investing the alaskan project cash flows: the sohio experience

Investing the Alaskan Project Cash Flows: The Sohio ExperienceAuthor(s): Kerry Cooper and R. Malcolm RichardsSource: Financial Management, Vol. 17, No. 2 (Summer, 1988), pp. 58-70Published by: Wiley on behalf of the Financial Management Association InternationalStable URL: http://www.jstor.org/stable/3665526 .

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Case Study

Investing the Alaskan Project Cash Flows: The Sohio Experience

Kerry Cooper and R. Malcolm Richards

Kerry Cooper is the Lamar Savings Professor of Finance, and R. Malcolm Richards is the Associate Dean of the College of Business Administration and Professor of Finance, both at Texas A&M University.

0 The absorption of the Standard Oil Company by British Petroleum in 1987 marked the end of an era begun in 1863. In that year, John D. Rockefeller launched an enterprise that would one day control more than 90% of this nation's refining capacity. The first Stan- dard Oil Company (incorporated in 1870) was the target of federal antitrust action resulting in its 1911 breakup into 34 companies. These other firms included the companies that would become Exxon, Amoco, Mo- bil, and Chevron. The original Standard became So- hio-a small firm with a single refinery and a marketing domain limited to the state of Ohio. (Sohio changed its name to the Standard Oil Company in 1986; the two names are used interchangeably in this article.)

The story of how Sohio's assets grew tenfold from 1969-1977 (which included the largest amount of domestic reserves of any U.S. oil company) and how Sohio became a leading crude oil producer was told in an article in the August 1979 issue of Financial Man-

agement [16]. This remarkable epoch began with an agreement between Sohio and British Petroleum that essentially involved a swap of BP's U.S. reserves (which included vast holdings on Prudhoe Bay on the North Slope of Alaska) for an eventual 55% ownership share of Sohio (BP obtained majority ownership in 1978). The 1979 article focused on how Sohio accomplished the herculean task of arranging nearly $6 billion in external financing needed for the Alaskan project from 1969 to 1977. The authors concluded that "Sohio's financing was a pioneering effort that has undoubted- ly caused changes in the way our capital markets function." However, the authors added, an equally great challenge lay ahead for Sohio's management, that of investing the huge cash flows that were to be generated from the sale of the developed Prudhoe Bay reserves.

This "sequel" to the 1979 Sohio article is an account of how the Prudhoe Bay revenues were invested by the firm in the 1978-1986 period, a largely unsuccessful

58



COOPER AND RICHARDS/THE SOHIO EXPERIENCE 59

venture. But this account of Sohio's investment failures, like the earlier account of its financing triumphs, may perhaps also be instructive. The successful financing of the Alaskan pipeline can be viewed as a case study in the efficacy of the corporate form of business organization in marshalling external capital for worthy investment projects. The story of how the Alaskan project cash flows were invested may perhaps be a case study in certain shortcomings of the corporation in ef- ficient utilization of internally generated capital.

The separation of ownership from management in an environment of market-driven capital allocation is, of course, the root source of the corporation's effec- tiveness as a means of raising capital. A corporation's capacity to tap investment funds reaches far beyond the limited bounds of the business organization forms in which ownership and management (and liability) are closely linked. Unfortunately, it has long been recognized that separation of ownership from management also gives rise to a number of potentially significant economic problems in the corporation's use of resources. In the past decade, finance theory has been en- riched by a series of insights into the nature of potential losses to society from the conflicts of interest between management and stockholders (see [8] for a review and analysis). Until only recently, most finance scholars who have examined the agency costs of the separation of ownership and management, including Jensen and Meckling [7] and Fama [3], have concluded that these costs are adequately contained by countervailing economic forces and by contractual arrangements. But the experience of a number of large corporations in the oil industry (including Sohio) and other industries in the 1980's has led some observers to suggest that the economic costs of nonowner corporate control borne by society may be much greater than the present state accepted theory holds.

The basic concern, of course, is that corporate managers may not seek to maximize the value of the firm (shareholder wealth) for one or more of a variety of reasons. The obvious reason is that of self-interested economic behavior on the part of management; a mo- tive that is both empirically traceable and contractually correctable. (A frequent example is that of the corporate manager who seeks to expand firm size because compensation and perquisites are a function thereof). However, management behavior that is not in the best economic interests of shareholders may also stem from such noneconomic considerations as manager loyalties to peer executives, employees, communities, or even company traditions. In the case of a multinational cor-

poration with transnational management, managers may allow national loyalties to shape decisions that are contrary to the best interests of shareholders.

The agency problem of the corporate form of business organization may thus result in a significant degree of misallocation of corporate resources, both in the aggregate and for some individual firms. Further- more, while management's disregard of the interests of stockholders and creditors does not hold for all firms, there exists no systematic means of predicting the par- ticular firms that will be materially affected. (If such predictability existed, the firms would be unlikely to at- tract external capital in the first place.) Rather, the external investors rely on a variety of contractual arrangements intended to shield them from various potential manifestations of any managerial actions which may be counter to their interests. Moreover, the theory of agency suggests that both creditors and new equity claimants exact a premium for the expected cost of a- gency when the corporation obtains new external capital. Thus, all external suppliers of funds to corporations have the protection of contractual safeguards (such as bond covenants), diversification, and "ex ante settling up" (the assessment of a risk premium), at the time that they make new funds available.

A check on management disregard of stockholder welfare is the fact that such disregard creates a profit opportunity for anyone who can take control of the corporation, replace management, and eliminate those practices that are not in the best interests of the shareholders. Thus the costs to society of the separation of ownership and management will be greater when op- eration of the market for corporate control is impaired by legal, regulatory, or political constraints, or some other circumstance [15].

