Perpetual Petroleum: How Buyouts Can Be the Way Out

The cost per barrel of oil is rarely what one expects it to be. With the low prices in the current market, some companies are looking to buy -- or sell -- to make the most money.

With companies like Noble Energy (NBL) and Whiting Petroleum (WLL) on opposite ends of the bargaining table, incentives are the real motivation behind these profitable, and often lucrative, buyouts. Hear how these -- and other corporations -- played their hands, on today's edition of Industry Focus.

A full transcript follows the video.

Sean O'Reilly: We're talking deals, deals, deals on this energy edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly joining you here from Fool headquarters in Alexandria, Virginia. I am joined today by Tyler Crowe and Taylor Muckerman. How are you today, guys?

Tyler Crowe: Most excellent.

Taylor Muckerman: Doing pretty good, man. It's been a pretty exciting week.

O'Reilly: Yeah. How about those games last night? Before we dive into the stock market?

Crowe: Well, that's maybe not the most exciting part about the week if you're a D.C. fan, just being in Alexandria, Virginia, and all.

Muckerman: There's a lot of them around here. There's some sports hangover going on around here. Around the office.

O'Reilly: There's a -- the jerseys were definitely out around Fool HQ yesterday.

Crowe: Yeah. Not so much today.

Muckerman: Unfortunate, too because there's a lot of Rangers fans in the building.

O'Reilly: Womp-womp. Anyway. So, obviously oil's fallen 50% since last year and everybody since then has been talking about, "Oh, this is going to be -- finally, we're going to see some mergers and all this stuff." We're finally starting to see some. That's what you were eluding to, Tyler. So, this Monday was announced the big news -- Monday morning, I think I got a push notification on my phone from Bloomberg at 7:30 A.M. But Noble Energy is buying...

Muckerman: That's very millennial of you. Push notifications from Bloomberg.

O'Reilly: For all our listeners we were having a debate about what defines a millennial. We'll probably have a Foolish chat about it later.

Crowe: Bloomberg is halfway there because, one, it is because you're getting a push notification, but it's not because it's from Bloomberg.

Muckerman: There's a quiz on PewResearch if you guys want to take a look at that.

O'Reilly: Oh, man. OK. So, my push notification that I got, because I'm a millennial that works in the financial industry, wrote, "Noble Energy is stepping up to the plate and buying Rosetta Resources (NASDAQ: ROSE)." This is the first -- I don't know, would you say it's the first oil-related play? Because, obviously, Shell did their deal. That was more of a natural gas thing.

Crowe: At least in the American shale this is...

O'Reilly: Yeah. Continental United States.

Crowe: This is the first shale-related deal that we've seen so far this year that is of major note. There might have been a couple small transactions, but this was actually a serious buy.

O'Reilly: Right. So, obviousl, Rosetta's stock, they're being bought out so it was up 25%, 30%. But interestingly enough, Noble, as I recall, fell 7%, or 8%. They're paying in stock, why do you guys think that happened?

Muckerman: I don't know. I was kind of surprised by that big of a drop. They didn't pay a terribly high premium for it, it's actually below the average of -- I read, I didn't calculate it myself -- I read that it's below the average of the last five years or so for deals like this. Only 28% above the last 30 days of trading activity. It was 38% on the day, but it was only a 28% increase over the last 30 days.

So, I don't understand exactly why. It seems like it's a good diversification play.

O'Reilly: They're getting more Texas-based shale.

Muckerman: They don't have any Texas-based shale until this deal. And they get into the highly performing Eagle Ford and the highly promising Permian.

Crowe: I guess -- if I were to venture a guess, and I'm not completely certain as to why the investors may have been a little bearish on Noble following this deal -- but if were to venture a guess, the two things that I would see about this was the assumption of Rosetta's debt, which was about $1.8 billion. It sounds like a big number, but if you look at...

O'Reilly: Adding debt in the current energy market's not the best.

Crowe: Right. It doesn't sound like the best idea. However, if you look at Noble, the combined company's debt profile doesn't change too drastically. Both companies will still be in relatively good "liquidity solvency metrics" in terms of total debt to EBITDA. It still looks pretty good.

The other thing that may be of question is the fact, like Taylor just said, Noble doesn't really have any exposure in Texas. So, it's not like we're doing a big overlap where these two companies are like, "Oh, yeah. We've been sharing property for 10 years. We know exactly what each other has and we can use cost synergies and well economics to improve on that."

It's basically, "We're straight up buying Rosetta. We're hoping that well economics that they have is going to be good enough in the future.

