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Occidental Petroleum CFO Stephen Chazen has no control over the price of oil. But he does get to spend the windfall.
CFO Staff, CFO Magazine
October 1, 2004
Oil. This year it has truly meant black gold for both producers and refiners of crude. With prices nearing $50 a barrel over the summer, the industry has reaped the benefits of record high profits — and taken lots of criticism for the same.
Los Angeles-based Occidental Petroleum Corp., which in 2003 produced the equivalent of 547,000 barrels a day, has been a top beneficiary. Its second-quarter earnings, announced in July, were up 55 percent over last year, to a record $581 million. Meanwhile, its stock price roared to a 52-week high of $53 in September.
But CFO Stephen Chazen knows how double-edged such success can be. Since energy prices are inextricably linked to economics, they have been blamed for all that is wrong in the economy. Companies, including Wal-Mart, have charged that overheated energy costs have caused weak sales. Economists warn that continued high prices could mean more inflation, fewer jobs, and instability in the stock market.
Although oil companies do not set the prices — national oil companies and the countries that run them do — the 58-year-old Chazen insists that the problem "will fix itself. If energy prices are too high, people won't pay them, the marginal demand will decline, and the price will fall. If it is $45 or whatever, that is not a sustainable price. It will fall over time." Still, he concedes, "the national oil companies have gotten used to the higher prices."
What Chazen does control is how Occidental spends the windfall. Overseeing the "capital program is the most important job of financial management," he maintains. And since all oil companies are racing to replenish an ever-diminishing supply, much of that spending must tap new reserves. To that end, Occidental may soon be the first oil company allowed back into Libya — where the company's tycoon-founder, Armand Hammer, made the first of several discoveries in 1966 — now that relations with that former rogue nation have thawed. Thanks to the tight supply of oil in the United States, Occidental is also keen to expand its domestic focus — where it has concentrated for the past several years.
At the same time, Chazen and his oil-company counterparts are still reeling from the scandal involving overstated energy reserves at Royal Dutch/Shell Group. In July, Congress held hearings addressing how oil companies tally their energy holdings, and the Securities and Exchange Commission is seriously considering requiring independent auditors to review those reserves. To Chazen, the crux of the problem lay in the decentralized nature of Shell's organization. And while he expects some added regulation, he is confident that Occidental's procedures are above reproach. Still, he says, Shell "certainly has not done the industry any favors."
Recently, Chazen — who is rumored to be a candidate to succeed CEO Ray R. Irani now that Occidental president Dale Laurance is retiring due to health issues — sat down with CFO deputy editor Lori Calabro to discuss the reserve controversy, his hopes for Libya, and why higher oil prices "will bring out more supply."
Let's start with what everyone wants to know: this summer we saw crude oil at almost $50 a barrel. How high will it go?
We don't know. Certainly by historic measures, these are high prices. The average over the past 5 years has been about $29. Over the past 10 years it's been about $25. But inflation-adjusted, [today's prices are] still much lower than they were in the 1970s. In the late 1970s, oil got to over $40 per barrel, which would be about $94 in today's dollars.
For many years, there was a lot of excess capacity. National oil companies, such as Aramco — which really control pricing — stopped investing in new capacity, because it was too expensive. Like every government, [their owner-countries] had to choose between spending a billion dollars drilling a well or a billion dollars building schools and roads and paying the Army. Not surprisingly, they picked schools, roads, and paying the Army. But then demand rose more sharply than people thought, mostly in China. And when you have small disruptions — such as the decreased oil supply from Iraq and Venezuela and the threat of interrupted production from Russia — which are natural in the oil business, you get spikes in the price. So we're going through a period of abnormally high prices.
What prices do you use for your own budgeting and forecasting?
Normally, we predict prices in the mid-20s. Because it's such a volatile business, we use three cases: a low-case price, a mid-20s case, and a high-20s case. But our ability to predict is nil.
The Energy Information Administration said they expected $37 a barrel through 2005. Where do they get their numbers?
They're making them up. If you look at the EIA and the International Energy Agency, they have an unbroken record of failure to [accurately] predict prices. It is very difficult, because you have to predict the marginal price. No one knows if the world economy is going to be good or not or if the Chinese are going to break the economy or not. What is relatively easy to predict is the supply. But there again, people forget that the existing supply declines and that as your base-load declines, you have to bring on new capacity. It's not like a chemical plant, where you just keep on producing the stuff.