In the case of Sohio, the control on management behavior afforded by the market for corporate control was essentially inoperative in the 1978-1986 period. The majority shareholder in Sohio was British Pet- roleum, a firm which had the British government and the Bank of England as its principal stockholders. Due to its ownership by British Petroleum, Sohio management (unlike its counterparts with Atlantic Richfield, Phillips Petroleum, Gulf, Conoco, Unocal, and other oil companies that were subject to the threat of hostile takeover) had nothing to fear from corporate raiders. Even Sohio's large debt burden played no significant disciplining role for management simply because of the sheer size of the Alaskan cash flow stream. And,until 1986, British Petroleum gave Sohio a considerable degree of independence.



60 FINANCIAL MANAGEMENT/SUMMER 1988

Exhibit 1. Standard Oil Company's Sources and Uses of Cash, 1978-1986 (in millions) 1978 1979 1980 1981 1982 1983 1984 1985 1986

Sources

Cash from Operations 1141 2463 3886 1930 3091 2946 3183 3474 1804 Sale of Long Term Securities 0 0 0 8 684 614 6 462 8 Other Investment Activities 193 0 0 38 0 378 46 55 340

Financing Activities: Increase in Long Term Obligations 290 50 24 12 276 151 0 408 1189 Other Financing Sources of Cash 87 90 304 1664 1108 0 700 218 399

1711 03 ITT4 3752 3159 40iT9 3975 4617 3740

Uses

Payment of Dividend? 91 147 344 553 628 641 639 657 657 Investment Activities 760 600 981 4197 2628 2218 2213 2555 1514 Purchase of Long Term Securities 0 0 1784 0 0 0 0 0 0 Other Investment Activities 0 5 21 0 262 0 0 0 0

Financing Activities: Decrease in Long-Term Obligations 630 736 370 285 306 493 273 679 1218 Repurchase of Common Stock 0 105 0 0 0 6 561 32 0 Other Financing Uses of Cash 0 144 0 140 1647 803 3 676 293

N48e1 1737 T 5 " T51- 34771 4161 36_8" 4599 3682

Net of Dry Hole Costs Expensed

Thus, Sohio management had a great deal of discre- tion in investing the cash flows from the Alaskan project. These huge amounts of funds (see Exhibit 1) came on stream in the late 1970's sooner and in even greater magnitude than anticipated (due to escalating oil prices and fortuitous production circumstances), creating a curious dilemma for Sohio.

I. Sohio's Investment Program: 1979-81 A. Factors Shaping Sohio's Corporate Strategy

With a new and relatively inexperienced management team, Sohio was obliged to rather quickly develop a strategy for investing its Alaskan oil revenue. Char- les Spahr, the architect of the British Petroleum merger and the Alaskan project, had retired as chairman and CEO in 1978. Spahr's successor was Alton White- house, an attorney who had represented Sohio in the merger negotiations with British Petroleum, but who had limited operational experience. In 1980, White- house tapped John R. Miller, who had been a leading figure in the planning and financing of the Alaskan project, to become Sohio president and his second-in- command. The June 27, 1980 Wall Street Journal story reporting this selection indicated that Miller, who had joined Sohio in 1968 as a chemical engineer, had held positions in the company's transportation, treasury,

corporate planning, engineering, and supply and dis- tribution functions. There was no mention of experience in petroleum exploration, refining, or marketing.1

Sohio's senior partner, British Petroleum, granted its American subsidiary considerable autonomy during this period of investment strategy formulation. British Petroleum gained majority ownership of Sohio in 1978, but did not choose to increase its representation on Sohio's board of directors (from three members) to reflect its majority position. It is likely that a major reason for BP's detached posture stemmed from political considerations. In the United States, oil was being viewed as a scarce strategic resource vital to national defense. Given that the principal stockholder in BP was the British government, BP management perhaps concluded that political prudence dictated that its Am- erican subsidiary enjoy considerable independence in appearance and fact. Further, given the highly success-

1 An August 25, 1980 Business Week article entitled "An Oil Giant's Dilemma" offers a number of insights into the company's thin ranks of broadly experienced executives and various other problems at the time that Sohio was seeking to develop a viable corporate strategy for the 1980's and beyond.




ful outcome of the difficult Alaskan venture, it was felt that Sohio had earned such independence. In addition, BP had major problems in its European operations in much of the 1970's and early 1980's, with Sohio dividends serving to offset losses from these operations during this period.

Given the outcome of Sohio's investment program, it is apparent in retrospect that the firm's stockholders would have been better served if a much larger portion of the Alaskan oil revenues had been utilized for debt retirement. A considerable amount of debt shrinkage did occur in the 1978-1981 period, when the net reduction in long-term debt exceeded $1.5 billion. Also, dividend payout rose sharply (see Exhibit 1). But in subsequent years, the lion's share of Sohio's Alaskan oil revenues flowed into oil and gas exploration and development expenditures, acquisitions, and losses.

The decision of Sohio's management to use the bulk of the Alaskan cash flows to acquire, expand, and diversify (rather than for debt retirement, dividend pay- ments, and share repurchase) stemmed from a number of factors. During the 1979-1981 period, both markets and managers were forecasting rising prices for oil and other natural resources -an error that would be recognized by markets far sooner than by most managers. In this environment, Sohio executives were confident that they could choose investments that would offer their stockholders a higher return than that afforded by debt retirement. Further, British Petroleum was eager for their American subsidiary to enlarge its presence in the U.S. economy. Another important reason for not u- tilizing Prudhoe Bay cash flows solely to liquidate debt and pay dividends to shareholders stemmed from the political environment of the late 1970's. Huge increases in energy costs had begun in 1973. The resulting public resentment caused the entire oil industry to be held politically suspect. The term "obscene profits" had been used by a powerful and prominent U.S. senator to characterize his impression of the industry's operating results during this period. Thus, Sohio, like many other major oil producers, was under considerable pressure to plow earnings back into the pursuit of more oil and gas and thus contribute to the nation's energy security and ease price pressures.

