Last week the top management of the newly merged Freeport McMoRan held a half day meeting in NYC to introduce the reconfigured company to analysts. Unlike most other minerals and mining companies that change management often, the top officers of this management team have been together for over forty years, a point that was stressed at this meeting. Led by the excellent geologist Jim Bob Moffett, McMoRan, in its various and ever changing iterations has been exploring for and finding massive deposits of sulfur, copper, gold, molybdenum, oil and gas in various corners of the world for decades. With this combination of assets it is emerging as one of the largest natural resource companies in the world.
For sure, management understands that commodity prices fluctuate with economic cycles. They have learned through the decades that when you are in a business in which prices are so variable, the smartest path is to have as little leverage as possible on your balance sheet so you can ride through downturns in pricing and not have to sell off your key assets. Without excessive leverage, you can hang on for the good times and reap the rewards of your discoveries In the good times.
The underlying concept of the merger of Plains Petroleum and McMoRan Exploration into Freeport McMoran Copper & Gold is to balance commodity risks, geopolitical risks, economic risks and cash flow risks in a rapidly changing world. Countries with major natural resource assets are realizing the value of those assets in the development of their economies and their position on the world stage. The added challenge abroad for any American company is to conduct business in an atmosphere where business practices are not necessarily those of the United States.
In any mining or extraction operation, the problem of safe practices is critical.Think of BP’s Macondo disaster as an example. The costs were astronomical and have had far reaching impacts on those drilling in the Gulf of Mexico going forward. Freeport has an exceptional record for safe operations. So it was shocking when miners in Indonesia were recently caught in a most unusual accident in a training facility at Grasberg. The ceiling of a training area simply collapsed without warning in an area that management has used in the past for its own meetings. Local LOCM -5.49% authorities had called for a cessation of all mining activities while an investigation was being completed. The importance of the Grasberg mine to the local economy, to the workers and to FCX is well grasped and it is not in anyone’s interest to drag out the investigation. Open pit mining is now back to 60% of capacity.
The prior investors in FCX as a minerals and mining company don’t necessarily know much about the oil and gas business based on the questions asked at the meeting. They don’t perhaps know that McMoRan was spun out of FCX years ago and so has always been a sister company. It has interlocking management for that reason. It was pursuing oil and gas activities rather than searching for and discovering and purchasing major world class mineral deposits in Indonesia, N. America, S. America and Africa as FCX has been doing.
More than two years ago, FCX telegraphed its interest in this transaction when it purchased preferred stock that MMR issued to continue its efforts in the Gulf of Mexico play. FCX said at the time it was looking for world class natural resource deposits and it felt that the Shallow Water Ultra Deep play fit that bill as an investment in a long term, long lived asset. For that reason it is hard to understand why some analysts think this merger came out of the blue and without considerable review and preparation.
As for Plains, PXP was involved as a partner in the SWUD (shallow water ultra deep play) with MMR as one of its key partners along with Energy XXI and Tex Moncrief. After the BP BP -0.62% Macondo catastrophe, Plains became more circumspect about its investment in the future of SWUD. Rather than be subjected to future cash calls for the partners, Plains agreed to sell its stake in the play to MMR in exchange for MMR stock. By doing that, Plains retained its interest in the Ultra Deep without having to worry about future cash calls for additional wells or development of discoveries.
Once the decision was made to repurchase MMR’s assets and bring them back into the Freeport McMoRan fold, then the logical next step was to pull in Plains’ 25% stake in the Ultra Deep by buying Plains as well. In addition, the Plains producing properties generate enough cash flow to help fund the Ultra Deep needs for the next couple of years until it starts to generate its own cash flow.
