In this week's Industry Focus: Energy, Sean O'Reilly and Taylor Muckerman explain what both companies would get from the massive deal, what concessions they'll likely have to make to make the merger regulations-friendly, and how shareholders should feel about it.
Also, the hosts review this week's updates on OPEC's proposed production cut, why the cartel is not as decisive these days as it was before, and how much the oil market could be affected by whether or not the cut actually goes through.
A full transcript follows the video.
This podcast was recorded on Nov. 1, 2016.
Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, November 3rd, 2016, so we're talking about energy, materials, and industrials. I am Sean O'Reilly, and I am joined in studio by the one, the only, Mr. Taylor Muckerman. What's up, man?
Taylor Muckerman: Not a whole lot. Pre-taping. I'm in the studio early, I'm not used to this Tuesday afternoon action.
O'Reilly: Full disclosure for our listeners, this Thursday and Friday is The Motley Fool's annual Foolapalooza. Lots of talking about the future, business plans, are you playing flag football?
Muckerman: Yeah. Eating, drinking.
O'Reilly: It'll be a good time. So, we will not be at HQ. I will not be editing or recording podcasts, you will not be picking stocks. We will be commiserating with our fellow Fools --
Muckerman: If you want to rob The Fool, Thursday and Friday are the days to do it.
O'Reilly: Who's staying behind? We usually leave one person behind. It's like a designated survivor kind of thing. Oh boy, I have to find out who the designated survivor is now.
Muckerman: We should just get a dog.
O'Reilly: The fact that we are pre-recording also adds a level of difficulty to the other big thing that is happening this week, at least in my world, which is the World Series.
Muckerman: Yes, you have the Cleveland Indians shirt on.
O'Reilly: I am born and raised in Ohio. My parents live in a suburb of Cleveland. I am of the opinion that they're going to win this thing.
Muckerman: I hope so. I'm not a Cleveland fan, but I'm not a Chicago fan.
O'Reilly: The rivalry between St. Louis and Chicago is pretty epic.
Muckerman: It's gotten pretty heated the last couple years, yeah, thanks to them actually being decent.
O'Reilly: Hear that, Cubbies?
Muckerman: It happens.
O'Reilly: So, obviously, we will know on Thursday when people are listening.
Muckerman: Hopefully we know tomorrow, which is the day before your hearing this.
O'Reilly: If the impossible happens, because the odds are quite good that the tribe is going to win this thing, if the impossible happens, please give me three or four days of mourning before you tweet at me next week and make fun of me.
Muckerman: Let's find out what the odds are.
O'Reilly: Nate Silver thinks it's about 75% odds that the tribe wins. Yeah, the Cubs won the game they were most likely to win in Chicago, and it's all uphill from here. I do not wish to take away from my deep love for the Chicago Cubs, though. They are a wonderful organization, many of my best friends are fans--
Muckerman: Oh, come on!
O'Reilly: No, when this started, I felt very badly about ... take my eyes, just don't make these two teams play each other in the World Series. Take my eyes! Fine, all right, we'll talk about energy.
Muckerman: Cleveland, not Chicago.
O'Reilly: This is the year, man.
Muckerman: You can't succumb to your friends.
O'Reilly: If I had a wish, it would be, if and when the tribe wins this year, I would be more than happy to do whatever it takes to make sure the Cubs win next year, if I had magical powers.
Muckerman: Oh my god! Alright, next topic, OPEC.
O'Reilly: Wow, you really just ...
Muckerman: Don't want them to win.
O'Reilly: (mockingly) Go Cardinals.
Muckerman: Yeah, why would you cheer for another team? You should want the Indians to win next year.
O'Reilly: I have the respect for the Chicago Cubs baseball.
Muckerman: OK, that's all I need to hear.
O'Reilly: Alright, so. Before we get into the big news of the week that involves a $30 billion check, we ought to talk about OPEC shenanigans really quick, because that's what we've been known for the past month. Why are the OPEC kiddies being mean now?
