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A SPEECH BY T. BOONE PICKENS, JR.
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Many industries face change and, ultimately, an industry's success and survival depends on its ability to adapt to these changes. For the American petroleum industry, the 1970s produced an environment where changes occurred at a revolutionary pace. The 1980s will surely bring more change as the industry has become a "tougher," more competitive business, and new political leadership grapples with topics such as inflation, deregulation and energy independence. Such factors as declining production and reserves coupled with increased finding costs will cause America's petroleum industry to reevaluate its direction.
Oil and gas companies, both large and small, are managers of depletable assets (i.e., reserves), and the continued replacement of production is essential to the maintenance and growth of the shareholders' investment. Therefore, the optimum reserve base for any size company is one which can be replaced annually through new discoveries and/or acquisition. Managements of oil companies that cannot replace production must ultimately answer to their shareholders. Under the present structure of the industry, the exploration and development budgets of many companies are not large enough to replace the annual depletion of reserves through new discoveries. For many of the larger companies, a portion of the cash flows from oil and gas operations are channeled into other industries because limitations on availability of technical personnel and quality prospects constrain reinvestment within the petroleum industry.
For some companies, there is no hope for replacing production. As a result, many of them will become involved in sell outs and/or mergers.
Sellouts will occur for several reasons including (1) managements reach retirement age without a clear line of succession; (2) a lack of prospective acreage prevents aggressive exploration; (3) the availability of necessary financing; and (4) some companies simply do not have the necessary desire to compete.
Takeovers will occur primarily because it is cheaper to buy reserves than to find and produce them. However, this course of action is not without problems. Friendly offers can spawn hostile ones, and companies which acquire additional reserves without the means to maintain the larger reserve base face more severe decline rates.
There may be a solution to some of these cases, though somewhat drastic—it involves a restructuring of the industry based on the royalty trust concept.
In 1979, Mesa pioneered the concept of creating a royalty trust as a means of ensuring its shareholders a more realistic value for the Company's assets. Mesa's common stock was selling at a fraction of its real value. If a company is replacing reserves, which Mesa has consistently done for 18 years, then its stock should not be selling at below asset value.
In its simplest form, the royalty trust grants each shareholder a direct ownership interest in producing properties, thus providing a substantial income stream unburdened by income taxes at the corporate level. Mesa spun off approximately half of its reserves, 8 million barrels of oil and 800 billion cubic feet of gas, to the Mesa Royalty Trust. By converting the economic benefits of the properties into a direct income stream, the stock market is more likely to recognize the value of the underlying assets, resulting in a significant appreciation of each shareholder's investment.
Mesa was successful in accomplishing this as indicated by the following sequence of changes in market value:
February 1979 (before trust was announced) - Mesa common stock was selling for $34 per share.
June 1979 - the trust was announced, and Mesa was selling for $44 per share.
November 1979 - the trust was actually formed, and the combined value of one share of Mesa common stock and one unit of Mesa Royalty Trust (distributed on a one-for-one basis to shareholders) was $65.
December 1981 - Following two stock splits on a one-for-one basis, the combined value was $115.
In less than two years, the market value had more than tripled.
By spinning off a portion of its assets, a company reduces its reserve base which then can be more meaningfully impacted by new reserve additions. By forming trusts, more companies would be able to replace production on a continuing basis, thus avoiding the depletion of the shareholders' investment. (While the reserves transferred to royalty trusts would deplete over time, each shareholder receives directly the income from production and, therefore, his economic interest is not impaired.) Consequently, these companies would become more viable and would very likely increase their price/earnings multiples. A company retains a 100% working interest in the trust properties; therefore, it keeps control of the reserves. Also, because a company maintains its full working interest, no reduction in personnel is required.
Today, there are fewer good prospects available, yet more companies have excess cash flow. This can result in those companies investing outside the industry becoming more vulnerable to stockholder and even political criticism.
Even with the election of President Reagan and the change in control of the U.S. Senate, political attitudes toward the industry can change rapidly. For example, in Great Britain, Prime Minister Thatcher said before her election that she would oppose any additional taxation of the oil industry. However,economic conditions have forced her to do so three times. In Canada, Prime Minister Clarke's election was viewed as favorable for the industry, but he held power for less than one year and was followed by Prime Minister Trudeau who began the "Canadianization" of the petroleum industry. Economic woes could even force President Reagan to look toward the industry as a revenue source.
If numerous companies formed trusts, it would create thousands of new royalty owners throughout the United States, which would provide increased and broader geographical-based political support for the industry. The reduced cash flow after a royalty trust distribution would be more in balance with many companies' prospect inventory and number of employees, thus allowing efficient reinvestment of capital within the petroleum industry.
To continually replace production requires a quality acreage position and aggressive exploration. Both require substantial budgets. Mesa has replaced and added to the Company's reserve base over its 18-year existence. However, on the basis of comparative reserves, Mesa has continually run budgets far larger than their peer group. Mesa's 1981 capital expenditures were approximately $470 million.
Not only could the industry benefit from the formation of royalty trusts but so could the U.S. Treasury Department. Mesa has prepared various analyses on the effect that the royalty trust concept could have on the industry. A study of 100 public oil and gas companies, includng all of the majors, indicates that if each of these companies created royalty trusts comprising one-half of their U.S. reserves, approximatley $130 billion in present value would be distributed to shareholders. Annual distributions of income from these trusts would approximate $15 billion.
Mesa estimates this would create additional federal tax revenues of some $10-$15 billion on the initial distribution and $2-$3 billion on the annual distribution.
The U.S. Treasury Department could further the recognition and acceptance of the royalty trust concept by announcing that it accepts the "grantor trust" tax status of such trusts. Additionally, the Treasury Department could agree to consider such spin-offs to shareholders as capital gains, further encouraging companies to consider the concept.
Obviously, the royalty trust concept will not fit all companies. Those who have acreage, personnel and cash flows in balance are probably not candidates. However, the managements of every oil and gas company with declining reserves and production plus excess cash flow owe it to their shareholders to seriously analyze the royalty trust concept. Upon objective analysis, many managements will find that it is a viable vehicle for assuring that shareholders receive full value for their assets.
Under the royalty trust concept, all parties are winners. The shareholders receive a more direct return on their investment and realize the full value of their assets. Managements would be able to more easily impact their company's reserves and not be under so much pressure. (Some managements object to the idea of "giving" part of a company's assets to its shareholders. In fact, they are "giving" nothing, as the shareholders are the company and, therefore, already own the assets.) And, the government would be able to increase its revenues.
In summary, America's petroleum industry is facing a period of dynamic change. This will include a complete restructuring of many companies with major portions of assets being distributed to shareholders. The result will be smaller, more exciting companies which can be more easily impacted with discoveries of oil and gas, and, therefore, attain their optimum reserve base.
Also, as a result of leadership by President Reagan, changes in the nation's political climate are helping end a long period of government roadblocks and criticism which have not only hampered the industry and business in general but also the nation's search for increased energy independence.
Without a doubt, a restructuring of the petroleum industry based on the royalty trust concept will be a major undertaking. However, the results will give new life to one of our nation's most important assets, an aggressive oil and gas industry.