Several years ago, FCX merged with Phelps Dodge. In one of the classic cases of a flea swallowing the elephant, FCX wound up the acquirer. PD had always been a very conservatively managed company with a great asset that was being run like a conservative utility. Few exploration efforts were undertaken beyond what was needed to maintain reserves. The assets as the transaction was booked were quite understated on the balance sheet in terms of the potential reserves. FCX was able to borrow money to make the acquisition even based on the understated reserves. Then as copper prices recovered far faster than anyone expected, and the reserve base zoomed, FCX was able to pay down that debt far more rapidly than anticipated.
Since copper prices are now well off their highs it can be hoped that those prices will recover and again facilitate a rapid debt pay down in this series of transactions as well. The quoted remark was “the best cure for low prices is low prices.” When producers cannot cover their costs to recover a depleting asset, they move investment capital to the higher paying commodities in their portfolio. FXC has one of the lowest costs of copper in the world in Indonesia because the deposits are relatively heavy in gold as well. Of course, in the last year, gold has swooned as well and has dropped about a third in value. Even if demand for copper diminishes in China, India is in the wings waiting to take up the slack along with other developing countries. Major resource discoveries are rare and unusual. Controlling the world’s second largest copper mine is a considerable resource.
Until the prices for its natural resources rise again with economic recovery, FCX has developed contingency plans to maintain its financial flexibility. It fully intends to maintain its dividend and recently declared a cash dividend of $0.3125 per share payable on August 1, 2013. It can defer some capital investment projects. It can slow down the development of some new facilities. It can carefully balance whether to pursue oil projects with oil still near $100 per barrel over natural gas projects where prices near $4 make the ROI less attractive in the short term. A year ago, Natural Gas was selling for less than $2 so current prices are twic the low but at the recent peak, gas was selling in the teens.
Whether gas is at $2 or near $4 as it is today, FCX’s Shallow water ultra deep prospects once brought online will be able to be produced for $2 or less despite the huge costs of discovery and producing these wells. That’s because the discoveries so far have been huge. By contrast, that is a far cry from the $6-7 cost of producing shale gas onshore with fracking techniques and explains why shale gas producers are having such a hard time of it of late. In many cases, wells are only being drilled to retain leases.
The FCX concept is to use the cash flow from Plains’ oil production in California and the Eagle Ford to fund the further exploitation of the Gulf of Mexico activities for which MMR (McMoRan) had become famous in the very shallow water. One exciting prospect is in only ten feet of water. MMR has been pursuing a new geologic model for the Gulf of Mexico which has, over the last seven years of drilling, been proven to be correct. The old model embraced by most academics believed that there was nothing to discover under the listric fault or salt weld. Seismic models have been refined in the last two decades to disprove this approach. McMoRan believes that it is in the lead by several years over its competitors. Majors such as Chevron regard MMR as a leader in this play and have invited it to participate in wells it is drilling such as the Lineham Creek well in the Rockefeller Preserve, onshore Louisiana.
Now MMR is busy tying together the geology in wells that are more than 100 miles away both to the south in the deep water and to the north in Southern Louisiana. It has yet to drill a dry hole and the wells completed as discoveries have found 200-500′ columns of pay contained within four way traps under the salt. The company owns equipment of its own design to drill and complete these wells which are exceptional in terms of temperatures and pressures attendant on drilling to depths of 30,000′ or more.
What remains now is to bring all of the shallow water ultra deep discovery wells into production. Presentations at the meeting indicate that it may be another year or two until significant progress is made on the completion part of this equation. Now that increasing numbers of wells are being drilled in both the shallow water and the deep water of the Gulf of Mexico, it has become harder to secure completion equipment and tubular goods without long lead times. Plains had also bought a 25% interest in some Anadarko prospects in the deep water and plans to continue funding those projects. For sure there will be some internal vying for exploration dollars between the deep water oil projects on which Anadarko is the operator and the shallow water gas activities in which McMoRan is usually the operator.
As with all cases of merging companies with different cultures, there will be some adjusting, jockeying and establishing of new reporting lines with new players in new roles. This analyst meeting was described as a first effort to convey the story to the Street.