O'Reilly: So, since the carnage of the oil industry started, people have been talking about how some of the majors -- the big players -- would start using this opportunity to snatch up shares of shale producers on the cheap. Do you like this deal, Tyler?

Crowe: Here's how I look at this deal. More than anything else, let's look at Rosetta Resources as a pure reserve replacement cost. If you were to tally up all of the proved reserves that Rosetta Resources has based on the price that Noble paid -- including the debt -- we're looking at about $13.65 per proven barrel of oil in the ground.

O'Reilly: That sounds very reasonable to me.

Crowe: That is very reasonable. Actually, for Noble it's an 18% to 20% reduction on what it has been traditionally -- its reserve replacement costs. That is pretty good. It's not a huge deal, but at the same time it's enough to change the dynamics of the company.

O'Reilly: Yeah, as I recall, you sent a report over to me a month ago when I was looking at EOG and they calculated the reserve replacement cost. I was like "What's it cost a lot of these companies to go out and replace their reserves?" The best is $18. So, this sounds very reasonable.

Crowe: Yeah. Most companies in this space, their total reserve replacement costs are somewhere -- some of the better gas companies are doing it in the $8 to $12 range. But somebody who's so heavy in oil -- such as Rosetta Resources -- having it that low is quite good. So, if there are a bunch of companies out there -- like you said, there's big oil companies, there's also some of the larger independent oil and gas players that have much higher reserve replacement costs.

If the industry were to use this as the new merger and acquisition benchmark,saying, "OK, the value of oil and gas today is $13.50 give or take per proven barrel in the ground," there are a lot of people out there who would say that is a pretty good target, and we're going to go after some people.

O'Reilly: So, what does this mean for the industry going forward? Is this the first of many shale acquisitions that you think we're going to see?

Muckerman: I think after the Shell-BG deal everyone's like, "Oh, the floodgates are going to open!" They didn't for a couple weeks, then this deal happened.

O'Reilly: I'm actually surprised it took this long.

Muckerman: Yeah. Barron's had another headline, "Oh, with this deal the floodgates are going to open." I haven't seen another big acquisition, other than the couple we're going to talk about. But they're really unrelated. So, you'd imagine that you'd see some more big deals. But there really isn't any indication that there are some in the works.

Crowe: One thing that I do remember hearing -- and this is maybe part of it, maybe not, I'm not completely sure -- but, Kinder Morgan's CEO Richard Kinder a little while ago was kind of lamenting that there is an awful lot of cheap capital out there for the oil and gas industry. Still, even at prices today. Which is kind of propping up a lot of people who may or may not deserve that cheap capital.

Something like that could slow down this process. A great example: Whiting Petroleum a while ago were looking to get bought out. The prices weren't that attractive at that time, and they said, "We can still access enough capital, keep ourselves going and not have to sell out at a bargain-basement price."

So, if you have something like that going on, it's going to hold back some of these deals.

Muckerman: That does kind of make sense because when you look at the 2007 and '08 oil collapse, banks were not lending out any money during the financial collapse.

Crowe: They wouldn't touch anything.

Muckerman: And then in the '80s interest rates were a heck of a lot higher than they are now. So, you could imagine companies that weren't highly rated would be paying near a fortune to get some money lent to them. So, yeah. That does make a lot of sense.

O'Reilly: That's an interesting point you brought up, Tyler, with Whiting because I completely forgot about that. There were no takers. I almost wonder if...

Crowe: There were takers. Whiting didn't like any of the deals.

Muckerman: I think it was just too early on for people to offer a deal that suited their fancy because the market had just been crushed. People were still trying to figure out what the heck just happened. Oil was less than $50 a barrel at that time.

O'Reilly: Right. Yeah, I almost wonder if Noble would have gotten a better reaction from investors if they would have used up most of the cash on their balance sheet -- but had they paid cash, or something, and not taken on debt and all that good stuff.

Crowe: It's hard to say. We'd have to go back...

O'Reilly: Pure speculation.

Muckerman: Yeah. It was all shares and debt. Yeah.

O'Reilly: Very good. Well, moving on, we actually had a deal the other day pop up as well. Williams Companies (WMB -0.27%) buying out the Limited Partnership -- the Williams Limited Partnership. That obviously was good for shareholders of Williams Partners (NYSE: WPZ) and everything. What are the details, Taylor?

Muckerman: Basically, $13.8 billion just snapping up their Williams Partners who...

O'Reilly: Had they always been separate?

Muckerman: I guess, Tyler, you said it was 2005?

Crowe: 2005. So, it's been 10 years since the Partnership has been publicly traded.

