Private Empire: ExxonMobil and American Power (78 page)

“I’ve got to do something about natural gas,” Tillerson explained. All of ExxonMobil’s corporate forecasting pointed toward rising gas demand during the next two decades and beyond, in the United States and globally. Shale or unconventional gas discoveries had upended American markets, flooding the country with apparently durable sources of supply. New discoveries were being announced around the world. ExxonMobil had no global organization dedicated to the full gamut of the emerging unconventional gas challenge—exploration, technology, engineering, drilling, finance, and marketing. Unconventional gas required new thinking in many of these disciplines. “I’ve either got to build my own or I’ve got to buy somebody with expertise,” Tillerson said. They discussed how ExxonMobil’s vast financial resources could bankroll a worldwide expansion of the business and drilling strategies Simpson had developed in the United States.

With XTO, ExxonMobil would buy some attractive American gas properties, yes, but the larger purpose would be to convert the acquired corporation into a new gas division inside ExxonMobil. The deal would not be driven by prospective cost savings. It would be a way to buy depth in the natural gas sector faster than ExxonMobil might create such capability on its own.

“One plus one has got to equal three or more,” as Simpson and Randall put it during the early talks, summing up the shared Exxon and XTO view of the merger’s goal.
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An agreement to merge with XTO would be the most important decision so far of Rex Tillerson’s tenure as ExxonMobil chief executive. The corporation had not made an acquisition worth more than $2 billion since the $81 billion merger with Mobil a decade earlier.
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An XTO deal would likely be worth only about half of the nominal value of the Mobil transaction, before accounting for inflation since then, but even so, it would constitute a major bet placed on behalf of ExxonMobil shareholders.

Until now, Rex Tillerson had presided competently over strategies, projects, and plans bequeathed to him by Lee Raymond. Arguably, the only major strategic shift Tillerson had steered since taking over was in politics and public policy, by repositioning ExxonMobil on climate change and carbon pricing, and by seeking, however quixotically, to improve ties to Washington’s ascendant Democrats. Tillerson could be sure of one thing: Once news of his talks with XTO became public, his strategic business judgment would be scrutinized as never before.

B
y the time Tillerson and Simpson moved into full-blown merger talks during the fall of 2009, it had become common for industry analysts to attribute the unexpected American natural gas boom to technological innovation—that is, the discovery, refinement, and implementation of new techniques to extract gas previously thought unrecoverable. There was truth in this, but the “eureka” explanations masked a long history. Engineers at Exxon and many other companies had known for decades that the United States had large amounts of gas trapped in sand, shale rocks, and coal beds. They had also long known that certain unconventional drilling techniques—horizontal drilling and techniques to inject pressurized fluids to fracture rocks to release and join isolated pockets of gas—might allow these reserves to be exploited. The obstacles to refining these techniques mainly had to do with their costs. During the 1980s and 1990s, the wellhead price of natural gas in the United States hovered at or below two dollars per thousand cubic feet. The drilling techniques required to unlock unconventional gas were often too expensive to justify at that price.

If the United States had possessed a national energy policy that emphasized domestic supply even when such supply might cost extra, the government might have stepped in to conduct advanced research. There was no such policy. The government-funded institute that studied unconventional onshore gas drilling technologies and techniques—the Gas Research Institute—had withered by 2000, for lack of industry, congressional, and White House interest. After 2001, American natural gas prices moved up, toward four dollars and then five dollars per thousand cubic feet, and later toward seven dollars. The price rises, not any fresh thinking in Washington, changed incentives.

One of the Gas Research Institute’s directors was a Texas natural gas wildcatter named George P. Mitchell, the founder of Mitchell Energy. His firm produced gas from a conventional field in the Barnett Shale, in North Texas, but his field was aging and its rates of production were in decline. Mitchell knew there was more gas beneath his leased ground, but the gas was trapped in shale rocks. As American gas prices finally rose, he galvanized his engineering staff, with aid from the research institute, to revive and improve drilling techniques to fracture rocks and pull gas from difficult beds. As he succeeded and proved the viability of this approach, others joined in—among them, XTO. Record-high gas prices and tax incentives that allowed for recovery of research costs forgave expensive learning and mistakes.
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Unconventional gas drilling damaged the environment. The techniques could contaminate groundwater, if carried out improperly, by causing chemical-laced drilling fluids and natural gas to leak into aquifers. Drilling companies did not typically disclose the chemical makeup of fluids used to fracture rocks, for competitive reasons, so the public could not easily judge whether the fluids were dangerous to human health. The onshore gas rush also had sizable impacts on land use and development in rural areas—it turned pristine spaces into industrial zones. In the early days of the onshore gas boom, however, the drilling took place mainly in oil-patch states like Texas, Oklahoma, and Louisiana, whose populations and political classes had long ago decided that the economic benefits of oil and gas exploitation, properly managed, outweighed the environmental risks.

