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Following Oil
Four Decades of Cycle-Testing Experiences and What They Foretell about U.S. Energy Independence
By Thomas A. Petrie UNIVERSITY OF OKLAHOMA PRESS
Copyright © 2014 University of Oklahoma Press
All rights reserved.
ISBN: 978-0-8061-4610-2
CHAPTER 1
EARLY ENCOUNTERS WITH THE OIL SECTOR
The Six-Day War, June 1967
It could have been the first oil crisis but wasn't.
As the Corps of Cadets formed up for the final Graduation Parade by myself and 582 other members of the U.S. Military Academy Class of 1967 on June 6, loudspeakers in the barracks areas announced that starting the prior day, Egypt and its other Arab allies were once again at war with Israel. While I did not fully appreciate the ramifications of what I was then observing, the fallout of this conflagration would be a factor that set the stage for a variety of global energy issues that I would later encounter over an ensuing four crisis-punctuated decades of my career as a petroleum analyst and energy investment banker.
Middle East tensions had been building for weeks, so the outbreak of hostilities was not entirely a surprise to the intelligence services of virtually all the major affected countries. While the Arab armies were still marshaling, Israel mobilized quickly and established momentum that enabled it to neutralize the opposing forces. A key element of its strategy was a decisive strike by an air-force-supported armored column driving across the Sinai Desert, with the goal of closing the Suez Canal. Israel achieved this objective in literally a matter of a few days, thereby inflicting a significant penalty on Egypt for its leadership of the Arab coalition. This included entrapment of one-third of the country's army in the Sinai Desert, loss of canal transshipment fees, occupation of the Sinai, disruption of tourism, and other indirect economic effects. On the sixth and final day of the conflict, other Israeli forces pushed up onto the Golan Heights and thus extended Israel's perimeter to the northeast with Syria to much more defensible terrain. This redrawing of the "Near Eastern" Middle East map did much to set the stage for an ongoing period of friction and agony that has characterized many, though not all, of the confrontations occurring in the region in the ensuing decades.
By many measures, what we now know as the "Six-Day War" of 1967 could also have given rise to the first global oil crisis. The short-haul route for Middle East oil going to Europe and North America was cut off, as would remain the case for over a decade. However, an actual crisis in terms of oil supply, it was not to be. Surplus U.S. oil production capacity readily available from a series of large fields discovered in the 1920s and 1930s (mainly in Texas and Louisiana) along with increased oil output by Iran and Venezuela were ample to meet both U.S. and European needs. On the first news, oil prices initially increased by about 10 percent but held there only briefly. They then rapidly retreated as the valves of non-Arab foreign and U.S. oil wells in West Texas and Louisiana were opened to ramp up output. These increases in output were interim measures that provided flexibility until the Arab embargo subsided and new supertankers, known as very large crude carriers (VLCCs), could be built to capitalize on the economies of scale needed to haul Middle East oil all the way around Africa to supply Atlantic basin markets.
Consequently, the return to the "old normal" of U.S. oil prices below three dollars per barrel (and OPEC oil below two dollars per barrel) was swift. For the moment, the message to global oil markets was that it would take more than a Middle East military conflagration to upset the economic order of the petroleum sector that had evolved post–World War II. Given a sixfold increase in tanker rates caused by the initial shrinkage in effective shipping capacity owing to the much-lengthened journey around Africa to reach Western markets, the build-out and launching of these highly economical ships occurred relatively quickly over the next three-plus years. This was a remarkable demonstration of how relatively unregulated markets can and often do respond to strong price signals.
However, some six years later, the balance of global petroleum power would indeed change dramatically. Spare U.S. production capacity was by then exhausted and had entered what soon proved to be a long-term irreversible natural decline from peak domestic production starting in 1970. The next Arab/Israeli war—at the time of Yom Kippur in October 1973—set in motion forces that resulted in a sustained increase in oil prices to more than triple their previous level. Price volatility would continue periodically to whipsaw global markets for years (and ultimately decades) thereafter. For consumers, U.S. oil priced at three dollars per barrel, and with it, cheap gasoline prices, became only a fond memory. Furthermore, OPEC, long considered a "toothless tiger" since its formation in 1961, was no longer so characterized.
My Grounding in the Petroleum Sector
Early lessons learned.
In the late spring of 1971 in the middle of this historic transition, I entered the profession of petroleum investment analysis. Following my commissioning as a second lieutenant, I completed the U.S. Army's Ranger School at Fort Benning, Georgia, as well as a couple of other officer training courses and then proceeded to two overseas tours, first in Germany and then in Vietnam. After returning to the United States for one more tour of duty, which concluded my contractual commitment to the U.S. Army, I decided not to pursue a career in the army. Having earned a masters degree in business administration through Boston University's overseas program in Frankfurt, Germany, I was interested in pursuing a career in the investment sector. While jobs were still scarce in 1971 because of the lingering effects of the 1970 recession, I was fortunate to land an entry-level securities investment analyst position with Colonial Management Associates in Boston.
