parent company was forced to break up for antitrust reasons. Over the years, the company absorbed a number of other major oil companies by acquisition, including Gulf, Texaco and Unocal, and changed its name to Chevron. It remains an integrated oil company in that it has both an “upstream” business of finding and producing oil & gas, i.e. E&P, and a “downstream” business of refining & marketing gasoline and related products, as well as some petrochemical operations. The company’s footprint is worldwide with $164B revenue in 2018. Anadarko was a logical fit for Chevron and there were a number of different places a combination would save money. 9 Consolidation in the Permian Basin would result in significant synergy. Chevron estimated annual cost savings of $1B, along with an ability to reduce annual capital spending by $1B by high-grading E&P opportunities. 10 ± $9B is a good estimate to use in the case analysis as expected NPV of synergy for Chevron. [Note: there is a one-page appendix at the end of this writeup as well as an Excel spreadsheet posted on Canvas to explain how to convert estimated annual synergies into NPV in this situation.] Chevron’s Offer. On February 6, 2019, Michael Wirth, Chairman and CEO of Chevron, presented Anadarko with an acquisition offer for $64 per share, with 25% or $16 of the price paid in cash and the rest in Chevron stock. 11 The offer was below where Anadarko had traded through the middle of 2018 a year earlier, but it was a considerable premium to Anadarko’s closing price on February 5. The Anadarko management & board felt it was in the best interest of its shareholders to sign a confidentiality agreement with Chevron and enter discussions to see if an acceptable deal was possible. Certain Deal Terms. While Chevron pursued its due diligence, the two sides negotiated a merger agreement. A lot of that negotiation centered around proposed language related to what are called fiduciary outs and termination fees. These are important deal terms in M&A which we will discuss in class, so let’s go over them briefly here. Start with the perspective of the potential buyer, e.g. Chevron in this case. If a deal can be made, a buyer would like to avoid the possibility that the target seller will subsequently abandon the deal to accept a superior 9 Although this abridged version of the case writeup does not drill into Anadarko assets beyond fracking, there were numerous overlaps in offshore Gulf of Mexico production, where both companies had producing properties. Chevron was also a major LNG operator in Australia, Angola and many other locations, so Anadarko’s Mozambique development was in Chevron’s wheelhouse. Anadarko’s majority interest in WES may not have been a particularly good fit, but Chevron could presumably develop a strategy to realize its value. 10 If we assume $1B capex reductions mean Anadarko & Chevron combined could achieve the same pretax cash flow as before with less spending, then as a first cut cost savings and capital savings are roughly equivalent. Capital savings would be worth more because some of the tax shield lost from reducing capex comes later in the future. 11 Building on what we covered in the Gatorade case, the Chevron offer had an advertised value of $64, meaning the exchange ratio for the stock component of the deal would be calculated based on the price of Chevron shares at the time the merger agreement was signed, and that ratio times the Chevron share price plus the per share cash component of the deal would then add up to $64. If the Chevron price increased after the merger agreement was signed, the actual value of the deal for OXY would be higher than the advertised value, and vice versa. 6 proposal from another company. Assuming it has made a compelling offer, the buyer is usually successful in negotiating language in the merger agreement that prohibits the target from actively soliciting further interest from other potential bidders.12 In many cases, the buyer will be successful in negotiating even stronger language that prohibits the target from even talking to or cooperating with another potential bidder.13 There is a limit, however, to how far a target board will go to lock up a buyer’s deal. Virtually all merger agreements include what is called a fiduciary out, which allows the target company to break a merger agreement and accept an unsolicited proposal from another bidder as long as that proposal is demonstrably superior to the original deal. 14 In its negotiations with Anadarko, Chevron pushed hard to limit the fiduciary out as much as possible, but ultimately to no avail. 