The Acquisition of Anadarko by Chevron. Discounted Cash Flow Analysis

Table of Contents

1.0 Introduction

2.0 Industry analysis
2.1 Company and Industry at a glance
2.2 Industry outlook
2.3 Firm Value Drivers

3.0 DCF Valuation
3.1 Forecasts
3.2 Choice of DCF methods
3.3 Leverage and Tax rate
3.4 Cost of Equity
3.5 Cost of Debt
3.6 Valuation results

4.0 Sensitivity analysis

5.0 Synergies

6.0 Value Creation

7.0 Conclusion

8.0 Bibliography

9.0 Appendix

Table of Figures

Figure 1: Anadarko's and Chevron's worldwide operations

Figure 2: Oil reserves by country

Figure 3: Anadarko DCF assumptions

Figure 4: Key leverage metrics

Figure 5: Beta regression

Figure 6: Different MRP assumptions

Figure 7: Debt table and key debt metrics

Figure 8: WACC components and results

Figure 9: Sensitivity analysis

Figure 10: Synergy assumptions

List of Tables

Appendix 1: Revenues and Gross Performance forecasts

Appendix 2: Sales forecasts

Appendix 3: EBIT and Balance Sheet forecasts

Appendix 4: DCF Discount Factors and detailed FCF Present Values

Appendix 5: Equity Beta input data

Appendix 6: Yearly market risk premium data

Table of Abbreviations

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1.0 Introduction

On 12th April 2019 Chevron Corporation announced that they have agreed to acquire all outstanding shares of Anadarko Petroleum Corporation for a total consideration of $65 per share. This marked the first major transaction announcement for quite a while in the Oil & Gas (O&G) industry, which previously saw stock prices near their 10-year lows. Despite a good initial reaction from Anadarko’s shareholders, Chevron ended up missing out on the deal, with Occidental Petroleum Corporation, a close peer of Anadarko, buying the company for $76.67 per share. With a smaller company bidding 18% more per share than an oil giant, this obviously raises the question of whether Chevron's initial bid was fair to begin with.¹

In this thesis, I am going to value Anadarko using the Discounted Cash Flow (DCF) method and applying reasonable assumptions for post-merger synergy effects with Chevron. As validation for my forecast assumptions, which are based on predictions and trends from early 2019, I will include a summary of the overall Oil & Gas industry as well Anadarko’s and Chevron’s positioning alongside the different stages of the value chain. To estimate my cost of capital I will apply the WACC method instead of APV, using the cost of equity and cost of debt as input factors, together with a terminal growth rate instead of an approach with exit multiples. In order to determine how sensitive my results are concerning key input variables like the Weighted Average Cost of Capital (WACC) or the terminal growth rate I will also run a sensitivity analysis. Lastly, I will talk about the synergy estimates used in my calculations and bring them into context with my DCF calculations in order to determine if the transaction would create value for shareholders on both sides of the deal.

Although my calculations ultimately lead me to the result that the price originally offered by Chevron was fair, both in regards to Anadarko’s share price prior to the deal announcement as well as the intrinsic value determined by my DCF, the deal would not have benefited shareholders on both sides equally. While Anadarko’s shareholders would have gotten an immediate double-digit price increase, Chevron shareholders would have lost value with the acquisition, despite my calculations including significant synergies of roughly $1bn per year.

The goal of my thesis, however, is not only to describe the assumptions, calculations and results of my DCF analysis, but to also bring them into context with their respective counterparts published by the management of both companies, financial advisors, equity research analysts as well as other industry experts and to determine key points of difference in our assumptions, while also explaining why I ended up using my numbers, assumptions and forecasts instead of theirs.

