3 Oil Firms Learn Cost of Freedom : Price Dive Begins to Crush Debt-Laden Arco, Unocal, Phillips

Camron Cooper, the corporate treasurer of Atlantic Richfield, sounds like the protagonist of a romantic novel confronting elemental forces when she declares: “We do know this--that we are going to be masters of our own destiny.”

If she sounds a little wishful, it is because Arco’s destiny and that of many other oil companies is likely to be dictated by a force beyond their control: a collapse in oil prices so precipitous that no one anywhere anticipated its severity.

The rapid fall in prices, which accelerated in December and January, has changed the rules of the oil game in ways that have increased the span between the strongest companies and the weakest, and have turned the weakest into enterprises of dubious health. Along with reserve size, revenues and refining capacity--the customary yardsticks by which oil companies are ranked--investors now use another: debt burden.

By that measure, the three companies that moved most aggressively to fight such corporate raiders as T. Boone Pickens Jr., who two years ago began a series of takeover attacks in the oil patch, are now the ones whose continued health is considered the most doubtful and whose stock and bond prices have lately been the most battered. In declining order of financial strength, they are Arco, Unocal, and Phillips Petroleum.

Takeover Defense

Expecting oil prices to decline, but modestly and slowly, many major oil companies decided a year ago that their best defense against raiders was to pump cash into the shareholders’ pockets before the raiders could.

Oil firms repurchased billions of dollars worth of their own stock, often with borrowed money. If the resulting debt load was too much to handle, they counted on paying down the loans and redeeming the bonds by selling off oil and gas properties and other assets.

The takeover wave in the energy industry was widely decried in some quarters as “drilling for oil on Wall Street.” But oil firms that chose to reorganize by acquisition--Chevron, for example, which bought Gulf Oil in 1984, or Texaco, which acquired Getty shortly thereafter--acquired valuable oil reserves at the equivalent of $4 to $6 a barrel, analysts say. Even in today’s pricing climate, that looks good in comparison to the $12- to $14-a-barrel cost of finding new oil in the ground.

But Phillips, Unocal, and Arco reacted to the acquisition boom by resolving to remain independent at any cost. The swift drop in oil prices has raised that cost to a level that company executives could scarcely have imagined. Strategies that won plaudits from Wall Street when the prospects were for a graceful slide in prices now appear to have been horribly imprudent in light of the precipitous drop.

‘Pickens’ Revenge’

Consequently, today the three companies suffer from what might be termed a case of “Pickens’ revenge.” Having sharply pared capital spending, converted billions of dollars of equity to debt by repurchasing their stock with borrowed money, and pumped more cash into their shareholders’ hands by increasing dividends, they find themselves blind-sided by a drop in oil prices of totally unanticipated scope.

“I don’t think there’s been a downward change of this magnitude that’s ever happened before,” Phillips President Glenn A. Cox says.

All their projections of cash flow and net income--keys to their ability to pay interest on their debt--are invalid. The sales of oil and gas properties by which they hoped to recover billions to reduce the debt load are now close to impossible, or can only be closed at fire-sale prices.

“In this market I don’t think there are any buyers out there,” says Donald Fernow, an industry analyst for Thomson McKinnon Securities.

Phillips, for instance, planned to raise $2 billion in 1985 by selling off properties to pay off debt. But the company raised only slightly more than $1 billion by the end of the year, leaving it with $6.8 billion in long-term debt rather than the anticipated $5.7 billion. The difference could cost it as much as $130 million a year in unanticipated interest expense.

The oil crash has even upended the very rhetoric Phillips and Unocal employed to enlist their shareholders in the fight against Pickens--that the loyal, long-term holders of company stock should benefit more than the short-term opportunists who were behind the takeover wave.

Holders Suffering

Since Pickens and his allies sold their shares back to the companies at the top of the market and at a profit, the subsequent disintegration of these companies’ stock and bond prices means, in the words of Sanford Margoshes, oil industry analyst for Shearson Lehman Bros., that “while the short-term shareholders did very well, the long-term shareholders are really suffering.”

Forced now to cut back on exploration and development, the oil firms are beginning to realize that they mortgaged their future to produce a short-term return.

The takeover-and-leverage game, says Lester C. Thurow, professor of economics at Massachusetts Institute of Technology, was “efficient as a financial market phenomenon, but not as a real phenomenon--and in the long run the real economy dominates. People were acting as if the oil industry was riskless, but we knew all the time that it was not.”

Thurow argues that the economic devastation concentrated in the oil patch is likely to take some of the bloom off the manifest economic benefits of lower oil prices. “The companies have been made much less robust,” he says. “They can’t take the downturn in oil prices or the economy that they could have, because they’ve borrowed more than their assets are now worth.”

The over-leveraged condition of many major oil firms has aggravated the spreading disaster in the oil-field service and offshore drilling industries, which count on the major companies as customers.

Less Exploration

“Its obvious that all these companies used discretionary funds for exploration purposes,” says C. Russell Luigs, chairman and chief executive of Global Marine, an offshore driller. “To the extent that restructurings or mergers have reduced the amount of discretionary cash flow, they’re spending less on exploration.”

Global Marine suspended payments on its debt in mid-1985, having become strapped for cash because of the chronically low drilling activity of the last couple of years. After nine months of negotiations, the company had just completed a new agreement with its lenders in December, when the latest price collapse struck. The company’s board decided to seek protection from creditors under Chapter 11 of the Federal Bankruptcy Code.

“The revised business forecast was devastating in terms of the company’s prospects,” says Jack Laeri, head of the corporate reorganization group at First Boston Corp., and the investment banker in charge of Global’s negotiations. “Global Marine only does business with 35 or 40 oil companies--the ones with the big exploratory programs. When those companies cut back their exploration budgets, the outlook is bleak.”