15 A merger agreement is a contract. When and if one side terminates the contract, for example a target seller terminates in order to accept a superior proposal, the other side will be able to collect damages, the amount of which may be specified in the agreement. For example, it is very common in M&A for a buyer to receive a termination fee or breakup fee if a target seller abandons the agreement to accept a superior acquisition proposal from another company. 16 From the buyer’s perspective, a breakup fee provides some protection against losing a deal to another bidder who is only willing and able to pay a small increment more to make a competing proposal. Since the other bidder, if successful, ends up with an additional financial obligation to 12 In some cases, particularly in a negotiated deal where there has been no auction, merger agreements will actually call for a limited period after a merger agreement has been signed for the target seller to solicit additional bids. We will discuss that approach further in later cases, particularly as we get into topics around PE buyouts. A clause that prohibits the solicitation of additional bids is referred to as a “no shop” clause. 13 A clause that prohibits communication & cooperation is sometimes referred to as a “no talk” clause. 14 There is a formal process to arrive at the conclusion that another unsolicited proposal is superior to the original deal, which involves the opinions of bankers and lawyers advising the board. The original buyer has an opportunity to revise its own price in response. This is referred to as a fiduciary out because the language allows the target to get out of the deal, and because corporate directors owe a fiduciary duty to the company and its shareholders to seek the best deal possible in a sale. That is a topic we will return to when we discuss unsolicited takeovers. 15 Chevron wanted language in the merger agreement that Anadarko would be required to submit its deal for approval by Anadarko shareholders even if the Anadarko board was no longer prepared to recommend the deal because another superior offer had been received. It is not unusual for proposals that are opposed by a board to be put to a shareholder vote – it happens regularly under SEC rule 14a-8 when companies are required to include certain unsolicited shareholder proposals in their annual proxy solicitation. But having shareholders vote on two competing M&A proposals would be quite unusual and an unflattering abdication of a board’s responsibility, so it is not surprising that Anadarko vigorously opposed and did not agree to Chevron’s “force-the-vote” provision. 16 There are in fact many different types of termination fees inserted into merger agreements to deal with other situations as well, and hopefully we will have some opportunity in class to talk about some of them. One such example relates to antitrust. Target sellers can sometimes negotiate a significant termination fee paid by the buyer to the seller if a deal has to be terminated for antitrust reasons. It is not a capricious payment for bad luck. There are many ways a buyer can satisfy regulators and solve an antitrust problem, e.g. by selling certain valuable assets, and the prospect of paying a significant fee may induce the buyer to be flexible in that regard. Another example of a termination fee that is common in merger agreements has come to be called a “reverse termination fee”. It is a fee owed by the buyer to the target seller if the buyer breaks the merger agreement for any reason other than in response to certain specified events, i.e. it is a substitute for a buyer breaking an agreement for what is called a material adverse event. Over various time periods in recent decades, reverse termination fees have become increasingly common in PE buyouts, and they essentially amount to giving the PE buyer a put option. 7 pay the breakup fee, it would have to be willing to top the original price by at least the amount of the fee to justify a competing bid. A typical breakup fee would be equal to about 3% of a deal’s value, and in this case Chevron was demanding a $1B fee be included in the merger agreement. 