Will the grass be greener going private as a large-cap oil & gas company?
Energy M&A Framework, Post #3
It's not easy being a publicly-traded oil and gas company these days, especially for the large- and super-caps that are in the crosshairs of climate & environmental activists, left-of-center politicians, and corresponding media outlets. And after last decade’s reality of poor financial and stock price performance, traditional investors remain broadly skeptical that the improved results of the past 12-18 months can be sustained in future years. The rise of so-called ESG investing, a non-trivial portion of which has deemed oil & gas "dirty" and unworthy of fund flows under any circumstances, adds the final contributing factor to discounted valuations (i.e., a high cost of capital).
The natural question is: Would oil & gas companies be better off being privately-owned rather than publicly traded?
This is an age-old question for small-cap companies, with access to public capital markets and the liquidity afforded to original owners and management usually a key reason to be publicly traded. For the entirety of my 30 year career, the idea of a large-cap publicly-traded oil & gas company going private has not been a serious question, even during prior cycle troughs. This is no longer the case, with Berkshire Hathaway having increased its stake in Occidental Petroleum (Oxy) to 26.8% and receiving regulatory approval to go up to a 50% stake. Additionally, Harold Hamm, founder and Chairman of Continental Resources, made an offer this past June to re-privatize Continental by purchasing the 17% of the share base that he (and related entities) do not already own.
DISCLAIMER: Regarding Occidental Petroleum, I am going to channel some old Goldman compliance training: This post in no way represents my opinion on what I think will or should happen between Oxy and Berkshire. I have not actively covered Oxy since retiring from Goldman in 2014. I believe it is not appropriate for me to publicly speculate on Oxy's fate or publish view points on what I think Oxy or Berkshire should or should not do. I mention it only because Berkshire's growing stake in Oxy has been widely reported and is the catalyst for the general discussion on the topic that is found in this post. The same holds true for Continental. I offer no public opinion on the viability or reasonableness of Mr. Hamm's offer.
Since this is definitely not a formal advisory opinion on the merits of any particular transaction, what follows are some high level thoughts intended as an introduction in a Q&A-styled format on the subject of private versus publicly-traded ownership. I would note that the post is narrowly focused on the large-cap oil & gas companies; many of the comments, though not all, would hold for small-caps as well, but it would likely warrant its own discussion.
(1) Why would anyone want to take private a large oil & gas company private when net zero objectives are calling for sharp declines in crude oil demand in coming decades?
Clearly, this is perhaps the key cost of capital disconnect and the basis for the opportunity to take a company private: i.e., the discounted valuations that have come from the belief that peak crude oil demand is near (or occurred in 2019). From a valuation perspective, traditional energy is suffering from the toxic combination of a non-zero probability being placed on the potential for a meaningful, structural decline in crude oil demand in coming decades coupled with the legacy of poor financial returns during the 2010s. For financial sponsors that believe otherwise, there-in lies the opportunity to take the other side of that view. My own view is that global oil demand is unlikely to structurally peak let alone enter a long-term decline prior to 2040 assuming trend population and global GDP growth continues over the next two decades.
(2) But even if you think peak oil demand concerns are overblown, we all know ROCE will ultimately normalize at much lower levels than what we are currently experiencing?
Sure. However, a buyer would likely have a view that is consistent with my outlook that 2020 marked the structural trough in the 2006-2020 return on capital employed (ROCE) downcycle and that a new 10+ year ROCE structural upcycle has begun. Presumably the buyer would believe the free cash flow/dividend potential from the structural upcycle would be sufficient to warrant investment even if “normalized” ROCE falls back to cost-of-capital levels for the sector.
I should emphasize that I agree that "normalized" ROCE for the sector measured over 20-50 years will be closer to 10% than the current 25%+. But for a variety of reasons I have discussed in previous posts, I believe we are in for an extended stretch of much higher ROCE even as there will be significant volatility on a year-to-year basis.
Furthermore, there is a track record of “best-in-class” companies generating sustained, double digit ROCE over very long periods, which does not appear to be reflected in the share prices of such companies today. The best historic examples are ExxonMobil and Royal Dutch Shell over the near 100 year period ending in 2010. It is indeed possible that privatizing a large-cap oil could make sense well beyond the current Super Vol era. There is, probably, a need to believe that the world will continue to prioritize energy availability, affordability, reliability, and security with as small of a climate and environmental footprint over “climate only” ideology.
(3) Isn't the Super Vol environment that I am expecting bad for the entity or persons that would take a large oil & gas company private?
On the contrary, a key advantage of being private over public is to move away from "debate/concern-of-the-day" noise. I would expect the number of "good" years/quarters will meaningfully exceed the number of "bad" years/quarters within the 2020s Super Vol energy crisis era. The freedom to focus on long-term fundamentals and escape the trading zig-zags driven by inherrent commodity market volatilty plus short-term investor pressures is perhaps the biggest appeal of being private over public.
(4) Going private is a great opportunity to escape all this ESG nonsense, right?