2.0 Industry analysis

2.1 Company and Industry at a glance

In order to accurately forecast future financial metrics and determine key DCF variables, it is important to understand the company you are valuing as well as the industry and its key competitors. Anadarko Petroleum Corporation, one of the world’s largest independent Oil & Gas companies, founded in 1959 and headquartered near Houston, is engaged in Oil & Gas exploration (E&P), production, gathering, processing, treating and transportation. In December 2018, the company had reported proven reserves of 1.5 billion barrels of oil equivalent, consisting of oil, natural gas and natural gas liquids.² The majority of Anadarko’s sales, reserves, and overall operations are based in the United States (US) with minor international subsidiaries in Algeria, Colombia, Cote d’Ivoire, Ghana, and Mozambique. The company does mostly engage in onshore operations, although it holds additional minority stakes in offshore platforms, mostly located in the Gulf of Mexico. Anadarko is mostly active in the early steps of the Oil & Gas value chain called Upstream, focusing on underground field exploration and subsequent oil extraction, production and sale with more than 11,000 wells in the United States, but they also have some Midstream capabilities, mainly in pipelines, transportation and oil processing.³ Anadarko does not have any exposure to oil field services or Downstream activities.

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Figure 1: Anadarko's and Chevron's worldwide operations Source: Anadarko 8-K Q1 2019

At the time of the proposed merger, the United States Oil & Gas industry was in a very healthy position. Continued overall economic growth combined with increasing usage of a more cost-effective oil extraction method called Fracking, increased US oil field competitiveness on the international markets and led to the US production of crude oil to double from 2 billion barrel in 2010 to 4 billion in 2018.⁴ Anadarko’s share price, however, was not able to substantially profit from this market development, as two years of uneven operating results, the 2017 Firestone leakage incident and the following temporary suspension of activity, as well as other operating issues, had caused the stock to tank from an all-time high of $112 in 2014 to $46 at the start of April 2018. This makes Anadarko an interesting acquisition target not only for its US E&P peers but also for so-called multinational integrated Oil & Gas conglomerates who engage in the entire value chain from Up- to Downstream, with operating facilities around the world. Anadarko’s closest peers, based on size, geographic focus, and profitability, are Noble Energy, Marathon Oil, EOG Resources, Chesapeake Energy, Occidental Petroleum, and other integrated multinationals such as ConocoPhillips, ExxonMobil, Chevron. The peers mostly compete on the US market, with a focus on Up- and Midstream oil and natural gas activities.

2.2 Industry outlook

The US Oil & Gas industry is driven by numerous growth drivers and risks. On the one hand, the global fracking fluids market is expected to grow at a CAGR of 13.5% until 2026, with the US being the clear market leader.⁵ The increase of fracking operations in the US in past years have already led to the US becoming one of the biggest oil producers in the world again and a substantial increase in recoverable oil reserves, with the US even overtaking OPEC member Saudi Arabia in 2018. Many of those reserves are located either in Texas, one of the main states of Anadarko’s operations, or in the Gulf of Mexico (Rystad Energy (2018). One of the main variables of US Oil & Gas production volume and E&P company profitability is the oil price. Fracking, as well as other new technologies and innovations already lowered the breakeven price for US exploration operations considerably, however OPEC countries and other large producer countries like Russia or Nigeria, are still able to have profitable exploration operations at lower prices compared to their US peers, which makes an increase in US oil production highly dependent on stable if not increasing global oil prices in order to keep US wells profitable and not get into immediate liquidity issues.

OPEC has shown in the past, most recently 2013 and 2014, that they are more than willing to drive down global oil prices with a sudden increase in production output in order to put North American Oil & Gas producers under price pressure (Slav (2019). Recently however, OPEC has refrained from further production cut deals and at the time of the transaction there are no planned deal meetings in the upcoming months, with the only major news being Qatar leaving the cartel, ultimately slightly limiting the cartels power. Furthermore, US sanctions against top oil producers like Iran or Venezuela have helped US producers gain market share and benefit from increased market prices since President Trump took office, who during his campaign often visited southern oil fields, stating that the American Oil & Gas industry will be of key importance in his plans as president (Husseini (2019). The US oil industry however faces significant risks from regulatory authorities like the US Environmental Protection Agency, mostly regarding the lasting environmental effects of the increased fracking operations including air and water quality, soil pollution, and long-term effects on the surrounding vegetation. While President Trump has started to roll back on some of the Obama regulations regarding oil extraction and mineral exploration, this could obviously start to change as soon as after the 2020 election cycle, as many states, watchdog organizations and environmental activists are already warning of the significant impact on nature and the people living in and around the nation’s oil fields.⁶ Anadarko themself had multiple incidents already, most notably in 2017 when they had to pay damages to a family living in the premise of one of their oil fields in Firestone, after a gas leakage caused their house to burn down, resulting in two deaths. Anadarko also famously had to pay fines in relation to their minority interest in the operation of the Deepwater Horizon offshore platform, costing the company roughly $160m after a court ruling in 2015 (Stempel (2015)).