17 So once a merger agreement was signed, anyone else would have to pay at least $1B more and Chevron would walk away with a consolation prize. From the perspective of a target seller, the breakup fee is a classic device to induce a bidder to make a strong bid in the first place. A good way to think about how that works is to focus on the process used to sell assets in a bankruptcy situation. In bankruptcy, one or more potential buyers for assets being sold will submit bids. One of the potential buyers is selected as a “stalking horse” and signs an agreement to the buy the assets at a particular price. A few weeks later the bankruptcy court will hold a formal auction among interested bidders. If the auction price does not come in any higher, or if there are no qualified bidders in the auction, the stalking horse gets to buy the assets as agreed. If the auction price does come in higher, the high bidder gets to buy the assets and the stalking horse gets a breakup fee. In a bankruptcy sale, most potential buyers would be reluctant to be a stalking horse for a competing offer if there were not a breakup fee involved. In the broader M&A community, the same principle applies. The fee can be a good inducement to facilitate competitive bidding. So Anadarko, like most potential sellers, was willing to offer Chevron a breakup fee as long as they concluded the price Chevron was offering was fair & adequate. Occidental Petroleum (“OXY”) OXY is a California company with a colorful history. In the 1950s, Armand Hammer acquired a controlling interest and assumed the role of CEO at OXY, where he remained for many years. 18 Hammer was born in and well-known for close ties to Russia, and was a highly visible figure in US business, political & philanthropic circles until he died in 1990. Under Hammer’s leadership, OXY became involved in many E&P projects around the world and 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. The company has considerable investments in unconventional oil shale reserves and production, as indicated by its lead position in acreage and production in the Permian Basin. OXY had $18B revenue in 2018. The CEO of OXY at the time of this case in 2019 was Vicki Holub. OXY had a strong motivation to acquire Anadarko. The potential synergy in the Permian Basin was significant, since OXY was the largest player in the Permian (see Exhibit 4) and presumably had many properties that were contiguous with Anadarko. There were overlaps in some other fracking locations in the US as well. Based on expected field efficiencies, OXY believed it could generate annual cost savings of $2B, along with an ability to reduce annual capital spending by $1.5B by high-grading E&P opportunities. So OXY’s synergies estimate pencils out a lot higher 17 It is important for you to note that the termination fee in this and most cases is significantly larger than the expenses incurred by a buyer in the deal. The purpose of a termination fee is not simply to reimburse expenses. 18 Multiple sources, for simplicity see e.g. Wickipedia. Mr. Hammer was well known to most people at the time. 8 than Chevron. Using the same approach as before, the NPV estimate is $3.5B x 4.5 = ± $15B, rounded down to be conservative, which we can use for purposes of our case analysis. Synergies beyond fracking if OXY were to acquire Anadarko were not very compelling. On the one hand, less synergy is obviously not a good thing. But on the other hand, OXY did not have the financial heft of a Chevron and Anadarko was a big company, so the opportunity to sell off some of its assets and operations after a merger could be helpful in mitigating the acquisition cost, depending on how much cash OXY would have to spend in the deal. 19 OXY’s Offer and Subsequent Negotiations. OXY had approached Anadarko unsuccessfully on more than one occasion in the past about a possible transaction. On March 23, 2019, presumably prompted by suspicion that Anadarko was in discussions with another potential buyer, 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. 20 Chevron decided not to respond with a bid increase at that point, and since OXY was offering a higher price, 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 were a little more tortuous than negotiations with Chevron. Like Chevron, OXY’s original proposal was comprised of 25% cash and 75% stock. Unlike Chevron, because of the relative sizes of Anadarko and OXY, Anadarko shareholders would end up owning pro forma 37% of the combined companies. In fact, under its offer, OXY would be issuing about 437M new shares of stock. It turns out 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. 21 OXY shareholders would also have to vote up or down on the merger as well, since NYSE rules require that buyer shareholders vote whenever at least 20% of its common stock is being issued in a transaction. 