San Ramone, California-based ChevronTexaco Corp. won the bidding yesterday for its California-based rival Unocal Corp. yesterday in a cash-and-stock package valued at $16.8 billion. The deal is the largest oil-sector deal since 2001 when the acquirer was created under Chevron’s merger with Texaco.
ChevronTexaco is paying a premium price for Unocal as U.S. oil companies face heightened competition for scarce oil-and-gas reserves, many of which are locked up in regions where the companies are not welcome. The theory behind the deal is that it turns the merged company into the second-largest holder of oil-and-gas reserves in Southeast Asia behind Petrochina Co. and also strengthens ChevronTexaco’s presence in the Caspian Sea region.
However, today’s high oil prices can turn such deals upside down in a hurry. Although the price allows companies such as ChevronTexaco to have the strong balance sheet necessary for such acquisitions, should oil prices retreat from current levels in the next two to three years, the risk of write-downs in goodwill is high. ChevronTexaco hedged that risk somewhat by financing the deal mostly with its own stock — ChevronTexaco will pay $4.4 billion in cash and the balance in stock, and will assume $1.6 billion in Unocal debt.
Moreover, the deal reflects the increasing price that oil companies will pay for reserves. ChevronTexaco was able to replace only about 20% of the oil and gas that it produced in 2004, even though it generated in excess of $13 billion in profits and ended the year with over $9 billion in cash. The merged company will have daily production of over 3 million barrels of oil equivalents and increases ChevronTexaco’s reserves by about 15%.
The deal values Unocal at $62.07 a share, which is a 3.6% discount based on Unocal’s closing price of $64.35 on Friday. Widespread market anticipation that Unocal would be acquired has increased its share price nearly 50% since the beginning of the year. News of the deal actually sent both Unocal and ChevronTexaco stock down yesterday on the New York Stock Exchange, Unocal to $59.60 and ChevronTexaco to $56.98.

Oil prices climbed to record highs Friday on mounting concern about limited supplies.
Crude futures for May delivery on the New York Mercantile Exchange settled up $1.87 at $57.27 a barrel. That price is a new record closing price, beating the old record of $56.72 a barrel of a couple of weeks ago. Adjusted for inflation, Friday’s closing price close is the highest since Oct. 11, 1990 when Nymex crude closed at $40.42, which is equal to $58.18 in today’s dollars. Nymex crude would still need to reach $90 a barrel to beat the inflation-adjusted high price that was established in 1980.
This Forbes graph provides an instructive overview of oil prices over the past 150 years. The last 30 years of oil price fluctuations has been quite a ride.

Houston-based Continental Airlines reiterated this earlier warning by announcing in this Form 8K filing that it is forecasting continued “significant” losses for 2005, but projecting cash flows and reserves are sufficient to carry it through the year so long as employee unions approve management’s proposed spending reductions. The company said in this latest filing that it expects ratification of the new labor contracts by the end of March.
Continental’s update followed similarly downbeat forecasts issued in recent days by other legacy airlines. Continental expects cash expenditures during the quarter of $200 million, which would allow it to come out of the first quarter with decent unrestricted cash and short-term investments balance of $1.3 billion to $1.4 billion.
Continental also said in the filing that it does not currently have any fuel hedges in place, which is a move that has protected Southwest Airlines from escalating oil prices.

This NY Times article reports on the concern in Houston business circles about Houston-based Citgo Petroleum Corp.’s status as the political football of choice for Hugo Ch·vez‘s Venezuelan government, which has controlled Citgo since government-owned PetrÛleos de Venezuela acquired a controlling interest in the company in 1990.
Basically, Mr. Ch·vez and his government have promoted popular sentiment in Venezuela against Citgo’s links to the United States while, at the same time, taking actions that indicate that the government is going to exercise greater control over the company. Citgo brands its name to over 14,000 independently owned gas stations in the U.S. and generates about 15 percent of the U.S. oil refining output.
About a month ago, Ch·vez fired Citgo’s chief executive Luis MarÌn and replaced him with Felix RodrÌguez, who is a senior executive at PetrÛleos de Venezuela and a political hack for Mr. Ch·vez. Then, last week, PetrÛleos de Venezuela purged the entire Citgo board of directors and replaced them with another group of Mr. Ch·vez’s political supporters.
Although the Times article tends to view the Venezuelan government’s control of Citgo as perilous to the U.S. energy market, I’m not buying it. Frankly, it is far more likely that Mr. Ch·vez and his government will make bad decisions regarding Citgo, which will present opportunities for its competitors.