Lastly, one also has to consider the impact of the climate change megatrend, which could lead to E&P Oil & Gas companies seeing a substantial decline in demand especially in the western world and other developed countries for their fossil fuel-based products. With stricter regulations regarding CO2 emissions in most of the developed world, mostly affecting the automotive industry, ultimately one of the biggest oil end markets, and an increased demand for renewable energies, electric and hybrid drivetrains, and other low-carbon technologies could send the market share for fossil-based fuels down to only 77% (Pyper (2018). While these trends and emerging technologies are already visible and in their start-up phase, I do not think that they will significantly impact the Oil & Gas market in a major way in the next couple of years. Due to extraordinary commodity volatility in 2018, many US Oil & Gas companies struggled to perform well, especially those in the E&P sector, resulting in not a lot of M&A activity in the third and fourth quarter of 2018. However, with many public listed companies in the US and Canada now trading near 10-year lows, industry experts and Oil & Gas bankers alike think it is very likely we will see a sudden increase in mergers and acquisitions again. Especially integrated companies capable of using their large balance sheet cash position like Exxon Mobil, Chevron, British Petroleum, or Shell might be among the players looking to further increase their US Upstream exposure in order to increase their efficiency via synergies and economies of scale effects (Eberhart (2019).

2.3 Firm Value Drivers

Overall the value drivers of companies engaged in the E&P industry can be narrowed down to three main aspects. The most important one is the oil and also gas price, as it directly impacts all of the firm’s current and near-future revenue positions, which trickles right down to an increased FCF and therefor a higher valuation. Another important variable are the proven reserves, as the company has to be able to supply the market with oil for many years to come. High reserves can lead to a higher perpetual growth rate assumption and would also increase the mid- to longterm revenue forecasts. Lastly technical innovations, like the introduction of oil extraction via Fracking in the past, can have a huge impact on the cost-side of the companies. Cheaper ways to produce oil would further reduce the operating costs and therefore lead to an increased cashflow, but it could also help reduce the massive Capital Expenditure spending that is currently necessary to explore new locations for their potential oil reservoirs. Lower costs would also lead to a lower profitability barrier, reducing the risk of the companies folding under pressure from OPEC price cuts, demand shocks and other external and macroeconomic influences.

3.0 DCF Valuation

3.1 Forecasts

I start my DCF approach by individually forecasting the important income statement and balance sheet line items for 10 years, with 2028 being the last forecasted year and basis for the terminal value calculation. I try to consider expert opinions, equity research reports as well as macroeconomic factors, and most importantly different sets of risks that could potentially affect the industries performance. Beginning with sales, I use a mixture of top-down and bottom-up approaches, meaning that I consider the size of the total Oil & Gas market, future market prices as well as demand growth.⁷ Forecasting commodity prices, especially those influenced by a multitude of macroeconomic factors and unpredictable events like OPEC volume changes, is very difficult. While analysts expect the oil price to fall slightly in the short term, the overall Oil & Gas production volume, especially in the US, has been growing steadily in the past 10 years (Rystad Energy (2020). Anadarko in its 2018 annual report also outlined proven oil reserves of over 1.5 billion barrels, implying that they could increase the volume if prices were to drop in order to keep revenues stable. With the US real GDP currently being expected to grow on average 1.9% per year until 2028 and Oil & Gas still being the most important fuel type in the world, I decide to use a 1.8% year on year growth rate for all oil, natural gas and other liquid sales items.⁸ I do not think that the switch to renewable energy or increased climate change regulations will affect the E&P business in the coming years, as most of these aspects are currently in testing and start-up phases, not yet ready for mass production and the wide-spread replacement of fossil fuel-based products. I also decide not to forecast any gains or losses for divestitures as these had been very volatile in the last few years, ultimately averaging out at roughly +-$0, and Anadarko’s management gave no indication of any planned divestitures in the 2018 annual report. Gross performance therefore increases from $13.4bn reported in 2018 to $15.6bn in 2028 in my forecasts, which serves as my terminal value year (For a detailed projection of revenues please see Appendix 1).