The investment strategy that Sohio adopted was essentially the use of its Alaskan oil revenues to expand its business base by becoming an integrated energy company, along the lines of Exxon and Texaco, while concomitantly diversifying outside conventional energy lines of business. The firm had divested itself of lackluster investments in restaurant and motor inn

businesses in previous years and was not now inclined to venture far from the natural resource and energy field. Thus Sohio proceeded to make substantial investments in oil and gas exploration, coal reserves, metals mining, chemicals, and petroleum refining and marketing. Unfortunately, downturns awaited all these sectors.

B. The Search for New Oil Reserves Sohio spent $2.4 billion on oil and gas exploration

during 1978-1982. As an aspect of what the financial media called "Prudhoemania," a large portion of these expenditures were in Alaska. The largest single outlay was Sohio's share of the $1.7 billion joint venture exploration of the Mukluk field in the Beaufort Sea off Alaska's north coast--a field that was eventually deter- mined to hold only salt water. Sohio was the largest par- ticipant in the joint venture and absorbed a loss of more than $300 million. Sohio had better luck with its ventures in the Kuparuk and Endicott fields on the North Slope. But perhaps its most productive outlays were for enhanced recovery techniques that extended the life of the massive Prudhoe Bay oil reservoir.

Sohio also made major exploration outlays in the "lower 48." In 1979, a $140 million acquisition brought Sohio about 1.5 million acres of oil and gas production holdings (both producing properties and undeveloped oil and gas lease holdings) in the Rocky Mountain Overthrust Belt. By the end of 1980, the firm had more than 3 million net acres of oil and gas properties under lease. Sohio moved next to acquire a major position in the Gulf of Mexico (the Outer Continental Shelf), spending hundreds of millions of dollars for leasing and exploratory wells in the early 1980's. By 1985, Sohio held more than 800,000 net acres in the Gulf. In 1982, Sohio began acquiring acreage in the natural gas-bear- ing Anadarko Basin of Oklahoma. Exploration outlays were more than $800 million in 1983, up from almost $500 million in 1982; in 1979, Sohio had spent only $35 million in the search for new oil and gas (see Exhibit 2).

What was the payoff to Sohio for these billions of dollars of outlays? The quantity of proven reserves held by Sohio in the lower 48 states actually declined from 1979 to 1985; the quantity of crude oil and natural gas liquids produced per day from Sohio's non-Alaskan sources was no higher in 1985 than in 1979. This dis- mal return reflects, in part, the fact that Sohio was late in getting into the game of pursuing new reserves. By the time that Alaskan crude was providing the cash for a major exploration program, other firms had already




Exhibit 2. Standard Oil Company's Capital Expenditures by Business Segment, 1979- 1986 (in millions)

1986 1985 1984 1983 1982 1981 1980 1979

Petroleum:

Exploration and production 1121 1535 1633 1795 1996 1447 761 500 Refining and marketing 185 489 247 151 120 113 48 40

T37 4 T T"-6 7 1-5-60 W g9 3T-5

Coal 53 74 51 23 68 666 42 22 Metals mining 101 98 176 156 202 1668 Chemicals 10 13 23 20 69 138 110 33 QIT 68 80 19 12 6 9 Other businesses 42 81 58 58 65 431 Corporate and other 38 114 122 83 82 29 46 7

1618 2T84 2329 2278 2608 4501 1007 602

nailed down the most promising prospects. But the outcome perhaps also reflected the firm's lack of experience in exploration for oil and gas.

C. The Diversification Effort In October 1979, Sohio's financial planning group

presented the board of directors with a $25 billion, ten- year spending plan. The goal of the proposed outlays was to reduce the contribution of oil and gas to Sohio's cash flows from 90% to 75%. The plan thus proposed large outlays for investments in coal, synthetic fuels, minerals, information processing equipment, chemicals, and other natural resource related industries. While this plan was later revised to reflect even larger projections of the investible cash available to Sohio (proposed outlays were hiked to $33 billion of 1981 dollars), the decision to diversify beyond conventional energy fields was firm.

In 1980, the Prudhoe Bay field reached full production. Sohio's net income jumped more than 50% from 1979, to more than $1.8 billion ($7.37 a share). At the end of 1980, Sohio held almost $4 billion in cash and liquid assets. In 1981, the firm began spending its cash hoard in earnest in a series of major acquisitions. Ken- necott Corporation was acquired for $1.8 billion. U.S. Steel was paid $600 million for coal properties, the largest of a number of transactions that made up an ag- gressive coal reserve acquisition program that was to be completed in 1982 (with a $105 million purchase from Republic Steel). Sohio thus invested heavily in minerals despite its inability to earn significant profits from its past ventures into this industry.