22 There was obviously a risk that either or both of those might not get 19 Compared to Chevron, OXY did not have any offshore Gulf of Mexico or other foreign oil & gas operations that overlapped with Anadarko, where possible tie-ins and cost savings might have been possible. Further, compared to Chevron, OXY had no exposure to or experience developing and operating an LNG facility such as Anadarko was building in Mozambique. From OXY’s perspective, that may have actually been an advantage, since the foreign oil & gas assets and the Mozambique LNG development could be sold off afterward to help finance the deal! OXY did own a few complimentary midstream processing & pipeline assets in the western US, and there may be some synergies for OXY in owning Anadarko’s majority interest in WES, although that is hard to evaluate. 20 As noted in footnote 16 above, $76 was the advertised offer price based on OXY closing price when the agreement was signed. The actual value would depend on OXY’s share price when the merger closed. 21 As noted at the beginning of the course, the maximum number of shares a company is authorized to issue is specified in the company’s certificate of incorporation/charter. Amendments to a charter cannot be made by the company board without shareholder approval. Unless specified elsewhere in the charter, an amendment requires an absolute majority of shareholders, not just a majority of shareholders voting. Since many shareholders often do not bother to vote, getting an absolute majority of shareholders to agree on something is harder than getting a majority of shareholders voting to agree on something. 22 As noted at the beginning of the course, a majority of mergers (including this one) are structured as “reverse triangular mergers” between a target company and a subsidiary of the buyer. In such cases, a merger vote by the subsidiary’s shareholders is nothing more than a vote by the buyer itself, since the parent owns 100% of the stock. 9 approval from OXY shareholders. 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. On April 8, after revisiting its funding sources, OXY compromised and came back with another proposal comprised of 40% cash and the rest in OXY stock. But that was as far as OXY could go in offering cash in the deal without securing additional financing, which would have required more time to arrange. By reducing the share component in its offer, OXY avoided the need for a shareholder vote on a charter amendment to authorize more shares, but the revised deal did not get under the 20% threshold for the NYSE, so 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. Meanwhile, time was becoming an issue, since there was a risk that Chevron might walk away at some point. In exchange for increasing the cash component of its offer and reducing the stock component to 40%, OXY lowered its offer price to Anadarko from $76 to $72 per share. That was not well received. In reaction to the price reduction, Anadarko immediately re-engaged Chevron, which agreed to raise its offer to an advertised value of $65 per share, comprised of 25% cash and the rest in Chevron stock, as before. Chevron was aware that Anadarko had begun talking to another potential buyer, but did not agree to any further improvement in terms, and eventually threatened to withdraw its offer entirely if Anadarko did not go ahead and sign the agreement on their deal at $65 per share. As it became apparent to OXY that the deal might be lost, 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. So that’s where matters stood on April 11th. The Decision Which of these two proposals would be the best for Anadarko shareholders? The board wanted a final decision made by the evening of the 11th. Once the decision was made, the plan would be to sign a merger agreement and announce a deal the next morning before markets opened. There would be a press release, and the CEO of the winning bidder would plan a few early morning interiews with the business press, e.g. an appearance on CNBC Squawk Box might be on the dance card, followed by an analyst call. A few victory laps. As you remember from the Gatorade case, market reaction to M&A news like this can make a big difference. Note: Figure 3 on the next page provides a summary term sheet comparison of the two proposals in front of Anardarko. Therefore a merger vote by the buyer’s shareholders is not legally required. However, a rule of the NYSE does require a merger vote by the buyer’s shareholders if 20% or more of the buyer’s common stock will be issued in a deal. That requirement would have been triggered by OXY’s proposal. 