With cost items instead of forecasting individual growth, I am going with a revenue-based approach. For 2019 values, I use the average percentage of total sales from the years 2016 to 2018 and then at first tried keeping this ratio constant until 2028. However as I do not include any regulatory risks into my revenue forecasts I therefore have to increase the ratio of some cost items namely exploration, marketing, administrative, production and impairment by 0.1% to 0.2% each year to more accurately represent the increased probability of fracking regulation, additional safety standards and an overall increase of regulation in the industry. Cost items with little to no regulatory exposure like operating and transportation as well as other operating costs are kept flat at the 2016 to 2018 average levels. Due to this, the overall costs almost double from $6.5bn in 2018 to $11.2bn in 2028. Anadarko’s management did state in their recent annual reports that they wanted to reduce costs, but the overall costs rising in 2017 and 2018, the chance of costly future lawsuits as well as the industry outlook render the achievement of this goal highly unlikely in my opinion. It also did not seem that there were any major new technologies or innovations to the broad market in the near future, which further proves that a minor increase in costs is indeed the most likely scenario (For a detailed projection of costs please see Appendix 2).

With costs growing at a higher rate than sales, the EBITDA margin decreases from 35.1% in 2019 to only 27.9% in 2028. While these margins, like most of my forecast values, are considerably lower than estimates by equity research analysts, as J.P. Morgan expects EBITDA margins of 55% for 2019 to 2021, I think they more accurately reflect the overall challenges and pressure that will be put on Upstream Oil & Gas companies in the upcoming years.

As with costs, I also use the 2016 to 2018 average to forecast the future depreciation levels, as there is no indication from the management to significantly change the asset base in the upcoming years, with no planned divestitures or M&A. With depreciation at 40% of total sales this means that EBIT would be negative over the entire forecasted period, which in my opinion is not out of line considering Anadarko, as well as other E&P companies, already had negative EBIT numbers in 2016 & 2017. I decide not to further forecast the income statement as EBIT is the last relevant item for my FCF calculation.

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Figure 3: Anadarko DCF assumptions

Due to EBIT being negative, there are no payable taxes in my DCF model, which means that NOPLAT and forecasted EBIT actually always have the same value. I choose to not consider loss carryforward, as I don’t expect EBIT to ever be positive in my forecasts. For capital expenditures, I also use the last three-year average for 2019, with every year after that using last year’s Capex minus 20%. The reasoning behind this is that the majority of Capex is used on exploration, new properties, and turf samples.⁹ There was a lot of spending in this regard in the last couple of years due to new technologies reducing both exploration costs and making production in the US more profitable as well as a large increase in reported oil reserves. These trends however cannot be sustained in the long term and especially considering the risk of potential regulation on Fracking, which should make new explorations more costly and ultimately not economically viable. I therefore believe that Capex will decrease in the coming years, with the focus shifting more towards the extraction and production of the already discovered oil and gas reserves. Anadarko’s Net Working Capital (NWC) has been quite volatile in recent years, but there has been a noticeable upwards trend since 2016. I choose to linearly continue this trend by increasing NWC by $27 million every year until 2028.

Overall Free Cash Flow is increasing from -$295m in 2019 to $3.7bn in 2028, which is largely due to the decreasing Capex and slightly growing revenues offsetting rising cost levels.

3.2 Choice of DCF methods

I now have to decide whether to use the WACC- or APV-method to discount my forecasted cash flows. The WACC based method should be preferred when a company intends to maintain its debt-to-value ratio relatively stable over the course of the forecasted years, while the APV method is usually more suitable for changing debt scenarios.¹⁰ Both methods still discount the same cash flows, but APV uses unlevered cost of equity as the discount rate while also separately valuing the tax benefits from debt, with WACC using the levered cost of equity. I decide to use WACC, as it is easier to use and understand as well as more widely used. During the last 5 years, Anadarko consistently stayed around $15bn in long-term debt, despite years of costly lawsuits, disappointing operating results, and minor acquisitions. With no large acquisitions planned by the management in the upcoming years, exploration Capex forecasted to decrease by 20% each year and a low chance of additional equity issuing due to depressed stock prices, I see no reason why Anadarko’s capital structure should be subject to change.