D. The Kennecott Acquisition The Kennecott acquisition involved paying a very

large premium for a firm with very large problems. Sohio paid about $62 a share for Kennecott, which closed at $27.125 per share on the day prior to the March 12, 1981 acquisition announcement (when trading in both Sohio and Kennecott stock was suspended). The firm's book value was $50 a share. According to the March 13, 1981 Wall Street Journal story announcing Sohio's offer:

'Although both companies managed to keep the wraps on their talks until yesterday, the news didn't shock most securities analysts.... Trading had been heavy in Kennecott stock in recent weeks, partly due to speculation that the big copper producer was ripe for a takeover and partly, some Kennecott advisers privately suspected, because a major investor was accumulating the stock. "

Furthermore, Kennecott had been the subject of a front-page Wall Street Journal story just a week earlier (March 5, 1981), which had been subtitled, "Is It Still a Takeover Target?" Thus it is surprising that takeover speculation did not drive the price of Kennecott stock up closer to Sohio's bid price, as is usually the case. (Kennecott stock was about $24 a share on March 5 and $27 a share on March 13.) A possible reason for the lack of a large run-up in the Kennecott stock price is, of course, that while the market anticipated Kennecott's acquisition, the market did not anticipate an offering price nearly as large as the $62 a share set by Sohio. The March 13 Journal story quoted an E. F. Hutton analyst as saying (to the effect) that Sohio was paying too much for Kennecott and that the analysis of Hutton's mining analysts indicated an appropriate price was in the $40-




Exhibit 3. Abnormal Returns for Sohio's Kennecott Acquisition (Announced 3/12/81)

4%

3%-

2%

1%

0% C) Z -1% -

-2% l- % -

-3%-

S-4%- n-

O -5%- z S-6%

-7%

-8%

-9%-

-10% 20 18 16 14 12 10 8 6 4 2 0 2 4 6 8 10 12 14 16 18 20 22

TRADING DAYS (Day 0 = Announcement Date)

45 per share range (meaning that Sohio had paid about $600 million too much.)

To gain further insight into stock market reaction, the authors examined the performance of Sohio common stock during a six week period centered on the announcement date (March 12, 1981) of the Kennecott acquisition. Sohio stock return performance was examined with the usual market model in which abnormal returns (ARt) are measured as:

ARt = rt - aj - bj rmt , (1)

where rt is the return on Sohio common stock and rmt is the return on the market index during the investiga- tion period. The parameters aj and bj (beta) are estim- ated with the market model using 1979-1980 returns, taken from the Center for Research on Security Prices (CRSP) Daily Stock Record file. Negative cumulative abnormal returns (CAR), the sum of the ARt, were 19.0% for this period, statistically significant at the 0.01 confidence level. Exhibit 3 shows the daily abnormal returns during the period, with the announcement date registering a decrease of 9%. Sohio stock closed at $55 a share on the day prior to the announcement day of March 12; on March 13, it closed at $52 a share. (A $3 per share loss on outstanding common shares amount- ed to about $360 million for its non-BP shareholders and about $380 million 53% equity ownership.)

As reported in the April 24, 1981 Wall Street Journal when A.W. Whitehouse (Sohio's chairman) was questioned about the acquisition premium by shareholders at the company's annual meeting, defended the price paid to Kennecott as the "lowest Sohio could bid and still retain the support of Kennecott management." The chairman also contended that the transaction lowered Sohio's stock price "three to five points at most." As for Sohio's majority stockholder, British Petroleum indicated that Sohio's purchase of Kennecott was made with its full support.

Sohio acquired a new senior executive along with Kennecott-perhaps a perceived benefit of "retaining the support of Kennecott management." Kennecott's chairman, Thomas D. Barrow, became a vice chairman of Sohio and, in February 1982, joined Whitehouse and Miller in an "office of the chairman" arrangement as part of management reorganization. Barrow had been a senior executive with Exxon prior to assuming his Kennecott position and thus brought experience in both oil and minerals to his Sohio responsibilities.2

2An April 6,1981 Wall Street Journal story reported that Barrow per- sonally earned $6 million on the sale of Kennecott to Sohio-$1 million from the sale of his own holdings of Kennecott stock plus a $5 million bonus payment based on the magnitude of the purchase premium.




Exhibit 4. Standard Oil Company Income (Loss) Before Interest, Income Taxes and Ex- traordinary Items by Business Segment, 1979-1986 (in millions)

1986 1985 1984 1983 1982 1981 1980 1979

Petroleum: Exploration and production 13 2442 2954 2848 3647 3900 3605 2239 Refining and marketing 436 351 200 453 390 266 259 191

Coal (255) (518) 61 21 (1) (8) 9 4 Metals mining (342) (851) (160) (91) (187) (99) Chemicals 57 39 45 (7) (22) 44 64 37 QIT 110 80 41 16 34 27 Other businesses (151) (98) (33) (173) (32) 24 Corporate and other (234) (270) (160) (158) (132) (86) (69) (37)

(366) T11757 19-8 2909 OT -97 TO 68 T24

Not only did acquiring Kennecott utilize a large portion of Sohio's cash holdings, Kennecott also needed very large cash injections by Sohio. Whitehouse indicated that Sohio was anticipating about $1.5 billion of capital outlays for Kennecott over a five year period. A November 2, 1981 Wall Street Journal article reported a statement by Sohio president Miller that the firm expected to invest more than $7 billion in Ken- necott over the next 10 years in order to modernize and expand the firm's mineral operations. While Kennec- ott's mineral reserves were vast, the mining firm's operating costs were much higher than its competitors due to its outmoded facilities. Kennecott's diversification attempts (i.e., its 1978 acquisition of Carborun- dum) had led to disappointing results. Further, the firm had not yet recovered from its three-year struggle a- gainst a hostile takeover attempt by Curtis Wright Cor- poration [9,10].

Thus Sohio had chosen a high-risk road in its diversification strategy. It is not unfair to characterize its 1981 acquisitions as gambles on future upturns in the prices of copper, coal, and other minerals. In addition, Sohio had acquired a company with a high quotient of firm-specific problems, in addition to its troubles stem- ming from the chronic boom-and-bust nature of the mining industry. As one response to Sohio's acquisitions of Kennecott and vast new coal reserves, Standard & Poor's announced a cut in Sohio's senior debt and preferred stock rating to double-A-minus from double- A, citing Sohio's diminished liquidity and its venture into "cyclical, low return industries in which it has an undemonstrated track record." S&P's comments were perhaps charitable. Sohio did have a track record; its

Old Ben Coal Company had a troubled history and its uranium activities had been only marginally profitable.