10  Figure 3 Comparison of Proposals Terms Chevron Proposal OXY Proposal Deal Structure A wholly-owned subsidiary of Chevron would be A wholly-owned subsidiary of OXY would be merged into Anadarko, and Anadarko shares merged into Anadarko, and Anadarko shares would be cancelled in exchange for the right to would be cancelled in exchange for the right to receive cash & Chevron stock, with Anadarko receive cash & OXY stock, with Anadarko becoming a Chevron subsidiary becoming an OXY subsidiary Merger Each Anadarko share would be converted into: Each Anadarko share would be converted into: Consideration $16.25 cash plus a fraction of Chevron shares to $30.40 cash plus a fraction of OXY shares to add up to $65 per Anadarko share calculated add up to $76 per Anadarko share calculated immediately prior to signing an agreement. 23 immediately prior to signing an agreement. Share Exchange Set on signing of the agreement; the ratio is Set on signing of the agreement; the ratio is Ratio fixed with no collar fixed with no collar Tax Treatment Structured as a tax-free reorganization with Structured as a taxable transaction with taxable gain to shareholders deferred on the immediate taxable gain to shareholders on stock portion of the merger consideration. 24 both portions of the merger consideration Appraisal Rights Dissenting shareholders can petition for Dissenting shareholders can petition for appraisal rights under §262 of DGCL appraisal rights under §262 of DGCL Conditions on Antitrust approval; majority vote by Anadarko Antitrust approval; majority vote by Anadarko Closing shareholders; other typical conditions shareholders; majority vote by OXY shareholders; 25 other typical conditions Financing No financing condition to closing, although No financing condition to closing, although specific sources of funds for the cash portion of specific sources of funds for the cash portion of the transaction had not yet been identified the transaction had not yet been identified Shopping & Anadarko not allowed to negotiate terms, Anadarko not allowed to negotiate terms, Termination Rights provide proprietary info or recommend any provide proprietary info or recommend any alternative offer; unless an unsolicited offer is alternative offer; unless an unsolicited offer is demonstrably superior to the Chevron deal demonstrably superior to the OXY deal Termination Fee $1B paid by Anadarko to Chevron if an $1B paid by Anadarko to Chevron if an alternative offer is subsequently accepted alternative offer is subsequently accepted Transaction Costs Assume fees & expenses of $50M Assume fees & expenses of $50M 23 Companies do not issue fractional shares of common stock, so in a merger, fractional shares are paid in cash. 24 Note that capital gains on a non-taxable transaction are not eliminated – they are simply deferred until the shareholder subsequently sells his or her stock. In any event, since Anadarko shares had fallen in price significantly prior to the transation, comparative tax treament for the two bids was arguably less important in this case. 25 Both proposals are structured as “reverse triangular mergers” which eliminates the requirement under Delaware law for approval by buyer shareholders. However, NYSE rules require approval by buyer shareholders if more than 20% of buyer shares are issued in the transaction, which would be the case in the OXY proposal. 11  Exhibit 1 Oil Production & Consumption 12  Exhibit 2 US Oil Production 26 Trends & Forecast 2016 26 As presented by the EIA, “tight oil” production encompasses drilling & extraction from a range of shale and other rock formations using modern, unconventional technology, primarily horizontal drilling techniques and hydraulic fracturing (“fracking”). “Nontight oil” production per EIA, which comprised the vast majority of US oil production prior to the last decade, encompasses conventional onshore & offshore drilling & extraction. Note that the exhibit is limited to oil production and does not include natural gas or natural gas liquids (NGLs), the production of which has also materially increased with the advent of unconventional drilling technology. Note that by comparison to conventional oil & gas production, there was a significant short-term decrease in tight oil production due to a fall in oil price around 2016. 13  Exhibit 3 Unconventional Drilling Shale Oil & Hydraulic Fracking Note: Image sourced from the internet. 