These prices have had an incredible impact on earnings. Your second-quarter results were 55 percent above last year on top of a 50 percent increase in the first quarter. Is that sustainable?
Oil companies are all like us — very transparent in the short term. A dollar change in oil price on an annual basis is about $90 million after tax. So, in the short term, there is very little we can do about our business. Over a three- or a four- or a five-year period, however, management changes the answer. So our investors tend to look several years out, using whatever they think the average price will be. Their other question, though, is, "What are you going to do with the windfall?"
Last quarter, you had $383 million in cash on the balance sheet. Many of your peers have launched share buybacks. What will you do with the cash?
The last time we did one was in 1998. We bought back about a billion dollars in stock at about $26 a share. But we let the market tell us if we're overcapitalized. [At this point, though,] we have taken our debt-to-capital ratio down from 57 percent a few years ago to 31 percent at the end of the last quarter. We look at retained earnings, and if we add $1.50 to $2 to shift the stock-market value for every dollar we retain, we don't think we're overcapitalized. Let's say we retain $10 million. We would expect the equity market value of the company to rise $15 million to $20 million. If we retain $10 million and generate $9 million of stock-market value, then we're overcapitalized and we need to return money to shareholders. It's fairly simpleminded financial theory, and you may say, "Well, that must be easy." The answer is no. Some of our competitors have large retained earnings and make a lot of money, but there is no stock-market value increase even with repurchase programs.
So you're not going to tell me that your share price is undervalued?
Our stock is trading at nine times earnings. But we're not in the business of telling people whether they should own our stock or not. We believe that with our disciplined financial management, we can be in the top quartile of shareholder returns for the oil industry. Whether it's undervalued compared with Emerson Electric or Google or something else, we don't know.... [Of course,] if somebody thought the price of oil were going to be $20 a barrel forever, then clearly the stock is overvalued. If somebody thought the price of oil were going to be $35 a barrel forever, then the stock would be undervalued. But who the hell knows? There are smart guys in New York — they know all that stuff.
One obvious investment is new production. Yours was up about 6 percent this year, but other companies are not stepping up production despite the windfall.
Remember we talked earlier about how production declines over time? Well, it isn't uniform. If you're in the Gulf of Mexico, you might be faced with a 20 to 25 percent annual decline before you did anything. If you're in West Texas like we are, you might be talking about a 7 or 8 percent annual decline. So, you have to invest different amounts of money to make up the shortfall. If you have a bad quarter, which everybody has, you could miss your production. We can't just wake up in the morning and spend more money.
You're in the process of trying to get back into Libya. How important is it to reestablish ties there?
It's important as long as the returns are decent. Right now, the Libyans are rightfully cautious about bringing people back too quickly. They want to make sure they get the best deal for their country. As for us, we're focused on making the right return. It helps, of course, that we're familiar with Libya. A lot of the people there used to work for us. We're familiar with the geology. The crude quality is very good. And don't forget that Libya is very close to Rome, so transporting is easy.
But there are also some concerns about inadequate infrastructure, and Libya's requirement that companies certify they won't do business with Israel.
They're producing oil now. If you're going to double production over the next 5 or 10 years, you're obviously going to need more facilities. But pumps wear out anywhere, and oil will be found in different places in the infrastructure. It's going to take a while, but none of this is nuclear physics. As for the rule about Israel, if you form a new company, you have to certify that you don't do business with Israel. We don't have to form a new company.
There seems to be a rush to get over there. Is there room for everybody?
No, probably not. Libya is attractive because it's underexplored and people know there is oil there. But even we wouldn't do it unless we thought we could make $100 million a year after tax.
Does the idea that oil has become such an economic scapegoat affect your company at all?
It seems there are three things you can blame everything on: the weather, the Chinese, or higher energy prices. It's never the fault of bad management or management that didn't anticipate well.
What do you blame things on here?
Is that all?
[Laughing] Internally, we blame it on bad management.
Still, day after day, there are stories about companies blaming high energy prices for poor expectations. And many experts predict that the high prices could lead to double-digit inflation or stagflation.