Geologists wielding modern computer software and ground penetration radar had not previously devoted themselves to looking for “tight” or trapped unconventional gas beds in the United States. When they did in earnest, after 2003, they reported large finds. As early as 2003, the Gas Technology Institute, successor to the Gas Research Institute, revised past estimates upward to report that America’s total natural gas resource base was about 2,000 trillion cubic feet.
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Americans consumed a little more than 20 trillion cubic feet of natural gas in 2003, roughly the equivalent of 8 million barrels of oil per day, or nearly the amount of the country’s actual liquid oil imports. (These numbers explained the very rough, back-of-the-envelope forecast that the United States had a century’s gas supply under the ground: One hundred years of consumption at 20 trillion cubic feet per year equals 2,000 trillion cubic feet.) As the years passed and other government and industry panels considered the matter, they published similar top-line figures. But the estimates proved shaky; there was no doubt that there was a lot of unconventional gas in the United States, but exactly how much could be recovered as commercial fuel involved engineering questions that had barely been studied. The most bullish forecasts sounded like hype because they lacked a solid scientific basis.

How long unconventional gas resources might truly last would depend, for example, on the pace of geological depletion in gas beds. This was a matter with which drillers had relatively little experience because the techniques were so new. Other factors would include the pace of demand for natural gas in electricity generation, particularly as a substitute for coal; the future of carbon pricing and greenhouse gas regulation; the trajectory of natural gas prices; and the pace of technical innovation. The idea that the United States truly had enough of its own gas to last a century seemed optimistic, but equally, the forecast in 2003 by Alan Greenspan that America might have only two decades of domestic supply remaining, and that “we are not apt to return to earlier periods of relative abundance and low prices” had clearly been proved incorrect.
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ExxonMobil reentered American unconventional gas exploration and production on a modest scale after prices rose enough to meet the Management Committee’s rigorous return-on-capital guidelines. After Tillerson took charge, he pushed into onshore unconventional gas leasing more aggressively. The environmental issues did not seem to concern him greatly. He conceded that there had been cases where the handling of fluids used to fracture rocks had “not been done as well as it could be,” but the “incidents” constituted a “very, very, very small percentage” in the context of total production. He also declared that the threat to underground drinking water from such drilling was “very low.” Tillerson’s emphatic tone echoed Lee Raymond’s early confidence about the evidence on climate change, but he was unabashed. Within ExxonMobil, there was controversy about shale gas, but it did not involve environmental issues. It concerned the company’s strategies for replacing the amount of oil and gas it pumped and sold annually.
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ExxonMobil’s huge investments in liquefied natural gas showed the corporation’s bias toward “manufacturing drilling,” a phrase that referred to producing oil and gas through industrial prowess rather than wildcatter guile. “We had become a very big company that did very big projects,” said a former executive. To win in unconventional gas, could ExxonMobil now adapt to the more classical land scouting, exploration, and entrepreneurial tactics required to outfox sellers and competitors? Some of the prospective challenges in unconventional gas played to ExxonMobil’s strengths in manufacturing—such as the need to develop engineering innovation that would improve the rates of early depletion in unconventional gas fields. But to apply its skills ExxonMobil needed big properties at a reasonable price.

ExxonMobil’s profitability reflected in part the deliberate, return-on-investment-driven decision making of its Management Committee. The upside was rigor and high rates of return on capital invested; the downside was caution and missed opportunity. How much of a flyer was ExxonMobil willing to take to get in on the gas rush, and how fast could the corporation move? Was it really possible for the corporation to replace reserves, capture the sudden emergence of the domestic unconventional gas play, and raise worldwide oil and gas production each year, all while demanding exceptionally high rates of return for every new project investment? In a perfect world, an oil corporation with cash flow like ExxonMobil’s would pour its cash into new oil and gas reserves when commodity prices were low and milk them when prices were high, as Raymond had done with the Mobil merger. But the opportunity emerging in American unconventional gas seemed to be now—when prices were high. Should ExxonMobil compromise its profit standards at least a little to make a strategic shift?