Colonial was an investment advisory firm whose clients included the endowment funds of Massachusetts Institute of Technology, Dartmouth College, and Massachusetts General Hospital, as well as a family of mutual funds. The firm was formed by James H. Orr, Sr., in the early 1930s. In the late 1920s, Mr. Orr had been a portfolio manager with the investment management subsidiary of the engineering and construction firm Stone & Webster. In the aftermath of the 1929 stock market crash, he had been given the task of finding a buyer for that operation. After many months of striking out, Orr reported to his superiors that given the depressed securities markets there were no other buyers, but he personally was prepared to assume responsibility for the investment portfolios. By 1932, he was in business for himself, and with shrewd trading and investment decisions, by mid-decade he was on his way to running a viable portfolio management enterprise. Sometime around 1934, he bought Tampa Electric bonds for less than the arrears interest and not too long thereafter was rewarded with their redemption at par with the full interest paid. In the deal with Stone & Webster, Mr. Orr was also aided by his having obtained control of the Rail and Light Securities Fund. Organized in 1895 along the lines of a Scottish closed-end investment trust, this fund gave him an arguable claim to be the first mutual fund (or certainly one of the first) in America. With that tagline and the fund's reconstitution as the Colonial Fund, Mr. Orr had entered the investment business at close to the Depression's market bottom.
In 1936, his reputation, much enhanced by a series of successful judgments (such as buying the Tampa Electric bonds) in a tough investment environment, resulted in an invitation for Orr to become the first public director of First Boston Corporation. This was the investment banking arm then being spun off from the First National Bank of Boston, pursuant to the Glass-Steagall Act. During World War II, George Woods, a senior First Boston executive, took a leave of absence to join the War Production Board, and it was Orr's task to take the train from New York to Washington following each board meeting to brief Woods on First Boston matters. In the postwar years, he built Colonial into a respected player among Boston money managers, and when Jerry Tsai sold his Manhattan Fund in 1968 for a stellar price, Orr and his partners followed shortly thereafter with a sale of Colonial Management at fifty-five times earnings.
All this occurred before I joined the firm, but hearing the story and knowing the principals involved opened my eyes to the exciting possibilities if one could combine effective judgment, a focused strategy, and a keen sense of timing in the financial sector. Jim Orr was my first mentor in the investment business. His advice and counsel over three decades was invaluably inspiring and remains deeply appreciated.
What I realize today is how fortuitous was the timing of my joining the firm. When I started as an inexperienced analyst, responsible for developing an understanding of publicly traded securities in the energy sector, this category of investments had been languishing for two years and was not showing signs of an imminent upturn. The stock market's aversion to oil sector investments was due in part to lingering effects of the prior year's recession. It also reflected rising investor concerns about the security of oil company ownership in foreign exploration and production (E&P) concessions. This was all in the aftermath of Colonel Moammar Khadafy's bloodless coup that deposed Libya's King Idris in 1969. While still serving in the U.S. Army in Germany, I had become well aware of the Khadafy takeover because it brought to an end the low-cost vacations by U.S. Army personnel looking to enjoy the North African side of the Mediterranean coastline. More importantly, Khadafy's ascension to power proved to be the beginning of a series of adverse changes in the economic terms for oil companies operating throughout the oil-exporting countries. In succession, Iraq, Venezuela, Nigeria, and Kuwait all weighed in to exercise their sovereignty. Combined with the early evidence of U.S. production shortfalls in 1971–72, these changes set the stage for the first oil crisis in 1973.
In retrospect, I was given the opportunity of a lifetime. John McNiece, my manager at Colonial, encouraged me to take the time available to learn all I could about the energy industry generally and, most particularly, about the petroleum sector. Over the following year, I was able to travel widely throughout North America to meet many members of senior management and become familiar with different energy companies. This experience allowed me to build a framework for understanding many of the corporate strategies and business models of the energy companies as well as the technical and fundamental drivers of performance and investment attractiveness of petroleum enterprises.
The first trip was to Marathon Oil in Findlay, Ohio. There I met several members of the company's management, including the chief financial officer, Elmer Graham. A full decade later as a corporate defense advisor, I was to spend intense time with Graham when Mobil Oil launched a hostile tender offer for the company. At this time, however, Marathon and its partner, Phillips Petroleum, were in the startup phase of a project to ship liquefied natural gas (LNG) from Alaska's Kenai Peninsula to Japan. While in percentage terms this was not a major asset of the company, in the then-prevailing environment of stable oil and gas prices as well as flat conventional oil and gas production volumes, a new and growing LNG export project was one of the more noteworthy drivers of the company's earnings outlook for the next several years. In addition, it afforded me the chance to gain an appreciation of the economics of LNG in the Pacific Rim, something that has been very helpful in assessing transactions involving other companies in subsequent decades. I also started to learn about the Yates field, a true West Texas giant oil accumulation. Having a deep understanding of this "crown jewel" asset of Marathon's would provide a major career-advancing opportunity for me a decade later.