II. 1982-85: Sohio's Troubles Begin The March 17, 1982 issue of the Wall Street Journal

featured a commentary entitled "Sohio Growth is Be- ginning to Level Off," that offered a sober assessment of the company's prospects. Sohio was seen as "glutted" with natural resources just as oil, coal, and metals prices were turning downward. "Nearly all oil stocks have declined sharply lately," the article noted, "but Sohio's stock is one of the worst. It recently dropped below $30 a share, its lowest level in 21/2 years and a decline from $91.50 in November 1980." With the Kennecott acquisition, Sohio had greatly increased its exposure to a downturn in mineral prices and, unfortunately, copper prices were at a five-year low. Coal prices were also declining and a long downward slide in oil prices was getting underway.

From 1974 to 1981, Sohio had enjoyed year-to-year hefty increases in sales and net income. In 1982, both operating revenue and net income fell. Three of its five operating groups--metals mining, chemical and industrial products, and coal-reported net losses. Kennec- ott lost $189 million as the already depressed average copper price of $.79 a pound in 1981 fell to a very depressed average price of $.66 a pound in 1982. The firm's copper production fell from 372,000 tons in 1981 to 286,000 tons in 1982. Oil revenues also fell as the result of significantly lower prices and slightly smaller volume, but still accounted for 86% of Sohio's total operating revenue.




Exhibit 5. Standard Oil Company Selected Financial Statistics, 1979-1986 (in millions, except for per-share amounts)

1979 1980 1981 1982 1983 1984 1985 1986

Net Income (Loss) 1186 1811 1947 1879 1512 1488 308 (345) Earnings Per Share 4.91 7.57 7.92 7.63 6.14 6.14 1.31 (1.47) Dividends Per Share .61 1.40 2.25 2.25 2.60 2.65 2.80 2.80

Long-Term Debt 3418 3141 3493 3812 3481 3222 2962 2951 Ratio of Debt to Borrowed and Invested Capital 51% 42% 37% 34% 30% 27% 27% 27% Return on Average Shareholders' Equity 47% 47% 37% 28% 20% 18% 4% (5%) Return on Average Assets 19.30% 23.7% 20.5% 17.2% 13.2% 12.4% 3.8% (1.3%)

Common Stock Market Price, High-Low 47-20 92-40 73-36 42-26 59-35 51-40 56-40 52-40

Oil and gas exploration expenses 35 176 368 486 834 704 1101 926

Sohio's decline continued in 1983. Net income de- creased 20% and cash provided from operations fell 5% from 1982 levels. Kennecott's net loss narrowed to $91 million, reflecting slightly higher copper, gold, and silver prices in 1983 (although they were declining a- gain by the end of the year), and also reflecting the reductions in production costs that were resulting from the large capital expenditures made by Sohio. The chemicals group also reported a significant improve- ment in operations (it lost only $3 million), but the industrial products division absorbed a $147 million loss, of which $137 million reflected the sale of its abrasives manufacturing operations. Petroleum operations net income was dampened by the Mukluk write-off and by lower prices. Sohio management could take no pleas- ure in the fact that the portion of total operating revenue accounted for by petroleum fell to 78%. The company's rate of return on borrowed and invested capital sagged to 13.4% from the 17.9% return in 1982 and 22% return in 1981. Earnings per share fell from $7.63 in 1982 to $6.14 in 1983 (see Exhibits 4 and 5).

The year 1984 showed a considerable amount of ac- tivity but no net forward progress for Sohio, who at last devoted some of its Alaskan cash for a major program of share repurchase and acquired 11 million of its shares, 4.5% of total shares outstanding, at $47.50 per share in a tender offer, and an additional 842,000 shares in the open market. (Contrary to the empirical evidence regarding share repurchase [1,13,19], Sohio's share buyback did not result in a sustained post-buy-

back increase in the firm's stock price.) Sohio management, in its letter to stockholders in the 1984 annual report, stated that share repurchase and reduction of debt would henceforth be serious alternatives for future investment. In January 1985, the Board of Direc- tors authorized the repurchase of an additional $100 million of common shares in the open market. The company also further reduced its long-term debt, re- ducing its debt-assets ratio to 27%.

However, while Sohio's balance sheet continued to be one of the strongest in the oil industry, problems on its income statement continued to exist (see Exhibits 4 and 5). Though the decrease in net income in 1984 was less severe than that of 1983, this was still the third consecutive year of earnings decline. (Earnings per share were the same as in 1983 due to the smaller number of shares outstanding.) The earnings in 1984 were less than three-fourths of the record 1981 net income. The weakness in 1984 earnings was due partly to declining margins in petroleum refining and marketing, but was primarily due to the $160 million operating loss of Kennecott. Both coal mining and chemicals and industrial products showed significant earnings improve- ment in 1984.

The first retrenchment steps at Kennecott were taken in 1984 as metals prices continued to decline. Cop- per prices fell $.10 a pound in the first half of 1984, to about $.61 a pound. At mid- year, Sohio announced a two-thirds cut in operations at the Utah Copper division, with about half of the work force to be laid off.




The firm also sold a number of Kennecott's small industrial products subsidiaries and consolidated the rest with Sohio Chemicals and Industrial Products Com- pany (SCIPCO).

