Nineteen billion dollars. That's the cost to transform Freeport-McMoRan (NYSE:FCX) from a copper and gold miner into a diversified resources company. It's a move that put it in the same league as Anglo-Australian resource giant BHP Billiton (NYSE:BHP). Unfortunately, we can only speculate right now as to whether this was the right move to fuel returns for the company. What we do know is why Freeport decided to diversify into oil and gas and how the company plans to use it to fuel returns.
In adding oil and gas to its portfolio, Freeport picked up a diverse base of assets located in the United States (see the following map). It added both onshore and offshore oil from California and the Eagle Ford and in the Gulf of Mexico, as well as picking up gas assets in the Haynesville, Rockies, and the Gulf. Right now these assets are driven by oil and liquids, which equates to about 90% of the revenue. Natural gas offers long-term upside, but it's not much of a needle-mover today.
One of the keys for Freeport is that its oil and gas business offers visible growth. Although Freeport has a plan to grow its annual copper production to more than 5 billion pounds by 2015, it was struggling to find ways to grow the business beyond that target. Large-scale, world-class copper projects are really tough to come by these days. So when the company saw low interest rates, but no real appealing projects to grow copper production, it saw value in adding oil and gas to the portfolio.
One reason is that over the next five years, Freeport believes it can double its oil and gas production. The best part of this growth is its completely self-funded. That meant that Freeport could tap the debt markets for cheap debt to scoop up these assets, without needing additional external capital to grow the businesses once acquired. Freeport could simply reinvest the operating cash flow from oil and gas production to double production and then use the copious cash generation of its copper business to pay off the debt.
As long as oil stays above $100 and gas is over $4.50, the oil and gas business should be throwing off excess cash by 2015. Further, depending on how copper does over that time, Freeport could be debt-free and even in a net cash position by 2016:
Still, a lot has to go right for that to happen. For example, one of its assumptions is that gold prices stay above $1,500. That will be pretty tough, as gold prices dropped by another $100 just last week and now sit at less than $1,300 an ounce. This has crushed gold stocks over the past year, with shares of Yamana Gold (NYSE:AUY), for example, down more than 40% over in the past year.
Freeport is down 18% over the same time; however, this does show where its diversified commodity profile really shines, as it adds some cushion when commodities fall. One of the reasons the decline in gold price has hit Yamana so bad is that about 90% of its production is gold, as the only other commodity the company produces is just a tiny sliver of silver each year. Diversity is important for Freeport, because each $50-per-ounce movement in the price of gold affects its operating cash flow by $45 million, whereas a $0.10-per-pound movement in copper affects operating cash flow by $275 million. A similar move in gold would have a more distinct effect on Yamana's profits.
Adding oil and gas takes away even more of the sting of commodity price volatility. That's because it will drop mining's effect on earnings to just 75% of its profits going forward. It's really tough to envision a future where oil prices drop much below $100 per barrel, as the cost of production alone would keep prices that high. Meanwhile, natural gas prices should at least be stable, if not provide upside, as we use more gas and begin to export our excess. Not only that, but Freeport's production is pretty well hedged into the future, with oil about 85% hedged this year and next, while about a third of its natural gas production is also hedged for the next year and a half.
The bottom line for Freeport investors is that the worst-case scenario for the oil and gas business is it simply becomes a cash-flow business post-2015 if natural gas prices remain in neutral. The downside risk is pretty limited thanks to production hedges and the business' ability to be self-funding. What will be interesting to see is where Freeport goes next as it could continue to build its oil and gas business or take another page out of BHP Billiton's playbook and further diversify its revenue into areas such as coal or iron ore.
Fool contributor Matt DiLallo owns shares of BHP Billiton. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.