Tim Cejka, a round-cheeked Pittsburgh native who had studied geology and risen through Exxon’s exploration division, ran the company’s upstream operations at the time of the XTO merger talks. Cejka was an oil and gas hunter who had served as an exploration adviser to various ExxonMobil divisions before reaching the Management Committee. He oversaw ExxonMobil’s leasing in search of unconventional gas loads—250,000 acres in the Horn River Basin in British Columbia, 400,000 acres in Hungary, and 750,000 acres in the Lower Saxony Basin in Germany.

Cejka knew that the risks in such exploration ran high and that ExxonMobil’s record was unproven. About the Hungary leases, he told Russell Gold of the
Wall Street Journal
in July 2009, just as secret talks between ExxonMobil and XTO were about to start, “Depending on how that goes, we’ll either be patting ourselves on the back or walking away.”
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Tillerson kept the XTO negotiations so secret that even Cejka did not know about them. Cejka kept working to compete with XTO on North American gas leases even as the merger talks ripened.

Tillerson faced a clear choice: Would it be smarter to keep trying to find North American unconventional gas, or would it be better to use ExxonMobil’s massive cash and treasury share positions to buy in?

ExxonMobil brimmed with cash. The corporation carried more than $30 billion in cash on its balance sheet. Plus, by 2009, it held in its “treasury” more than 3.2 billion shares of its own stock, with a market value of more than $220 billion, which it had repurchased over the years from the open market and set aside for possible use in acquisitions.
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During the great recession and financial panic that followed the collapse of Lehman Brothers in 2008, many American banks, corporations, and their employees worried week by week about whether their businesses might go under. Rex Tillerson’s greatest worry during the dark September of Lehman’s collapse, he later confessed, was whether ExxonMobil’s massive cash deposits were parked in banks that would survive the crisis. As the global financial system teetered, ExxonMobil shuffled its billions to safe havens and waited for the economic storm to pass.

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ood morning, and I want to thank all of you for joining us today,” Rex Tillerson said into a speaker set before him. “ExxonMobil and XTO Energy Inc. have announced an all-stock transaction valued at $41 billion. . . .

“This is not a near-term decision, obviously. This is about the next ten to twenty to thirty years of what we believe has now emerged as a very important part of the global resource portfolio. . . . It’s going to be important to meeting energy supply, and that’s the real value creation that we see.”
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It was December 14, 2009. The secret talks with Simpson and the senior team at XTO had not leaked. ExxonMobil retained the investment bank J.P. Morgan and the Wall Street law firm of Davis Polk & Wardwell to lead its side of the negotiations; XTO retained Barclays Capital and the longtime mergers law firm Skadden, Arps, Slate, Meagher & Flom. Tillerson initially proposed to pay a modest 15 percent premium over the market price for XTO shares; Simpson said that “would not be acceptable.” Each side prepared valuation ranges based on forecasts of varying natural gas prices in the future, and their merger bankers prepared charts showing prices paid in comparable mergers in the energy industry and in other sectors. Once the deal became public, another acquirer might swoop in to try to overbid ExxonMobil, so in one of their periodic meetings, Tillerson extracted an agreement from Simpson that XTO would pay a breakup fee of $900 million to ExxonMobil if the merger were not completed. In the end, they circled in on a price agreement by which ExxonMobil would pay about 25 percent above XTO’s average stock market price during the month before the announcement. That seemed an uncontroversial compromise—it was the median premium above-market price paid in U.S. corporate transactions greater than $10 billion since January 1, 1998, according to a Barclays analysis. In a tax-free exchange of shares, ExxonMobil effectively paid $51.69 per share for XTO. During the final weeks, they had also wrestled over the employment terms required to retain top XTO executives and engineers, who had grown accustomed to the get-rich stock options doled out by Bob Simpson; they would now have to adjust to the more conservative compensation rules at ExxonMobil. To retain XTO’s top five executives long enough to manage a smooth transition, Tillerson restructured their compensation contracts and wrote rich new consulting agreements that linked performance to millions of dollars in stock and cash over the next several years, including a total of $84 million for Simpson; $48 million for XTO chief executive Keith Hutton; and $37 million for senior executive Vaughn Vennerberg.
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