Ingrates! McMoRan Exploration Holders, Given Drilling Failures, Should Grab Takeover Offer
McMoRan Exploration (MMR) is being sued by some investors who believe the pending sale of the company to Freeport-McMoRan Copper & Gold (FCX) discounts the actual worth of their shares. Slumping production at existing natural gas properties, combined with deteriorating fundamentals and continued execution risks in ultra-deep shelf properties, suggest shareholders should consider themselves blessed – and walk away.
Freeport-McMoRan is acquiring the Gulf Coast operator for approximately $3.4 billion in cash, with shareholders receiving $14.75 per share in cash – an 84% premium to the closing price of McMoran Exploration on December 4, the day prior to the announced acquisition.
Disgruntled investors opine that Freeport deliberately offered less-than fair value to capitalize on reported difficulties the New Orleans-based company is having with production flow tests from Davy Jones #1, located in just 20 feet of water off the coast of Louisiana. Chairman Jim Moffett had previously promulgated that this field could hold trillions of cubic feet of natural gas. Validation of these potential reserves has been repeatedly delayed, however, due to equipment failures. Most recently, blockage from drilling fluid associated with drilling operations prevented any meaningful interpretation of this much-hyped discovery.
Grousing that the buyout price excludes potential production from Davy Jones is not only wrong but misleading. It is worth reminding investors that management under Moffett has spent more than $1 billion in prospective drilling on Davy Jones and four other exploratory ultra-deep wells in the shallow waters of the Gulf, with no tangible results.
Appraising the actual amount of hydrocarbons in the (Wilcox) reservoir, located at depths exceeding five miles – never mind the economic viability of extracting such reserves – is pushing known drilling technology to its limits. What geological consultants told me in an article I wrote back in January 2010 still rings true today:
“Bottom-hole pressures may be as high as 25,000 pounds per square inch, by far the highest pressures known in Gulf of Mexico wells, and almost 10 times the rocket engine chamber pressure required for spacecraft liftoff. Reservoir temperature is probably considerably more than 400 degrees Fahrenheit too. Gas has never been produced at these temperatures and pressures, and may present engineering obstacles.”
Despite the uncertainty surrounding Davy Jones and its other ultra-deep wells, Freeport hasn’t shut out investors completely. In addition to the $14.75 cash offer per share, the metals miner will issue 1.15 units of a royalty trust that will make payments – should any of these existing ultra-deep exploration properties (in development) actually start-up producing natural gas and other hydrocarbons. Further, the trust could be callable in six-years at an implied valuation of $10 per unit (not bad for “dry” properties).
The depletion characteristics of its Gulf of Mexico properties could explain management’s “swing for the fences” business model. After just three years in operation, the production curve at its largest asset, the nearby Flatrock field, has peaked: its 55% working interest in the five active wells averaged 46 million cubic feet equivalent per day (MMcfe/d) in third-quarter 2012, down from 67 MMcfe/d last year.
Steep decline rates mean McMoRan needs to keep drilling to grow top-line production and replace used reserves. The company has been losing the battle on all fronts, according to regulatory filings: Daily production averaged 134 MMcfe/d in the September quarter, down from 187 MMcfe/d last year; and, from 2008 to 2011, proved reserves (excluding oil and natural gas liquids) fell 37.4% to 152,051 MMcf.
Continued weakness in natural gas prices has adversely impacted McMoRan’s bottom-line results and financial condition. Operating losses totaling $107.8 million through September were inadequate to cover fixed charges (including interest and certain lease payments) of $42.7 million. Consequently, funds from operations aren’t sufficient to cover working capital (including maintenance) and an active drill-bit program. In the first nine months of 2012, McMoRan recorded free cash flow losses of $345.8 million – compared with losses of $282 million and $119 million in the prior two fiscal years!
Given an unstable financial outlook and limited visibility on the commercial prospects of Davy Jones and other ultra-deep, shallow water assets, investors might want to rethink their hostility toward $14.75 per share in cash – especially an offer that’s worth almost three times current book value. To put Freeport’s offer in perspective, the premium being paid for this under-performing “wildcatter” is higher than that of better-run oil & gas plays, such as Exxon Mobil (XOM), Chevron (CVX), and ConocoPhillips (COP).
David J. Phillips, a contributing editor at YCharts, is a former equity analyst. His journalism has appeared in Bloomberg BusinessWeek, Forbes, and Kiplinger's Personal Finance. From 2008 to 2011, David was a reporter for CBS News Interactive. He can be reached at firstname.lastname@example.org.