Kennecott was clearly a major problem, disappointment, and embarrassment for Sohio management. Af- ter Sohio had paid a huge premium for the metals mining firm and devoted hundreds of millions of capital outlays to the modernization of its mines, Ken- necott had generated about $350 million in losses. Sohio's parent, British Petroleum, expressed concern. Sohio promised action in 1985.

A more successful acquisition (perhaps because the assets involved were devoted to refining and marketing- Sohio's traditional strength) was accomplished in 1984. Chevron Corporation (which had previously taken over Gulf Oil Corporation) agreed to sell Gulfs wholesale and retail businesses in eight southeastern states and a refinery in Louisiana to Sohio for $690 million. Chevron's divestiture of the properties had been required by the Federal Trade Commission as a condi- tion for its approval of the company's takeover of Gulf. Sohio was the high bidder. The purchase served to give Sohio a 45% increase in refining capacity, allowing it to refine more of its crude oil instead of selling it, and to significantly expand its marketing presence. Sohio's marketing operations were also expanded by its early 1984 acquisition of Truckstops Corporation of Amer- ica from Ryder System, Inc.--essentially 24 full-facility truck stops along interstate highways in 15 states.

Sohio's marketing and refining acquisitions were a bright spot in the firm's 1985 operations, contributing to a significant expansion in sales and operating revenue. But there were few other happy notes in the company's 1985 record. In that same year, Sohio under- took what its parent termed in the BP annual report "a far-reaching rationalization programme." The firm's management apparently gave up waiting for increases in oil and metals prices to solve its problems. More than 1300 positions in the firm were eliminated as part of a corporate-wide reorganization and elimination of some corporate offices. The Utah Copper Division was closed for modernization of facilities. In 1985, capital expenditures were reduced by 25%. A large number of exploration leases and minerals and coal properties were sold or cancelled. Budgeted oil and gas exploration expenditures for 1986 were cut 10%. For the fourth quarter of 1985, Sohio announced it would take a $1.15 billion charge to earnings. Hundreds of millions of dollars of copper, coal, shale oil, and other properties were written down or written off. These actions

resulted in a charge of $1.86 billion to pre-tax net income for 1985, or $1.15 billion after-tax. These extraordinary charges lowered 1985 net income to $1.31 per share.

With the single, small exception of its industrial products line, Sohio's non-petroleum operations turned in disappointing results for 1985. Old Ben reverted to its low profitability mode (operating income of $8 million), after its record income of 1984, as soft coal market conditions drove down prices and reduced volume. Chemicals operating income also declined-dip- ping $18 million to $27 million. But metals mining was again the big loser in operating income with a loss of $165 million.

A large portion of Kennecott's 1985 losses was at- tributable to the shut-down costs associated with the suspension of operations of the Utah Copper Division. But copper prices remained low-so low that the ren- ovated mines in Arizona and New Mexico could do no better than break even. The latter fact made Sohio's plan to spend $400 million to similarly renovate and modernize the Utah Copper Division appear ques- tionable. The Board of Directors of British Petroleum certainly questioned it.

Ill. 1986: BP Replaces Sohio Management

On February 27, 1986, the Board of Directors of what was now The Standard Oil Company (Sohio hav- ing just changed its name) announced major changes in the management of the company. Robert B. Horton, then a managing director of BP and a member of So- hio's Board of Directors since 1983, was to become chairman and chief executive officer on April 1, 1986. Frank E. Mosier, then an executive vice president of Sohio and also a Board member, was to become president and chief operating officer on that same date. Alton W. Whitehouse and John R. Miller were leaving the company. (Thomas W. Barrow had previously retired.) Two other BP executives were also shifted into key positions at Sohio.

Given the track record of Sohio since 1980, it is hard- ly surprising that BP moved to replace Sohio management. Indeed, the most surprising aspect of the change is that BP waited as long as it did to take action. The actions taken by Sohio's new leaders and by the BP Board over the ensuing twelve months clearly indicate that the partial retrenchment actions taken by the dis- placed management were considered inadequate by Sohio's majority stock-holder.3




Soon after taking the reins at Sohio, the new chairman and CEO, Robert Horton, announced major cutbacks in capital outlays and exploration spending. The already shrunken planned exploration budget of $680 million was slashed to $450 million. Budgeted capital outlays for 1986 were cut from $1.25 billion to $980 million. Earnings for the first quarter of 1986 fell sharply. The company reported a loss for the second quarter, as a charge of $1.43 billion (pre-tax) was taken for write- downs of assets. The earnings hit reflected the decision of the new management to abandon about one-half of Sohio's leased oil acreage as part of a massive exploration cutback, sell its undeveloped coal reserves, and proceed to divest most of the firm's industrial products businesses. In September 1986, the sale of Kennecott's copper mines in Arizona and New Mexico for $220 million was announced. The loss on the sale, the amount of which was not specified, had been included in the second quarter writeoffs as part of a $460 million provision for expected losses on disposal of minerals and industrial products. These sales came close to clos- ing out the unfortunate Kennecott chapter in Sohio's history. The $1.8 billion acquisition, followed by hundreds of millions of dollars of capital outlays, had generated more than $700 million of operating losses and, now, hundreds of millions of losses from their sale. All that Sohio retained (or intended to retain) of Ken- necott was the Utah copper mine, where operations were still suspended, and a small number of industrial products.