Muckerman: Well, they met last week to try and drum up an idea of what they wanted to agree upon on November 30th. All over the weekend, people were talking, "Oh, yeah, they reached an agreement." But then, it comes out that Iran, Iraq, Libya, Nigeria, they're still on the fence about it because they want to continue to raise production since they've either been under sanctions or had civil strife going on, so they haven't really been producing what they think they can. So, all four of those countries seem to be in agreement that they might not want to be on the hook for a production cut, leaving the other nations to take the full brunt of the supposed cut. The markets don't really think it's going to happen.
O'Reilly: They were suspicious from the beginning, even a month ago.
Muckerman: Yeah. I mean, this has happened before, quite recently, where OPEC said, "We're going to negotiate a cut," and nothing happens. We're in the same boat again, waffling, continued waffling. You look at a bunch of investment banks out there, and they're saying that they would not at all be surprised if this doesn't go through and then oil could crash back down to about $40 a barrel.
O'Reilly: On the other hand, I have noticed -- you remember two weeks ago, Russia was like, "We're totally in on a cut," and the market loved it, and oil went up. Then, this past week, Russia is like, "Eh, we don't know ... " Is it possible that a lot of this is just a negotiation tactic? It's a poker game, and they're all at the table.
Muckerman: Yeah, no one wants to show their hand. These are countries, that were talking about, that rely very very very very heavily on oil and natural gas sales to support their government, to support their people. It's not exactly just a few companies going bankrupt. You're talking about countries could go bankrupt if they don't support oil prices, or support their own internal production and exportation. So, yeah, this cartel has many more perspectives than just the sole cartel.
O'Reilly: Cartels encourage cheating. That's the beauty of a good old-fashioned cartel. However, on the other hand, I just never understood why these guys don't seem to care about what you learn in econ 101, about cost benefit. Like, you decrease production by 4%, and do you make double the money on the other 96%. What is the problem here?
Muckerman: Well, that all depends on who else is producing. They thought they were going to shut U.S. shale down by collapsing oil prices. Shocker --
O'Reilly: We have technology.
Muckerman: There were some bankruptcies, but nothing uber meaningful. In fact, the companies that declared bankruptcy are just about producing the same amount, if not more, than they were while --
O'Reilly: They keep on operating, chapter 11, or they sell their assets, run something stronger, yeah.
Muckerman: Yeah, exactly. Just because they declare bankruptcy doesn't mean they're not producing oil. So, as the prices continue to creep back up, it's much more likely that they will emerge from bankruptcy still producing oil. So, yeah, you look, in a vacuum, sure, they should cut production because they're producing at record levels. But if they do cut production, somebody's going to fill that spot, just like they did in 2014 when Saudi Arabia was like, "Yeah, we're just going to start pumping just to pump because we can." You look at all these wells that are drilled and uncompleted in the United States, nearly 4,000, those are starting to come back online. Inventory is out there.
O'Reilly: Lots of fun. And we'll know more in a week, I'm sure.
Muckerman: Yeah. You'll continue to hear more about it for the next month. Personally, I think that if you invest in oil right now, you have a little bit more downside than you do upside at the moment because if they announce it and they say, "Yeah, we're going to announce this cut," they're producing at record levels, they're not really cutting a whole heck of a lot, and that gap can be filled. If they don't say they're going to cut, then you still have this outstanding supply, and you have the downside risk.
O'Reilly: Oy. On the flip side of the coin, though, one of the largest industrial conglomerates on this planet --
Muckerman: Any planet that we know of.
O'Reilly: That we know of. We have not explored Mars a ton, but it's there. GE decides to buy Baker Hughes for $30 billion.
Muckerman: Well, no, they're not buying them, they're just merging with them. They're forming a merger with their oil and gas unit. Basically, they're writing a $7.4 billion check to Baker Hughes shareholders for 2/3 of the company, or of the combined joint venture.
O'Reilly: Right, which will be about $30 billion.
Muckerman: $32 billion in annual revenue.
O'Reilly: What was your first thought when you saw this come across the wires? I got the push notification from Bloomberg on my phone. Clearly, GE has been trying to shift away from the GE Financial Services type thing and just get rid of all that.
Muckerman: Yeah, they've gotten rid of about $200 billion in assets in GE Capital.
O'Reilly: Be the Premier manufacturing industrial company in the United States of America. This is a good way to do it, I guess?