What are you going to do? Most of the blame fortunately falls on the refiners, Chevron and Exxon. There is no Oxy gas. I always tell people that there are 42 gallons in a barrel. We're selling ours for only a buck a gallon. The other buck is obviously being taken by somebody else. Those are the guys to look for.
Can we talk a little bit about what happened at Shell? Were you surprised by the reserve accounting debacle?
Yes and no. We've always held Shell in high regard technically. But if you allow the reserve engineers to work for the profit centers, then they're under pressure to make reserves better. And if you have a long history of doing that, it's hard to get out once you cheat. It's like someone who warms the books. Pretty soon they can't get out of warming and have to cook them, and pretty soon they're frying them. That's what happened there.
Were bad accounting rules to blame?
The things that Shell did, as I understand them, are not gray areas of the rules. Estimating what you can't see is not necessarily easy. But, for example, you're not permitted to book reserves beyond your contract life. That has always been true. So, if you have a 10-year contract with some country, even though you might think you might be able to extend it 5 more years, you are not allowed to book those 5 years of reserves. You're required to have a market for your gas.
What was your immediate response?
Our board hired someone to go in and check our reserves.... But we had a lot of competence because of the nature of our processes. If you look, for example, at your revision to prior [reserve] estimates, which is what you put in your annual report, it ought to be uniformly positive every year because you're not supposed to estimate what's there; you're supposed to disclose what's sure to be there. The other thing is to look at the percentage of proven, undeveloped reserves. Again, if you have a very high percentage of proven undeveloped [reserves], you have a lot more risk in your estimate because you really haven't put the money in yet. Most of the companies years ago had very little proven undeveloped reserves, and now a lot of them are up around 50 percent. We're about 20. Fifty percent means there's a lot of risk in the calculation.
Are you saying that other oil companies use very aggressive accounting techniques for reserve reporting?
It's not that it's necessarily aggressive. It's simply at the upper end of the band of acceptable calculations.
There was some indication that the problem was more operational than financial. It wasn't until four months later that Shell CFO Judy Boynton was forced out. Did you change your reporting structure in response?
The internal audit — the internal reserve audit people — now report to the vice president of finance rather than to the oil company. Not that we thought it was necessary, but we thought it made people feel that it was under a different setup.
How about your disclosure practices? Lately, when there has been any inkling of an accounting scandal, part of the answer has been more disclosure.
A little bit, but that's really nothing. The revisions are key. We have an internal committee that reviews the reserves now. We have different reporting relationships for the reserve auditors and an annual review by an outsider. We changed the format, but we don't expect to change the answer.
Energy prices are a hot political button. There is an energy bill — currently stalled in the Senate — that calls for reducing our dependence on OPEC and increasing domestic production. And both Kerry and Bush are announcing policies. But is there really anything the government can do to control prices?
In the U.S., one thing they could do would be to speed up the process of building LNG terminals. That would bring the cost of energy down probably faster than changing mileage requirements for cars. Gasoline might stay high, but it would be displaced by natural gas from Indonesia. All the other [proposals] are longer term, and lowering mileage makes Japanese carmakers stronger than U.S. ones. That doesn't work well in Michigan and Ohio. And last I looked, they were swing states.
Still, would a Kerry victory be bad for the oil business?
I don't think it makes a lot of difference. We've been in a bull market for the commodity since 1999. I don't think George Bush or any other President changes it very much. They can make it worse. They could raise taxes on us, but I think the government is moderately rational.
You talk about demand for oil, but some experts worry about the supply. Do you believe we may be at the peak?
Eventually, that's true. But if oil keeps going up in price, people will adjust their usage. There's a lot of natural gas in this world. So you might see migration of the chemical businesses to where natural gas is [used more] in the United States. You might see more LNG run our power plants. Oil itself is a very useful commodity, and would be better off focused on those things that it's more useful for, which is probably cars rather than stationary power sources.
Is this a good time to be the CFO of an independent oil company?
It's an easy time. But if it stays this way forever, the job becomes more challenging. You see, even negative volatility is OK. In that scenario, we have the resources to do things such as buy additional reserves and invest in other long-term projects. If people start banking on $45 forever, it will be more difficult to grow.... But we can't do anything about the current situation [except] count the money.