Royal Dutch/Shell Group announced another sharp cut in its energy reserve estimate yesterday even as high energy prices allowed the company to generate a fourth-quarter profit of $4.48 billion. Here is a series of posts over the past year on the reserve estimate mess and related problems that Shell has been confronting.
Shell’s announcement highlighted a problem that is facing most of the major exploration and production companies — i.e., the struggle to find new reserves to replace the oil and gas that the companies are currently producing.
Shell’s problems in that area are are worst than most. Yesterday, the company reduced reserves by an additional 1.4 billion barrels of oil equivalent, the fifth such cut over the past year.
This brings the cumulative reserves reduction to about one-third of total company reserves since Shell first disclosed early last year that it had drastically overstated its reserves numbers. Moreover, Shell has not filed its required 2004 year-end reserves numbers with the U.S. Securities and Exchange Commission, so even further reductions are possible. Shell expects the five-year earnings impact of these cuts to total about $700 million, which is about 1% of the company’s profit over that period.
Despite that relatively small impact on profits, it is Shell’s dismal performance over the past year in replacing energy reserves that is placing the company in a precarious position within the industry. Reserves are the estimated bank of energy reserves that an oil and gas company has in the ground and energy companies typically attempt to replace at least 100% of the reserves they pump annually in order to provide markets with the confidence of future growth potential.
Shell is not even close to that standard. The company announced that it expected its 2004 reserve replacement ratio to be somewhere between 45% to 55%. Moreover, if one includes the effect of divestments and technical adjustments related to year-end oil pricing, the replacement rate plunges to a horrifying 15% to 25%.
Although not as drastic a problem as Shell’s, the entire oil and gas industry is having a difficult time replacing its energy reserves. Last week, Houston-based ConocoPhillips announced that it replaced just 60% to 65% of its reserves in 2004 and ChevronTexaco Corp. announced that its replacement rate will also be disappointing.

One of the most interesting (and misunderstood) aspects of the energy business is the economics of extracting oil and gas. Those economics not only have much to do with the price that we end up paying for energy, but also the success or failure of investing in a particular exploration project.
In this instructive Wall Street Journal ($) op-ed, Peter Huber and former Reagan administration staffer Mark Mills — who are authors of the new book, The Bottomless Well: The Twilight of Fuel, the Virtue of Waste, and Why We Will Never Run Out of Energy (Basic 2005) — make an interesting point about why energy prices tend to gyrate from time to time:

Oil prices gyrate and occasionally spike — both up and down — not because oil is scarce, but because it’s so abundant in places where good government is scarce. Investing $5 billion dollars over five years to build a new tar-sand refinery in Alberta is indeed risky when a second cousin of Osama bin Laden can knock $20 off the price of oil with an idle wave of his hand on any given day in Riyadh.
By simply opening up its spigots for a few years, Saudi Arabia could, in short order, force a complete write-off of the huge capital investments in Athabasca and Orinoco. Investing billions in tar-sand refineries is risky not because getting oil out of Alberta is especially difficult or expensive, but because getting oil out of Arabia is so easy and cheap.

Moreover, the authors point out that new technology is having a dynamic impact on the cost of extracting oil and gas:

The cost of oil comes down to the cost of finding, and then lifting or extracting. . . But these costs have been falling, not rising, because imaging technology that lets geologists peer through miles of water and rock improves faster than supplies recede. Many lower-grade deposits require no new looking at all.
To pick just one example among many, finding costs are essentially zero for the 3.5 trillion barrels of oil that soak the clay in the Orinoco basin in Venezuela, and the Athabasca tar sands in Alberta, Canada. Yes, that’s trillion — over a century’s worth of global supply, at the current 30-billion-barrel-a-year rate of consumption.

Here is the entire piece. Also, Tyler Cowen over at Marginal Revolutions has this comment on Messrs. Huber and Mills’ new book.

This previous post from last summer told the story about a bizarre Federal Trade Commission investigation that had been launched into the planned closing of an unprofitable Royal Dutch/Shell Group refinery in California.
Shell had been unable for years to find a sucker, er, I mean, a buyer for the Bakersfield facility. Shell had lost more than $50 million over the past three years on the refinery and was facing between $30 million and $50 million in turnaround and environmental costs on the old facility. However, given that the closure would crimp gasoline supplies further in California — where supplies are already tight and prices the highest in the nation — both the federal government and the California state government pressured Shell to find a buyer rather than close the facility. Not surprisingly, buyers were not exactly lining up to bid on an obsolescent refinery, so last month the federal government agreed to let Shell exceed pollution standards in operating the facility in return for Shell keeping it open for another three months to find a buyer.
Well, Shell announced yesterday that it had finally found a buyer for the facility — Flying J Inc., a closely held Utah-based oil company that specializes in distributing diesal fuel to truckers. The purchase price was not announced publicly, but is estimated to be around $130 million by sources close to the deal.
So, let’s take stock here. Shell lost $50-$75 million to sell an asset for $130 million — not bad, but not the type of risk that Shell normally indulges to make a return on its investments. Rather than adopting policies necessary to induce major companies such as Shell to invest the capital necessary to build new refineries that would address the tight supplies in the Western part of the United States, the federal government and State of California took legal actions and then even compromised their sacrosanct environmental standards to prod Shell to sell an obsolescent facility to a tire kicker. Flying J is a good little company who will continue to operate the refinery, but it does not have the capital necessary to turnaround the declining production at the facility or build new refineries that are really needed to increase gasoline supplies. In the meantime, average gasoline prices in California have risen almost 27 cents a gallon to $1.93 from last year when the feds and the State of California started strong-arming Shell over its plans to sell the refinery.
My sense is that the postscript on this story is that the federal government and State of California’s actions in this matter have, in the long run, made California’s chronic gasoline supply problems worse. So it usually goes with governmental intervention into problems that markets should be resolving.