Muckerman: So, they're already, if not the largest, one of the largest oil and gas equipment manufacturers in the world. And now, through this joint venture, it's going to create the second-largest oil field services company in the world. They overtake Halliburton. Right there, I was like, son of a gun, my boys at Halliburton tried to make this deal happen, where they would officially merge with Baker Hughes, and that obviously didn't go through after a year of legal battles with regulators. Now you have GE stepping in. It's kind of interesting, because they've spent $14 billion or so over the last decade on oil and gas acquisitions. Now, they're hinting that, potentially, they could spin that business off one day.
O'Reilly: I was kind of surprised, because Baker Hughes, even if and when there's a decent recovery in the energy sector, they weren't projected to be making gobs of money for years. I looked at multiple reports this morning, and I popped over to S&P Global Market Intelligence, looked at the analysts they polled. And you should take anything these people say with a grain of salt, but, bottom line, they've just been cost-cutting like everybody else, they've been pruning product lines, focusing on the lines that have a hope of making a decent profit margin. What does GE see? You would have to be looking way down the line.
Muckerman: They see a greater exposure to a recovering in oil and gas. Now, they're not just an equipment manufacturer, they're actually a services company. And they do sell equipment to Baker Hughes, so there are some synergies that could be exposed there. They say they'll continue to sell equipment to other service providers outside of Baker Hughes, which I would have to imagine, that would be part of any regulatory approval. You can't just go ahead and cut off the faucet to other competitors. You look at this, they still expect oil to be around $45-$60 a barrel out until 2019, the end of that year. So, they're not expecting a big, huge recovery. $60 a barrel isn't too far off, it's maybe a 20% increase in oil prices. But in the grand scheme of things, it's still half of what it was a few years ago. I think this is just them placing a bigger bet on a recovery, maybe not an immediate one, but yeah, a sustained recovery in oil and gas, and the technological advantages they can probably discovered by combining a services company with an equipment company. You get a little bit better communication, you might understand some changes that need to be made in the products that GE was originally making more so than if Baker Hughes was just giving them feedback as a customer. I think there's a little bit more incentive there to align product and service.
O'Reilly: It's funny you bring that up, because, again, most people don't realize, Baker Hughes is an 80 countries.
Muckerman: Yeah, they're very widespread.
O'Reilly: Europe, North America, they're off the coast of Africa, I believe they're a little bit in the North Sea in terms of operations. It's interesting you talk about the information, though.
Muckerman: Yeah, I mean, there's definitely going to be some exchange there. You would have to imagine that IP would be one of the big reasons why GE thinks this could work out. And then you think about GE as a whole, they have a $25 billion aviation business, they have a $21.5 billion power business, almost $18 billion healthcare business, all those are 2015 revenue levels. But if they can do this with their oil and gas business, which is about $16 billion, what other kind of joint ventures could they do or possibly spin out into a separate entity from these other companies, that would be a meaningful player on their own in any of those industries I just mentioned?
O'Reilly: Yeah. So, do you like the deal, bottom line?
Muckerman: Bottom line, yeah, I think it gives GE good exposure to oil and gas. I was surprised they didn't make more acquisitions within the last year, closer to the bottom of the cycle, when oil was in the $30 range. It seemed pretty unfathomable that it would remain that low for an extended period of time. And, they had the capital. So, obviously, they didn't issue any shares for this. They're just forking over some cash. Some as in $7.4 billion. Yeah, I was surprised that it took this long for GE to make a move.
O'Reilly: At least buy more parts manufacturers.
Muckerman: Yeah, something. They probably made a few tack-ons that didn't really make a big splash in the news. But I was expecting something similar to this, maybe not the same structure, but maybe the same dollar tag, to bring somebody on board that could help them take advantage once oil prices rise.
O'Reilly: Cool. Really quick before we head out, I wanted to get your thoughts on a couple of oil majors. ExxonMobil had the potential accounting scandal -- I don't know how to describe it.
Muckerman: Yeah, it was the SEC -- they were investigating.
O'Reilly: Yeah. And it is kind of wild that their oil reserves haven't really come down and light of oil prices in the past few years. However, on the other hand, Exxon is known for its conservatism in estimating reserves. So, what's going on here?
