Statement of Problem & Alternatives
George Keller of the Standard Oil Company of California (Socal) is considering how much to bid for Gulf Oil Corporation (Gulf), which is currently in the middle of a bidding war. Gulf is unwilling to consider bids below $70 per share even though their share price was $39 at the time Boone Pickens began purchasing shares in the hopes of a takeover. II. Statement of Facts and Assumptions Under the direction of James Lee, Gulf pursued a twofold strategy. First, Gulf renewed its focused on oil whereas in the past, Gulf had developed into an energy conglomerate through various acquisitions of coalmines, uranium mines, and synthetic fuel plants. These ventures would be de-emphasized going forward. For second part of the strategy, Gulf planned to implement a policy of increased expenditures on exploration and development (E&D).
During the years leading up to the takeover attempt, Gulf more than doubled its exploration outlays. While Gulf was continuing with its ambitious E&D program, the real price of oil and natural gas declined from 1982 through 1983. As 1984 began, almost all industry experts were in agreement that the price of oil (in constant dollars) was not expected to change for the following 10 years. Lee trimmed exploration expenditures in 1983 in response to these changing fundamentals. Even at the reduced level, spending for exploration in real terms equaled or exceeded that of every year before Lee’s arrival except one. Based on this picture, Socal needs to value Gulf. There are several sources of value that can be considered: the value of Gulf’s petroleum reserves; the cost savings related to the immediate suspension of Gulf’s E&D program; the tax benefits associated with additional leverage; the value added by shortening the recovery lag; and the value of any adverse effects due to the acquisition of Gulf by a competitor1.
In addition to calculating Gulf’s reserve value, Socal needs to be mindful of its competition. Both Atlantic Richfield Company (ARCO) and Kohlberg Kravis Roberts & Company (KKR) are financially limited should Gulf’s share price continue to escalate. It would be difficult for ARCO to bid more than $75.00 per share given that its resulting debt-to-capital ratio would exceed 60% (historically high). KKR is in a similar situation. Mesa, led by Pickens, currently holds 13.2% of Gulf’s stock at an average purchase price of $43. In order to bid successfully, Mesa would have to borrow many times their net worth. With banks queuing up to lend money to support an $80 share price (or higher), Socal will have to take on a considerable amount of financial leverage.
III. Analysis Although there are multiple sources of value, this analysis focuses on valuing Gulf’s reserves, assuming E&D activities will cease post acquisition (liquidation value). The critical elements that enter into the valuation of Gulf’s reserves are: Acquisition date: Since we are trying to establish why Gulf became so valuable within a short period of time from when their share price was $39 to when a minimum bid level of $70 per share was established, it’s appropriate to use January 1st, 1984 as the first year Socal assumed ownership of Gulf. Reserve life: Assumed a reserve-to-production ratio of 12:1. It takes approximately 4 years for the stream to come online and the field, once online, is productive for another 7-10 yrs. Based on this ratio, Gulf’s reserves are depleted at a rate of 192.75 million barrels per year over a 12-year period. Inflation rate: 4.67% based on the average inflation rates observed between 1982 and 1983.
There was an unusually high rate of inflation between 1978 and 1981 so years prior to 1982 were not included. However, a sensitivity analysis was performed to observe the effects of a higher inflation rate based on historical averages (see Exhibit 1). Oil sales: Oil price is expected to stay at $22.42 in constant dollars (prices are adjusted for inflation). Production costs: Production cost per barrel is expected to stay at $6.48 in constant dollars (prices are adjusted for inflation). See Exhibit 2. Exploration costs: The capitalized portion of past extraction costs are recognized as depreciation when the corresponding oil is produced.
These depreciation expenses vary from year to year based on historical costs. See Exhibit 3. Working capital: For this analysis, working capital is assumed to be negligible given that the analysis is geared towards determining Gulf’s reserve value. Capital expenditures: For this analysis, capital outlays are assumed to be zero given that the analysis is geared towards determining Gulf’s reserve value. Gulf’s E&D program ceases post acquisition.
Discount rate: Gulf’s weighted average cost of capital calculated to be 15.35%. See Exhibit 4. Utilizing a discount rate of 15.35% and the assumptions outlined above with a free cash flow model (see Exhibit 6), Gulf’s reserves are worth an estimated $80.73 share ($16,120.69M)2. Adjusting the inflation upwards to 8.37%, Gulf’s reserves are worth an estimated $96.16 per share ($15,895.35M). Since Socal would be taking on additional debt, it’s important to check whether or not future free cash flows cover the incremental interest expense. Exhibit 7 shows that future cash flows easily cover interest expense associated with up to a $90 per share purchase price.
Additionally, taking the free cash flow derived in Exhibit 6 (basis for an $80.73 share price) and discounting based on Socal’s WACC (16.96% – see Exhibit 5), we arrive at a reserve valuation of $75.56 per share. Adjusting inflation upwards to 8.37% and discounting at Socal’s WACC, Gulf’s reserves are worth an estimated $89.65 per share.3 IV. Recommendations Based on the analysis, a bid of $75.56 per share for Gulf is appropriate. A bid above this price would result in a loss for Socal shareholders. This price is also above the $75 threshold, which if offered by ARCO or KKR would send their leverage above historical highs (greater than 60%). Given the valuations sensitivity to the assumed inflation rate, discount rate, and recovery lag, $75.56 represents a pessimistic valuation giving Socal management room to adjust its bid upwards if necessary.
These estimates do not consider the possibility of recovering Gulf’s unrelated fixed assets. It’s important to note, the analysis is very sensitive to the discount rate assumed, recovery lag, and the inflation rate.