14  Exhibit 4 E&P Companies in the Permian Basin Major Companies by Acreage, 2018 Major Companies by Production, 2018 GlobalData, Permian Basin the US, 2019 – Oil and Gas Shale Market Analysis and Outlook to 2023, Report Code GDGE0302MAR, May 2019, p.s 20,22 15  Exhibit 5 Anadarko Petroleum 2016-2018 Financial History Anadarko Summary Line Items 2018 2017 2016 Percent Revenue from Oil & Gas Activity 81.4% 76.4% 76.4% Annual Sales Volume in MMBOE 243 245 290 Average Sale Price for Oil per BBL 27 $65.51 $50.66 $40.34 Operations Consolidated Revenue 28 $13,382 $11,908 $7,869 EBITDA 29 $7,432 $5,726 $4,073 EBITDA Margin 55.5% 48.1% 51.8% Cash Flow Requirements Net Cash from Operations after DD&A $1,675 ($270) ($1,301) Add Back DD&A $4,254 $4,279 $4,301 Acquisitions and Capex ($6,183) ($5,006) ($5,245) Property Divestitures $417 $4,008 $2,356 Other Items, Net ($787) ($753) ($160) Dividends and Share Repurchases ($3,260) ($1,203) ($143) Consolidated Requirements ($3,884) $1,055 ($192) Outside Financing Sale of Common Stock & LP Units $3,351 Net Debt Additions/(Repayments) $728 $366 ($345) Consolidated Financing $728 $366 $3,006 Result Change in Anadarko Cash ($3,156) $1,421 $2,814 Dec 2018 Balance Sheet Consolidated Debt $16,417 Cash on Balance Sheet $1,295 Net Debt $15,122 27 Average annual price net to Anadarko, excluding the impact of hedging derivatives. Average prices for natural gas & NGLs are not shown, but follow similar trends, with 2016-2018 growth in gas prices somewhat more muted. 28 The largest share of Anadarko revenue is from oil & gas sales, primarily in the domestic US, but 18.6% of 2018 revenue was attributable to Western Midstream Partners (“WES”), which owns pipeline systems in the western US, some of which connect Anadarko field production to markets elsewhere. Although WES is a separate MLP which is 45% owned by public limited partners, Anadarko is the general partner and the MLP is fully consolidated into Anadarko financials. For all intents and purposes, WES is an Anadarko subsidiary. 29 The line item is actually EBITDAX. EBITDAX is essentially EBITDA with exploration expense added back. The adjustment allows analysts to adjust for accounting variation in exploration expenses across time periods and companies, so EBITDAX is often used in place of EBITDA for valuation, such as for example by the banking advisors involved in the Anadarko case. 16  Exhibit 6 Anadarko Petroleum Company Projections 30 The following table summarizes the Anadarko management forecast as of April 2019 for the fiscal years 2019 through 2025 ($ in millions). The forecast was prepared with two commodity pricing scenarios: one based on oil & gas futures as of February 25, 2019, which in the case of WTI oil price declines from $55/BBL to roughly $54/BBL over five years; and the other based on a “Wall Street consensus estimate” of oil & gas prices as of the same date, which in the case of WTI oil price increases from $59/BBL to $64.50/BBL over five years. 2019 2020 2021 2022 2023 2024 2025 Strip pricing case Total Net Production (MBOE/D) 728 774 834 912 973 1,086 1,198 Consolidated EBITDAX (1) $ 7,691 $ 8,641 $ 9,023 $ 9,945 $ 10,538 $ 11,687 $ 12,874 Consolidated Capital Expenditures (2) $ 6,042 $ 5,781 $ 6,048 $ 6,366 $ 5,806 $ 5,371 $ 5,260 Unlevered Free Cash Flow (3) $ 49 $ 1,951 $ 1,965 $ 2,492 $ 3,646 $ 5,076 $ 6,227 Wall Street consensus pricing case Total Net Production (MBOE/D) 728 774 834 912 973 1,086 1,198 Consolidated EBITDAX(1) $ 8,519 $ 9,785 $ 10,813 $ 12,068 $ 12,890 $ 14,292 $ 15,690 Consolidated Capital Expenditures(2) $ 6,042 $ 5,781 $ 6,048 $ 6,366 $ 5,806 $ 5,371 $ 5,260 Unlevered Free Cash Flow (3)(4) $ 670 $ 2,809 $ 3,308 $ 4,084 $ 5,410 $ 7,030 $ 8,339 (1) Consolidated EBITDAX is defined as net income (loss) before income taxes; interest expense; depreciation, depletion and amortization; exploration expense; gains (losses) on divestitures, net; impairments; total (gains) losses on derivatives, net, less net cash from settlement of commodity derivatives; and certain items not related to Anadarko’s normal operations. Consolidated EBITDAX is a non-GAAP financial measure as it excludes amounts included in net income (loss), the most directly comparable measure calculated in accordance with GAAP. This measure should not be considered as an alternative to net income (loss) or other measures derived in accordance with GAAP. Consolidated EBITDAX differs from Adjusted EBITDAX historically reported by Anadarko due to its exclusion of amounts of net income attributable to noncontrolling interests. (2) Consolidated capital expenditures includes the following assumed capital expenditures of Western Midstream Partners, LP: 2019 - $1,157; 2020 - $984; 2021 - $839; 2022 - $1,037; 2023 - $752; 2024 - $625; 2025 - $641. (3) Unlevered Free Cash Flow is defined as net income (loss) before interest and taxes, less unlevered taxes, plus depreciation and amortization, plus (less) changes in working capital, less capital expenditures (and other investing cash flows excluding capitalized interest expense), plus non-cash exploration expense, plus other non-cash items. Unlevered Free Cash Flow is a non-GAAP financial measure as it excludes amounts included in net income (loss), the most directly comparable measure calculated in accordance with GAAP. This measure should not be considered as an alternative to net income (loss) or other measures derived in accordance with GAAP. Unlevered Free Cash Flow differs from the definition of Adjusted Free Cash Flow historically provided by Anadarko due to its exclusion of interest expenses and associated tax shield when including impact of tax expenses. (4) Footnote & table entries added by instructor. Cash flow projections using Wall Street consensus pricing were inadvertently left out of the relevant disclosures and had to be estimated. The only difference between the two scenarios is oil & gas prices. Therefore, cash flow in the second scenario is estimated as cash flow in the first plus the after-tax difference in projected EBITDAX, using a tax rate of 25% based on US federal & state taxes. 30 Data & notes taken directly from Anadarko disclosures, except for data per footnote (4). 17  Exhibit 7 Anadarko Share Price Performance 2004-2018 Monthly 200 Oil Price E&P Peer Index Anadarko 150 100 50 0 Sources: Anadarko & peer index returns are from CRSP. Peers are the companies listed in Exhibit 8 ex Chesapeake. Oil price is WTI monthly prices from EIA. Note that returns include both dividends and changes in share price. 18  Exhibit 8 Selected Banker Valuation Ranges 31 Valuation Metrics Range Anadarko Share Price $46.80 Comparable Multiples: EV/2019 EBITDA $35.34 – $53.83 Based on Projections: Comparable Multiples: EV/2020 EBITDA $41.19 – $69.96 Goldman DCF Analysis $41.92 – $69.48 Evercore DCF Value per Share $56.41 - $76.49 31 The banking advisors to the Anadarko board were Goldman Sachs and Evercore. Anadarko and comparable company market values were calculated as of April 11. Dates for comparable company estimates for EBITDA used in the multiples analysis are not known. Analysis presented by the two bankers were different in several respects, and assumptions were not the same. The table in Exhibit 9 is only a subset of results that were presented, but it is enough to capture the essence of banker valuation work on a forward-looking basis. 19  Exhibit 9 Selected Comparable Companies 32 Data as of April 11, 2019 Comparable Market Enterprise EV Ratio to Debt Ratio to Companies Value ($Bs) Value ($Bs) EBITDAX 33 EBITDAX Apache Corporation $13.4 $23.3 4.9x 1.7x ConocoPhillips $75.0 $89.3 4.8x 0.4x Chesapeake $5.4 $15.0 6.1x 3.9x Devon Energy $12.9 $17.4 6.0x 1.5x EOG Resources $57.3 $62.2 7.3x 0.6x Hess Corporation $19.3 $26.6 8.5x 1.4x Marathon Oil $14.1 $19.3 4.9x 1.1x Noble Energy $12.0 $18.2 6.7x 2.3x Occidental (OXY) $50.2 $58.8 6.5x 0.9x Pioneer Resources $25.4 $26.7 7.8x 0.4x Range 4.8x – 8.5x 0.4x – 2.3x 34 Average ex Hess 6.3x 1.4x Median ex Hess 6.3x 1.3x Anadarko $23.4 $45.6 5.9x 2.1x Pro Forma Anadarko ex WES 35 $29.9 4.9x 1.4x 32 The table lists the E&P companies which were included in Anadarko filings as comparable, excluding Chevron which was omitted due to its size and fully integrated status as a major oil & gas company. 4/11/2019 market values were calculated based on Yahoo! share price data since CRSP files for 2019 were not yet available when the table was produced. Other info was based on company filings. 33 EBITDAX has been previsouly defined as EBITDA with exploration expense added back. The adjustment is commonly used bycompanies, analysts & bankers in the E&P. The EBITDAX #s are estimates for 3/31/2019 LTM. 34 Excluding Chesapeake which filed for bankruptcy in 2020. Chesapeake was included in the table only because it was one of the comparable companies included by Anadarko in its filings. 