Muckerman: So they say.
O'Reilly: Ah, so they say.
Muckerman: They're known for what they say.
O'Reilly: That being said, Exxon might have to lower its reserves.
Muckerman: Yeah, they say they might lower them about 19%. This isn't going to be a global reduction in reserves. This is going to be predominantly coming out of their Kearl Canadian oil sands operations, lowering the expected reserves from that by about 75%.
O'Reilly: And is that price based, meaning, you and I both know the costs associated with oil sands.
Muckerman: Yeah, oil sands is one of the most expensive, outside of Deepwater.
O'Reilly: Stop me if I'm wrong, but it's like $80-$90 a barrel.
Muckerman: It's close, if you really get into the high tail of this Canadian oil sands. And you say Royal Dutch Shell sell $1.4 billion of Canadian oil sands assets maybe a month or so ago. So, just trying to trim down on these higher costs projects. They're also going to trim a little bit of reserves from other North American fields. Pretty much all coming from North America, predominantly coming from the Canadian oil sands. This is after they released a 38% drop in third quarter earnings, right along there with Total and Chevron displaying lower earnings in this latest third quarter. It is interesting that they're now saying they might lower their reserves. And 19% is no small amount. But then again, they can raise the reserves again once oil prices rebound, if they do.
O'Reilly: Sure. So, really quick, what did you think of Chevron's cost overruns at its Australian LNG operations? That's supposed to be the growth business, so that's unfortunate.
Muckerman: They're heavily invested in Australian LNG, multiple projects, Wheatstone and Gordon being two of the largest, if not the largest projects, in the whole Australian LNG scene. And yeah, you're looking at total in Australia's LNG market, $50 billion in cost overruns.
Muckerman: Yeah. You're talking about $5 billion more from Chevron, they just announced, on their Wheatstone LNG. But the largest by far, you look at its Gorgon project, and that was projected to cost $35 billion, it's now right around $54 billion.
O'Reilly: It was a gorgon when it was supposed to be $35 billion. Now it's a Gorgon.
Muckerman: Now it's a GORGON, every single letter is capitalized. That's not only the most expensive projected, but it's also the most expensive now being realized--
O'Reilly: Were there hints of this stuff happening?
Muckerman: They slowly announced these things, $1 billion at a time, until all of the sudden, you're like, "Holy smokes, that almost doubled the price of what they were expecting." Granted, these projects supposedly have 30-40 year lifespans. But you look at the price of LNG in the stock market, when some of these projects were announced back in 2012-13 --
O'Reilly: It seemed like a good idea at the time.
Muckerman: -- it's, like, 2/3 lower now. So, not only are you spending more, but you're not making as much if you're selling LNG right now. So, they're definitely hoping for a rebound. But they're not the only one. Woodside cancelled a $40 billion project that they were partnering with BP (NYSE:BP) and Shell on.
O'Reilly: There's these capex cuts again.
Muckerman: And, Shell cancelled a $20 billion project, the Arrow LNG project. At least they're not overrunning, they're just scrapping them altogether.
O'Reilly: Yikes. Alright, you get the last word, before we head out, how are you feeling about your BP call from a few months ago?
Muckerman: We just talked about Chevron, Total, Exxon releasing lower earnings in this latest third quarter. BP announced the profits rose 35% versus the year-ago third quarter, reversing three quarters in a row of losses. So, they've been doing well with their cost-cutting initiatives, and it looks like they're progressing with this slow but sure rebounds in oil. Maybe it hasn't been reflected in the stock price yet, but a nice reversal of course here, you're looking at almost $1.7 billion, in profit.
O'Reilly: Awesome. Well, Mr. Muckerman, once again, thanks again for your thoughts!
Muckerman: Thank you very much!
O'Reilly: See you at Foolapalooza.
Muckerman: Yes, indeed. Go Indians!
O'Reilly: Thank you very much. Go tribe! That's it for us, folks. We would like to give a shout-out to our brilliant producer, Austin Morgan. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at firstname.lastname@example.org. Once again, that's email@example.com. As always, people on this program may have interests in the stocks 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. For Taylor Muckerman, I am Sean O'Reilly. Thanks for listening and Fool on!