My next visit that summer was to Louisiana Land and Exploration Company (LL&E), where I began to appreciate the value of owning undeveloped petroleum mineral rights in a strategic location when the necessary technology emerges to identify and exploit attractive hydrocarbon resources. LL&E was formed in the late 1920s and benefited from the advent of geomagnetic surveys and subsequently from seismic technology to locate previously unrecognizable subsurface traps of oil and gas in the marshlands of southern Louisiana. From 1930 to well into the 1950s, the company was able to benefit from the leasing of its extensive land holdings to Texaco and other major oil companies that brought both the financial capital and the exploration expertise to develop significant production on LL&E leases. As a royalty holder with the operating and capital costs that were allocated to the working-interest operators, LL&E enjoyed impressive returns and free cash flow.
Now, however, the task at hand was to develop a research perspective on LL&E's new strategy to transform itself into a more traditionally structured operating oil company that would reinvest its royalty cash flows in drilling new wells as a working-interest owner. Toward that end, the company in 1971 was benefiting from a noteworthy success involving its participation with Standard Oil of New Jersey (now Exxon) in the discovery and development of the Jay field in what was known as the Smackover Trend in Florida. This field caught my attention, partly because the Jay field was the largest onshore U.S. discovery of oil in over two decades (since the 1948 opening of the Sacroc field in West Texas). It also piqued my interest because it was located in Florida's panhandle, not far from where I had endured and survived the "swamp" phase of Army Ranger training in 1967. I had hiked many hundred miles in combat gear over that kind of ground while alert to avoid poisonous snakes and alligators. However, I have since come to appreciate that worthwhile economic treasure could lie beneath otherwise very unattractive and challenging parts of the earth's surface. This is a lesson that was reinforced repeatedly over subsequent years on trips to regions ranging from the Alaskan and Canadian Arctic to Colombia and Peru in South America. These trips included numerous excursions to other remote regions in both the Eastern and the Western Hemispheres of the globe. Much later, in 1983, my understanding of the fundamental positioning of LL&E paid dividends. Then I was part of the First Boston mergers and acquisitions (M&A) defense team that helped defeat an unsolicited hostile bid for the company. It involved turning back an opportunistic proxy contest initiated by Delo Caspary and two of the Hunt brothers (Nelson Bunker and William Herbert).
In the early fall of 1971, I attended an oil analysts meeting at Club 21 on Fifty-Second Street just west of Fifth Avenue in New York City called by Leon Hess, CEO of Amerada Hess Corporation. This was my introduction to one of the more interesting, challenging, and "out of the box"-thinking oil executives I have met during my career. The Leon Hess story is the stuff of legend, and it did much to convince me that I had found a profession in which one could be passionate about developing and pursuing insightful investment conclusions.
In the 1930s, Leon Hess drove a fuel truck for the distribution business that his father, Mores Hess, had developed in New Jersey. In the Great Depression year of 1933, the business went bankrupt, and Leon, still in his twenties, reorganized it and put it on a growth path by building a terminal in Perth Amboy, New Jersey. During World War II, he served in Europe as a fuel officer in General George Patton's Third Armored Division. There he undoubtedly learned discipline under the pressure of a leader who set demanding goals that on many occasions put his tanks on the verge of running on fumes. Returning home after the war, Hess was back in the family business as it grew to meet America's expanding fuel oil demand in the 1950s. In the early 1960s, Leon was the CEO of Hess Oil and Chemical. The company now had the Port Reading Refinery located in Perth Amboy and Woodbridge, New Jersey, as well as multiple fuel storage tanks and an extensive commercial fuel oil delivery service.
In 1966, the breakout opportunity for Hess occurred when he seized the chance to purchase a 10 percent block of shares in the Amerada Petroleum Corporation for $100 million from the Bank of England. The bank had acquired this holding as part of Germany's World War II reparation payments. With this block of stock in hand, Hess Oil and Chemical in 1969 merged into Amerada Petroleum. In this transaction, Hess prevailed over a competing offer from Phillips Petroleum, and this success catapulted the company into an entirely new league. This acquisition provided Hess the ability to build a large refinery on the island of St. Croix in the U.S. Virgin Islands to process its anticipated share of production from the newly discovered Prudhoe Bay oil field on Alaska's North Slope. The company planned to bring the oil from Alaska through the Panama Canal to the Caribbean, capitalizing on an exemption that St. Croix enjoyed from the requirement to use U.S. flag vessels. This cost advantage amounted to $2.15 per barrel. In addition, he had the ability as a larger public company to use Amerada's high-quality production base in the Williston basin of North Dakota, the Gulf of Mexico, and the Permian basin of West Texas to fund what would become a major new source of profitable offshore production in the United Kingdom (U.K.) and Norwegian sectors of the North Sea.
(Continues...)
Excerpted from Following Oil by Thomas A. Petrie. Copyright © 2014 University of Oklahoma Press. Excerpted by permission of UNIVERSITY OF OKLAHOMA PRESS.
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