Chairman Horton indicated that the company's new strategy was to return to Sohio's pre-Alaskan-project profile as an oil and gas company emphasizing refining and marketing. Indeed, the drastic cutbacks in exploration outlays in the lower 48 states left Sohio essentially an oil producer only in Alaska. The implication was that Sohio would thus shrink as Alaskan oil flows inev- itably declined. However, Horton did indicate interest in acquiring natural gas pipelines or other gas businesses, and perhaps production, refining, and marketing properties as well. Such acquisitions were deemed potentially desirable because they were consistent with Sohio's revised corporate strategy and theywere poten-

tially cheap given the depressed energy marketplace. "Our strategy for Standard Oil," Horton wrote to stockholders in the company's 1986 annual report, "has four simple rules: first and foremost, we are an oil company; diversify in moderation only-nonoil must fit, be competitive, and be profitable; keep our financial position strong; manage for profitability, not for size or growth for its own sake." As for acquisitions, the Chairman stated, "We have no intention of spending money simply because we have it. Any acquisition we consider must be at the right price, must fit our overall strategy, and must not be at the expense of our financial strength." It is not difficult to interpret Horton's statement as an implicit critique of the failures of his predecessor as So- hio's chief executive.

The Standard Oil Company reported a net loss of $345 million for 1986, or $1.47 per share. Even before the various special charges and extraordinary items that were made in 1986, the earnings record was com- paratively poor. In his letter to shareholders in Stan- dard's annual report, Horton put the best possible face on the 1986 performance in stressing the company's strong balance sheet and cash flow position and pointing to the $1.3 billion of debt retirement that had been accomplished in 1986.

IV. The BP Buyout The October 23, 1985 issue of the Wall Street Jour-

nal included a story about rumors of a potential move by BP to buy the 45% minority interest in Sohio. The British firm's move to line up a $6.5 billion line of credit is what purportedly prompted the rumors. The word on the street was that BP wanted more of Sohio's cash flow than 55% of its dividend payout. As for the bid price, "traders and takeover speculators said they expect any offer for Sohio to be about $70, based on Sohio's earnings, cash flow and the premium Royal Dutch/Shell Group paid earlier this year to acquire what it didn't own of Shell Oil Co. At that price, it would cost $7.3 billion to acquire the rest of Sohio."

But is was not until March 27, 1987, that the Journal featured the headline, "British Petroleum Bids $7.4 Bil- lion for the Rest of Standard Oil Stock." The purge of Sohio's top management by BP had come a year earlier. Why did BP move now to complete its ownership of Standard Oil? The official explanation, as stated by Sir Peter Walters, BP chairman, was that the move was essential to further U.S. expansion by BP. Walters labelled the current arrangement with Sohio as giving rise to a "cumbersome, dual-board structure" and po-

A March 7, 1986 front page Wall Street Journal articles offers an analysis of "How and Why BP Put Its Own Commanders at Standard Oil Helm," and identifies the failure of Sohio's top managers to deal more decisively with the Kennecott disappointment as a salient cause of their departure. (More recent statements by BP Chairman Sir Peter Walters suggest that the degree of independence exercised by Whitehouse and Miller had simply become unacceptable to him.)




Exhibit 6. Relative Performance of Sohio Stock vs Selected Indices

500

Oil-Domestic 450

400

350 - 1'

300 L

0

0 r

N, " '?

Oil-Composite

200 -.a- . _.f...000

150l-

o.e".--...

S & P 400

100 - Sohio Common Stock

50

1981 1982 1983 1984 1985

sing potential competitive conflicts with Standard Oil in pursuing initiatives in the U.S.

As those unnamed "traders and takeover speculators" quoted in the October 23, 1985 Wall Street Jour- nal had predicted, the bid price was $70 per share. In due course, BP was obliged to sweeten the offer a bit- raising the price to $71.50, throwing in a quarterly dividend of $.70 per share, and adding a warrant on BP stock worth about $2.00 to the offer. Such sweetening, which raised the total bid to $7.9 billion, was made necessary by the firming of oil prices in late 1986. Had BP made its move in the summer of 1986, when Stan- dard stock was trading at about $40 per share, it could probably have bought out the minority shareholders for around $50 a share, or about $2.5 billion less than the 1987 price. Thus the Standard Oil Company of Ohio became a wholly-owned subsidiary of the British Petroleum Company, p.l.c., of London, England. Later in 1987, the company became a part of BP America, Inc., along with BP's other North American businesses.

V. Conclusion: Significance of the Sohio Case

Exhibit 6 depicts the performance of Sohio stock relative to the Standard & Poors 400 and two oil stock indices (one of nine integrated domestic firms and one broad composite index of 16 oil stocks including the former nine firms, plus five integrated international

firms and two crude oil producing companies) in the 1980-1986 period. It is apparent that Sohio stock un- derperformed both the broad market and most other oil company stocks after 1981. Indeed, one can specu- late that the generally flat performance of Sohio equity during this period (even after other oil firm stocks rebounded) essentially reflects a discounted market valuation of the firm's Alaskan reserves-with the dis- count largely reflecting a lack of confidence in Sohio management's ability to effectively employ the cash flows these reserves would ultimately generate.

Many of the missteps so retrospectively evident on Sohio's part in the early 1980's were also taken by other oil companies during this period. In a study of the impact of capital expenditure announcements by firms on the announcing firms' stock prices in the period 1975- 1981, McConnell and Muscarella [14] found that when oil companies declared an increase in exploration outlays, there were systematic decreases in their stock prices, and vice versa. (The reverse was true for changes in investment outlays by industrial firms.) Picchi [17] analyzed the returns on the exploration and development expenditures of 30 large oil firms in the 1982-1984 period and found that the average return on the pre-tax outlays was less than 10%. Certainly even a casual review of the operating pattern of major oil companies in the early 1980's clearly demonstrates the same general course taken by Sohio in that period-




large outlays in pursuit of new oil reserves and disappointing acquisitions aimed at diversification.