Wrong. Yes, exposure to "bad” ESG will be reduced, which I have previously defined as the virtue-signaling, anti-fossil fuel, "climate only" ideologues in the investment and activist communities. But substantive ESG is both needed and here to stay. As an example, I don't believe a privately-held large-cap E&P could suddenly start unmitigated flaring of methane. Governance could, presumably, improve under private ownership. I suppose gender diversity initiatives might be an area that could receive less emphasis under private ownership; of course, given the dearth of female senior executives among publicly-traded oil & gas companies, it's not clear this possible critique is somehow unique to the private-ownership world.
(5) Will going private allow companies to return to growth mode and stop the variable dividend model? Or, conversely, skip all growth and move to a model of maximizing dividends?
In my view, going private isn't about choosing sides on a growth versus dividends debate. Rather, I would argue it's about the potential to focus on optimal long-term capital allocation without worrying about short-term Street reactions. A private company would: (1) face less pressure to declare quarterly/annual production growth guidance; (2) face less pressure to avoid short-term production declines if that is in the interest of long-term value creation; (3) be able to pursue selective growth opportunities that might make sense even if at the expense of near term free cash flow; and (4) be able to dividend cash back to shareholders whenever it makes sense without worrying about how it will be explained, understood, or valued by investors.
(6) How would being private impact the ability to pursue M&A?
This might be perhaps the biggest potential disadvantage of going private to the extent that some selling companies will prefer to receive publicly-traded shares in the acquiring company. I'd imagine there would be an ability to provide equity if desired, but the liquidity and valuation of a private company is inherently subject to more debate than one that is publicly traded.
(7) Why can't a publicly-traded company run itself more like a private?
They all can and should! In my humble opinion, this should be the goal: All companies should be making decisions without obsessing about the short-term Street reaction. To be sure, many publicly-traded companies make ill-advised decisions the Street instinctively and rightfully pushes back on. My comment about not obsessing about short-term reactions is narrowly focused on the top performance quartile of companies that have demonstrated they can achieve double-digit through-cycle ROCE, have fortress balance sheets, a strong commitment to returning excess cash to investors, and are leaders on substantive ESG metrics.
Examples of short-term trading dynamics impacting decision making include the hesitancy to pay special dividends over concerns investors won't "give credit" for such actions or forgoing advantaged CAPEX projects for fear of being viewed as "undisciplined" during a period the Street is in "don't you dare try to grow" mode.
⚡️On a personal note…
In the U.S., the debate on whether private or public golf is better was settled long ago, with the vast majority of the premier courses in this country run via the private country club model. To be sure, there are a number of high profile courses accessible to the public such as Pebble Beach and Bethpage Black as well as resort-styled courses in Kiawah, Bandon Dunes, and Streamsong. Still, if you want a premier golf experience in the U.S., a certain level of affluence is a prerequisite and most of the best golf courses in most areas across the country are not open to the general public. It is a private golf model in the U.S. (Note: there are many fine public courses in most areas of the U.S.; but I know of no serious golfer that has the means to afford a country club that doesn’t choose to join one.)
Since 2019, I have had the great pleasure to have made five trips to Scotland to play golf and visit family in St Andrews. In my view, the Scottish approach to golf access is something to admire if not aspire towards. ALL courses are accessible to the public. There are preferred tee times, reduced greens fees, and many other benefits to becoming a member of a particular club. But everyone has the opportunity to play every course in Scotland. Remarkably, the most famous venue—Old Course in St Andrews—is a public park on Sundays!!! No golf on Sundays and anyone can walk the 18 holes with family, friends, and dogs.
To be sure, there would be significant challenges to the U.S. employing a Scotland-type model given the much larger golfing population that exists in the U.S. And I think I can safely assume that there is zero appetitive for any private club member at any club across the U.S. voting to allow for regular public access to their course. If Super-Spiked is about being truthful, I know I feel that way even as I express my admiration for Scotland’s approach.
So in the spirit of offering solutions as part of Super-Spiked, I would recommend everyone that enjoys the game to make frequent trips to Scotland, contemplate purchasing a second home or at least a flat in the country, and take advantage of the opportunity to play the greatest version of the game that exits: links golf in the Home of Golf.
If I could only play golf in one region of the world for the rest of time, it would be in the Kingdom of Fife. My top courses in Fife in order of preference:
Old Course (St Andrews Links)
Kingsbarns
The Castle Course (St Andrews Links)
Dumbarnie Links
Balcomie Links (Crail Golfing Society)
The Golf House Club, Elie
Jubilee Course (St Andrews Links)
New Course (St Andrews Links)
Lundin Golf Club
The Dukes
Leven Links
Craighead Links (Crail Golfing Society)
⚖️ Disclaimer
I certify that these are my personal, strongly held views at the time of this post. My views are my own and not attributable to any affiliation, past or present. This is not an investment newsletter and there is no financial advice explicitly or implicitly provided here. My views can and will change in the future as warranted by updated analyses and developments. Some of my comments are made in jest for entertainment purposes; I sincerely mean no offense to anyone that takes issue.
Regards,
Arjun
To paraphrase Margaret Thatcher, Netzero is, in fact, a classic utopian project, a monument to the vanity of so-called environmentalists, a programme whose inevitable destiny is failure; only the scale of the final damage done is in doubt.