Muckerman: Which seems pretty early on to me. I don't know, in the grand scheme of MLPs. But it definitely seems like they were one of the pioneers, and they've certainly grown to be one of the larger arrangements of this kind. Obviously, not the size of Kinder Morgan, who consolidated on a $44 billion deal, but this is a pretty meaningful play, and if you're a smaller MLP out there you're definitely wondering, "What the heck do they know that I don't?"

Crowe: Well, my guess is -- more than anything else -- one of the things they did mention on this deal, pretty much Williams Companies' acquisition of its MLP comes down to -- more than anything -- accounting. Taxes and incentive distribution rights.

O'Reilly: That's what I was wondering, because at least with the Noble and Rosetta deal, Rosetta's stock is down big-time from last summer. Whereas Williams has just been hanging out, not really going up, not really going down. I was like, "Why now?"

Crowe: Well, let's talk about these two big things that are a big reason that Williams Partners is doing this right now. That's incentive distribution rights, and depreciation. In other words: taxes. Starting off with IDRs -- incentive distribution rights -- for listeners who don't know what these are.

These are basically a management fee that a limited partnership -- like Williams Partners -- would pay to its general partner. Basically, at the end of every quarter the limited partner will say, "We have this much cash that we can distribute to unitholders." And the general partner says, "OK. Through our incentive distribution rights we get X% of that before you distribute out to each individual share."

The bigger that lump goes, the larger percentage actually goes to the general partner. They get it for management, and fees, and whatnot. However, the longer and longer you have these, the bigger the percentage cut gets, and it makes it more expensive to grow. To raise those distributions, which incents shareholders to actually buy your stock; it becomes harder and harder to do.

O'Reilly: For the partnership, you mean.

Muckerman: Yeah. In this case you have to know that companies have different incentive distribution.

Crowe: Right.

Muckerman: I think, was it Enbridge that doesn't even have them?

Crowe: Some don't.

Muckerman: Williams Companies, definitely not.

[crosstalk] 

Crowe: This past quarter the Williams Limited Partnership would have paid -- or did pay -- based on the back-of-the-napkin calculations I did, they paid about $250 million in incentive distribution rights.

So, we're looking at $800 [million] to $900 million per year, in just management fees that Williams Partners has to pay to the general company. You do that, it increases your cost of capital, it makes it more difficult to access the debt markets, more difficult to raise new equity, makes it more expensive to build.

Now, when you have Williams Companies, who is, I want to say, in the $20 [billion] to $30 billion range; they have $30 billion in projects that they want to build over the next 10, 15 years. Which is about the same size as Kinder Morgan, who is way bigger than they are.

O'Reilly: Way bigger.

Crowe: So, if you're looking at trying to build up that much, cheap capital is going to be huge for them. So, eliminating your IDRs is a big, big win for that. Then you've also got the depreciation and tax breaks. Williams Partners said over the next 15 years that this deal will save them $2 billion in taxes, and a lot of people will say, "How the heck is that possible?"

It all comes down to depreciation. If you have an asset you're allowed to depreciate it, basically saying it's not worth as much today as it was yesterday because we're going to have to replace it, fix it -- whatever. It's going to cost more. So, after 10, 15 years, all of that ability to depreciate that asset goes down, because the value of it is less.

However, when you sell a company, that depreciation clock is reset because you're buying it back for a book value again. So, over the next 15 years, basically, Williams Companies can take that asset that was well depreciated as the partnership for the past 10 years, bring it back up to a book value level, and then redepreciate it again.

O'Reilly: So, they've been doing the deprecation since 2005, now they get to reset the clock and...

Crowe: They get to reset the clock and redepreciate those things.

O'Reilly: Uncle Sam loses.

Crowe: Yeah. That's about $2 billion over the next 15 years.

O'Reilly: Calling it like I sees it. Very good. Well, thank you guys for your thoughts. And thanks for listening, Fools. That is it for us, but before we go, I wanted to make our listeners aware of a special offer for all of our Industry Focus listeners. If you found this discussion informative and you're looking for more Foolish stock ideas, Stock Advisor may be the service for you. It is our flagship newsletter started more than 10 years ago by Motley Fool co-founders Tom and David Gardner. We are offering the lowest price out there for all of our Industry Focus listeners. It is $98 for two a two-year subscription to Stock Advisor.

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Muckerman: What was that URL again?

O'Reilly: Once again, that is focus.fool.com. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So, don't buy or sell anything based solely on what you hear on this program. That's it for us, Fools. Thanks for listening, and Fool on!