Although many other oil companies are likely to cut back their drilling and exploration programs until oil prices stabilize, it is the debt-burdened ones that must move first. Arco, for example, which loaded up on nearly $3 billion of debt last year, last week cut its 1986 capital spending budget by a third, to $2 billion. Oil and gas exploration and production, which last year consumed $2.95 billion, were cut to $1.35 billion.

Spending Reduced

Unocal, which added $4.8 billion in debt last year to repurchase shares, has slimmed down capital spending as well. A spokesman says, “we feel we can reduce our capital expenditures without jeopardizing our exploration projects.”

And at Phillips, Cox says all exploration decisions are on hold. “We will not make discretionary commitments until we see how this all settles out,” he says.

By any measure, Phillips is the most vulnerable of the three, having the largest debt burden and the most threatened dividend. Consequently, its stock has suffered the largest relative price decline recently among major oil companies, and its bonds command the highest interest yields (thus, the lowest relative prices) among the same group. When Standard & Poor’s last week listed 13 oil-related companies whose credit ratings were likely to be revised downward, Phillips was the only integrated oil company in the group.

These market reactions reflect a perception in the investment community that the company overreacted to Pickens’ assault. “With the aid of some hindsight, you’d have to say they would have been better off capitulating,” says Mark P. Gilman, oil analyst for E. F. Hutton & Co.

Pickens mounted his attack on Phillips in November, 1984. He gave it up a month later when the company bought back his stock holdings for $472 million, giving him an $89-million profit. As part of the truce, Phillips undertook a $3.5-billion recapitalization ostensibly designed to prop up its stock price at $53 per share. (Following a 3-for-1 split, the stock is now selling for the equivalent of about $28.)

Increased Debt

Phillips repurchased 38% of its stock, borrowing the money to do so and thus increasing its long-term debt to $6.5 billion, or some 80% of its total net worth, from $2 billion. Its annual interest payments rose to $778 million from $314 million, or more than its actual profits. Company executives had no illusions about the impact of this enormous change. “Did we expect this to reduce our flexibility? The answer is yes,” says Cox, the company president. “And the company does face limitations on what it can do today.”

But even those manifestly straitened expectations were based on assumptions about the oil market that looked sagely pessimistic at the time but now appear Pollyanna-ish. The company forecast that the price of oil would remain at $27 a barrel through 1985 and 1986, rising to $28 the following year. If the price fell to $25, Phillips said, it might lose as much as $120 million in annual profits.

Below $25 a barrel, the company warned, all bets were off as to the market’s impact. “Once it got beyond there, our accuracy melted away very rapidly,” Cox says.

Still, using the company’s rule of thumb of a decline of up to $60 million a year in profit for each $1 drop in oil prices, the $10 decline thus far would wipe out Phillips’s entire net income.

Dividend Threatened

The Phillips debt prospectus did make one firm statement: If prices fell to $20, the company would have to eliminate its dividend. With prices now closer to $15 a barrel, many in the industry wonder whether Phillips’s dividend of $1 per share is about to become a thing of the past.

Cox says the dividend won’t be cut or eliminated at least until oil prices stabilize and their long-term trend can be better discerned. “Prices have been falling for a little over a month,” he says. “That’s not the evidence you base a dividend decision on.”

“They recognize that the dividend is the key variable that holds the price of their stock where it is today,” remarks Frederick Leuffer, oil analyst for Cyrus J. Lawrence Inc., a New York investment firm.

At Los Angeles-based Unocal, analysts say, the annual dividend is not quite as vulnerable because it consumes a smaller portion of the company’s cash (about $139 million annually, compared to $285 million at Phillips).

But the company’s long-term debt of $5.2 billion year-end 1985 is still well more than 70% of its net worth, a level unwise for any company in almost any industry.

“We probably would not have undertaken what we did, had we not found ourselves in the situation we did,” says a spokesman, referring to Pickens’ takeover campaign.

Arco is considered to be the strongest of the three most highly leveraged companies, partially because it undertook its restructuring before any raider was actually puffing at its door, and thus faced less immediate pressure.

Cut Its Overhead

Basing its program on the assumption that oil prices would decline to as low as $18 per barrel of West Texas crude from the $29 level in April (it is now around $15), Arco stressed cuts in its operating overhead, paring $250 million a year from its exploration budget and $115 million a year in staff expenses by laying off thousands of workers.

“We felt the restructuring would be solid even against a drop to $18 a barrel by 1987,” says Anthony Fenizza, Arco’s chief economist. “We got the drop we expected, but all in one year. We’re damn happy now we went through the restructuring, particularly the cuts in overhead.”

Arco did cut back the scope of its restructuring as the price slide began. Initially planning to repurchase $4 billion in shares, the company cut its program short at $3 billion “because of the speed of the decline,” says Cooper, the corporate treasurer.

But because Arco was not facing an immediate threat many analysts feel the company “overreacted,” says Shearson’s Margoshes. “They exaggerated their stock buy-back and preempted a hostile takeover with a substantial debt-equity swap. Now the chickens have come home to roost.”

Although executives at Unocal and Phillips say no one in the executive suites has suggested that they should have sold out to Pickens, they are clearly uneasy that their ability to control their own futures is limited by their own financial squeeze and by the machinations of Saudi Arabians.

“Given the circumstances that the world energy situation is in today,” says Cox of Phillips, “we’re such a minute factor that there’s nothing a company the size of us can do. All of us could second-guess ourselves all over the lot, but I think basically our response ( a year ago) was appropriate under the circumstances.”