35 The multiple for Anadarko is a blended average of multiples for its E&P operations and its midstream assets, i.e. WES. Based on the market trading value of WES LP units at the time, the calculated enterprise value of WES was $19.3B and EBITDA, which was reported separately by Anadarko, was $1,566. By implication, WES carried an EBITDA multiple of 12.4x, which was part of the reason the blended average multiple for the company as a whole was as high as it was. As noted above in the write-up, specifically footnote Error! Bookmark not defined., the b ankers chose to value WES based on company cash flow forecasts rather than its market price at the time. The result, at least in the case of one of the banker where inferences are possible, appears to have reduced the WES LP unit value by 30%, so that the WES enterprise value on that basis would have been $15.7B with an EBITDA multiple of 10.0x. To stay consistent with the bankers, that is the value adopted in the table, i.e. the Anadarko enterprise value attributable to E&P operations only would have been $29.9B on EBITDAX of $6,102, which is net of WES EBITDA. Backing WES out of the numbers therefore results in a multiple of 4.9x, which is well below the peer group average, although it is almost exactly on par with three of the comparable companies: Apache, ConocoPhillips and Marathon Oil. 20 Appendix: Oil & Gas Synergy Value Deal synergies are estimated in terms of annual pre-tax cash flows, which are usually assumed to continue indefinitely. But the benefits from consolidation in an oilfield are different. Production from a finite amount of oil reserves that are already in place in a particular field will be depleted as they are produced & sold, and over time, production shifts elsewhere to other new reserves & operations. As cash flow from assets that are acquired runs off, the consolidation benefits associated with those assets will logically dissipate, i.e. capital & cost savings from buying acreage & reserves in, for example the Permian Basin, are not a perpetuity. So companies like Chevron and OXY considering the acquisition of a company like Anadarko, for example, should and would build a model that calculates NPV of capital & operating cost savings over a finite time horizon instead of using a perpetuity terminal value. For interested students, I have included a simple spreadsheet in the Excel file on Canvas to illustrate the difference that a finite horizon for synergies can make. The spreadsheet assumes a uniform amount of annual pre-tax synergy in field operations for 8-10 years, for example, brought back to present value at 8-10% discount rates. 36 Synergy in this case was essentially an annuity over some specified number of years, which is easy to calculate in finance. At a midpoint of 9 years and 9% discount rate, $100 of annual pre-tax synergy would generate $469 of after-tax NPV, which is a 4.7x multiple of annual synergy. By contrast, if the annual synergy were a perpetuity, the midpoint NPV would be 8.7x, almost twice as much. Look at market valuations for E&P companies like Anadarko, summarized in Exhibit 8 and discussed further below. The sample of comparable companies traded at multiples in the ± 5x EBITDA range, with several companies, including Anadarko itself, after certain adjustments, trading below 5x. It would not make any sense for cost savings to be valued more highly than cash flow from the core assets themselves. So a good go-by for consolidation benefits as we go along in this case would be ~4.5x annual pre-tax synergy (rounded down to be conservative). 37 As a final point, note that capex savings in a case like this can be thought of more as a rough equivalent to expense savings versus a reduction of investment, which would normally be accompanied by a reduction in future cash flow. In this case capex reductions typically mean two companies combined in an oilfield could achieve the same pretax cash flow as before with less spending. Capital savings would actually be worth more because some of the tax shield lost from reducing capex [versus reducing expenses] doesn’t come until later in the future. 36 Actual modeling by oil & gas company staff would obviously be more sophisticated than the shortcut version I am using here, but that level of precision is not the point of the exercise. The 8-10 year time frame used may be a bit generous for typical oil & gas reserves, since for example, the reserves-to-production ratio for Anadarko in 2018 was less than that. Equal amounts each year is obviously a simplification and probably also generous, since there is presumably a phase-in period and oil & gas production follows a long-tail decline curve as the reserves are depleted, at which point capital & cost savings would have long since dissipated. The 8-10% discount rates are used to match up with the estimate of Anadarko’s WACC made by the bankers involved in this case. 37 Although it is not always theoretically justified, it is not uncommon for analysts & bankers to use a multiples approach to estimate synergy value. It is a shortcut that should be OK this time for class homework & discussion. 21