Chevron's Gamble

The Wall Street Journal

By Russel Gold
August 11, 2005

Deal for Unocal bets on oil prices staying high

With its planned purchase of Unocal Corp. for $18.1 billion, Chevron Corp. has landed the biggest oil acquisition in years and snatched a prize away from a government-controlled Chinese company.

Behind this victory, though, lies a giant bet on the future of energy prices. If they stay high, Chevron Chief Executive David O'Reilly could be remembered for a stroke of genius. If they tumble, Chevron's results could suffer for many years to come because of the high price it paid for Unocal.

Unocal shareholders approved the deal Wednesday, giving Chevron access to oil and gas fields across Asia and North America. O'Reilly needs the new supplies: Chevron's production has fallen 14 percent since he took the reins in 2000, according to the energy research firm John S. Herold Inc.

Chevron's decision to swallow Unocal comes amid an increasingly tense debate over whether the world's oil supplies have hit a peak and are about to start running out. If so, that will mean sky-high oil prices and a race for control of companies such as Unocal that own proven reserves.
Some leading oil companies, including No. 1 Exxon Mobil Corp., flatly reject the so-called peak-oil theory. They say there's still plenty of oil out there. They think oil prices, which hit $65 a barrel this morning, will retreat over the long run and that it doesn't make sense to pay a premium price for companies like Unocal.

Exxon Mobil's outgoing chief executive, Lee Raymond, has dismissed his competitor's deal as ill-timed. "I can never remember an industry consolidating at high prices," he said in an interview earlier this year.

While O'Reilly hasn't said that oil production is peaking, he believes oil output won't be able to keep pace with galloping demand as China and India emerge as huge oil consumers. With governments scrambling to secure energy supplies, he foresees oil becoming an increasingly scarce and expensive commodity. O'Reilly, 58 years old, declined to be interviewed before Chevron completes its Unocal acquisition.

When Unocal became available, O'Reilly went flat out to snap it up. After Chinese company Cnooc Ltd. lobbed in a higher bid, Chevron helped fan protectionist fears in Congress and sweetened its own bid. Last week, Cnooc withdrew, citing the intensity of the political opposition in the United States.

Chevron, based in San Ramon, Calif., posted net income of $13.3 billion in 2004, up 85 percent from a year earlier, thanks to soaring oil prices. This made it the fifth-most profitable U.S. corporation, trailing only Exxon Mobil, General Electric Co., Bank of America Corp. and Citigroup Inc. Since O'Reilly took over, Chevron's total shareholder returns have been neck-and-neck with Exxon's and outpaced those of big competitors Royal Dutch Shell PLC and BP PLC.

The strong results, however, mask weakness in Chevron's core business: finding oil and gas. Last year, it pumped the equivalent of 2.5 million barrels of oil out of the ground every day. After factoring in asset sales, new discoveries and revisions to previous estimates, it didn't come close to adding that much in proven reserves. Its "replacement rate" was just 18 percent - one of the worst showings by a large oil company in recent years. If that continues, Chevron could eventually pump itself out of existence. That is why many in the oil patch see Chevron's acquisition of Unocal as a sign of weakness, not strength.

Unocal is much smaller than Chevron. A pure exploration and production company, Unocal has operations in nine countries. By comparison, Chevron operates gas stations, drilling rigs, chemical plants and refineries in 180 countries. Unocal has several projects - Gulf of Mexico production platforms and a minority ownership in a Caspian Sea venture - that are about to ramp up production.

Chevron is paying about $10.30 per barrel of proven reserves at Unocal. Last year, the cost of finding and developing a barrel of oil rose to $9.16 a barrel for big international oil companies, according to the investment firm A.G. Edwards, up from $7.40 in 2003.

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