I also have to make assumptions for the terminal growth rate of Anadarko, which like all other previous forecasts, disregards the effects of inflation completely. With Anadarko’s business model being the exploration and production of fossil fuels, mainly Oil & Gas, I have to take into account that these resources are limited by nature. Integrated oil company BP predicted in its 2016 statistical review that both oil and natural gas reserves would be depleted in 50 years (Ritchie (2017)). US oil consumption continuously rising since 2010, an overall healthy economic outlook worldwide and strong population growth especially in Asia and Africa could lead to reserves vanishing even quicker than previously estimated.¹¹ The growth however could also be limited by government regulation in a multitude of ways. Regulatory risks reach from fracking limitations, higher taxation of fossil fuels to stricter end-user regulation in the automotive sector, or residential heating. I believe that starting in the 2030s many more agreements similar to the already existing Paris Agreement could be in place, essentially forcing a decrease in oil usage even if there still were plenty of reserves available. There also is the non-regulatory climate change related risk of an increased energy mix share of renewables. With renewable electricity output to quadruple their 2010 values in the next 40 years in the US alone, with many European countries expected to grow at even higher rates, it is very likely that these energy sources might be a viable competitor to oil as well as natural gas in the medium to long-term future.¹² Due to this, I decide to use a 0.25% growth rate and not nominal GDP or any other economic growth factor for the terminal value, as they all seemed too high in light of the huge amount of future challenges for the E&P industry and therefore Anadarko.

3.3 Leverage and Tax rate

Due to debt financing benefitting from a tax-shield in most jurisdictions, it is important to consider the implied advantages in the WACC formula. This is usually done by including an effective tax rate into the equation, as the actual tax rate of the previous years can be influenced by one-off items, tax refunds, or like in our case can even be nonexistent due to a negative EBT for US operations. With multinational companies however there often is the problem of choosing the right tax rate, considering revenue in Anadarko’s case is coming from the US, South America, and other regions. However according to the 2018 annual report, all non-US operations are held by a respective national holding company, which in turn is either directly or indirectly 100% owned by Anadarko’s main US entity located in Texas. This means that the vast majority of Anadarko’s revenue is currently taxed under US tax code, so I decide to disregard the minor foreign taxation in my calculations, especially since the share of non-US operations is not expected to grow in the near future. While the tax rate ideally should take the differences in state tax codes in the US into account, there is no reliable data regarding an effective corporate tax rate for the state of Texas or Houston. I, therefore, have to rely on a national effective tax rate, which before 2017 used to be at roughly 35%, before President Trump cut the taxable income items to bring the tax rate down to 21%, with some companies reportedly only paying 18% by using loopholes (Amadeo (2020)). Since there is no indication of Anadarko using such loopholes, I decide to use 21% as my effective tax rate.

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¹ Occidental Petroleum Corporation. (2019, Mai 9). Occidental to Acquire Anadarko.

² Anadarko Petroleum Corporation. (2018, December 31). Anadarko Annual Report 2018. P. 18

³ Anadarko Petroleum Corporation. (2018, December 31). Anadarko Annual Report 2018. P. 9

⁴ US Energy Information Administration. (2020, April 3). US Field Production of Crude Oil.

⁵ Research and Markets. (2018, December 4). Global Fracking Fluids Market Outlook.

⁶ Lipton, E., & Tabuchi, H. (2018, October 29). Driven by Trump Policy Changes, Fracking Booms on Public Lands.

⁷ McKinsey & Company Inc., Koller, T., Goedhart, M., Wessels, D., & Company, M. K. (2015). Valuation. P. 227

⁸ Congressional Budget Office. (2018, August 13). An Update to the Economic Outlook: 2018 to 2028.

⁹ Anadarko Petroleum Corporation. (2018, December 31). Anadarko Annual Report 2018. P. 75

¹⁰ McKinsey & Company Inc., Koller, T., Goedhart, M., Wessels, D., & Company, M. K. (2015). Valuation. P. 135

¹¹ CEIC Data. (2019, September 12). United States Oil Consumption [1965 - 2020].

¹² US Energy Information Administration. (2019, January 24). Annual Energy Outlook 2019. P. 22