Jensen [4] cited evidence from the oil industry for his 1986 article postulating the agency costs of "free cash flow" (cash flow in excess of that required to fund all projects that have positive net present values when discounted at the relevant cost of capital). Jensen poin- ted to the large cash flows in the oil industry resulting from the huge oil price hikes of the 1970's and the fact that, "consistent with the agency costs of free cash flow, management did not pay out the excess resources to shareholders." Instead of paying the shareholders, the oil company managers ploughed much of these cash resources into a search for more oil and into diversification efforts. The latter is characterized by Jensen as acquisitions that "turned out to be among the least successful of the decade, partly because of bad luck (for example, the collapse of the minerals industry) and partly because of a lack of managerial expertise outside the oil industry."4 Kensinger and Martin [11] concur with Jensen's analysis and point to the use of royalty trusts, master limited partnerships, and similar organizational devices as a means of better aligning uses of free cash flow from oil revenues with owner interests.

Sohio's failure in reinvesting the Alaskan cash flows can thus be viewed as a part of the larger story of the stumbling oil industry in the 1980's. Certainly most of Jensen's analysis [5] of why the industry faced retrenchment, why it resisted retrenchment, and why so many of its members made unprofitable acquisitions, is ap- plicable to Sohio. However, while most oil companies did experience some degree of economic mishap during the early 1980's, Sohio's performance was especially marred for a number of reasons:

(i) Sohio management was inexperienced. Such a lack of experience in the oil industry was not only that of top management but included the lack of experience at all levels of management in making decisions in what had become, in a very short period of time, a very large organization. The mis- judgments leading to the ill-fated acquisition of Kennecott-an action which in some respects ap-

pears to be an almost desperate bid to do "some- thing big"-probably stemmed from this lack of experience. The painful slowness of Sohio management to recognize and deal with mistakes is perhaps also a symptom of inexperience. It is possible that a major reason for the failure of the firm's top executives to face up to the reality of the Ken- necott error, and take the painful but necessary actions to cut their losses, was the fact that Sohio's "Office of the Chairman" included Kennecott's former CEO. It can only be conjectured as to what extent that post-acquisition organizational arrangement stemmed from real and perceived inexperience of Sohio's management. However, it is understandable that Chairman Whitehouse and Vice-Chairman Barrow, who had agreed on the price that Sohio would pay for Kennecott, should be loath to acknowledge (or perhaps unable to recognize) the magnitude of their mistake. (ii) The majority ownership by British Petroleum served to make Sohio even more sensitive to political pressures than other oil companies. This was a period of keen political sensitivity in the U.S. to foreign ownership of a scarce resource like Alas- kan crude oil, so BP's board of directors felt it was prudent to give Sohio's American managers a remarkable degree of autonomy. The fact that the British government was a major stockholder in BP was an accentuating factor. The separation of management from owners primarily concerned with economic performance was thus profound, accentuating the firm's response to real and perceived political pressures. (iii) Sohio was obliged to make its initial long-term commitments of the cash flow from Alaskan oil at the time of the greatest political pressures on the oil industry (the early 1980's). A massive dividend payout to its stockholders was politically unpal- atable-especially given that BP was its majority stockholder. Diversification too far afield from the natural resource related, and national security related, domain (especially in the wake of Mobil's Montgomery Ward acquisition) was also politically unacceptable. And certainly public opinion de- manded (or so the conventional political wisdom proclaimed) that oil profits be ploughed back into the search for national energy security. Thus the Sohio case reminds us that one of the shortcomings of the corporate form of business organization is the vulnerability of the large corporation to political pressure. (See Jensen and Meckling [6]

4Jensen [4] points out that, while both oil company outlays in search of new oil reserves and for nonoil acquisitions often resulted in losses to oil company stockholders, aggregate economic resource misallocation was much greater in the former case. Acquisitions (i.e., Mobil's purchase of Montgomery Ward and Sohio's buyout of Ken- necott) served to place cash resources in the hands of external investors for subsequent reinvestment, whereas fruitless expenditures on oil exploration were losses to society as well as oil company stockholders.




for an analysis of this aspect of the corporate form of business organization.)

The most significant lesson of the 1979-1986 Sohio experience (and, indeed, the experience of numerous other oil companies in this period) lies in the fact that the mistakes made were those of managers, not markets. Men of apparent integrity and competence pur- sued courses of action that led to abysmal results, but the record shows that the financial markets foresaw the consequences long before these managers recognized their failures.

Jensen [4] suggests that corporate debt motivates organizational efficiency and mitigates the set of incen- tives that lead managers to invest internally generated funds in uneconomic projects. Implicit in this "control hypothesis" is the notion of the superiority of financial market judgements as compared to those of managers. Easterbrook [2] and Rozeff [18] argue from a like premise that dividends are paid to disburse internally generated cash and to oblige the firm to seek external financing, thus subjecting management actions to financial market scrutiny. Implicit in these arguments is the notion that shareholders would gain from a change in capital structure that heightened such financial market scrutiny, but Litzenberger's analysis [12] of the Phil- lips and Unocal recapitalizations suggests that such gains did not materialize.

While the story of Sohio's $6 billion investment failure is consistent with the analysis of Jensen, Easter- brook, Rozeff, et al., this explanation is much too simple to be an adequate account. Various other factors such as those mentioned above all played a significant role, as did mere bad luck and bad management. But, given the enormous significance of the corporation as a means of allocating investment capital, any shortcomings in that regard-and any lessons pertaining to it-are clearly of great significance.

References 1. L.Y. Dann, "Common Stock Repurchases: An Analysis of Re-

turns to Bondholders and Stockholders," Journal of Financial Economics (June 1981), pp. 113-118.

2. F.H. Easterbrook, "Two Agency-Cost Explanations of Divid- ends," American Economic Review (September 1984), pp. 650- 659.

3. E.F. Fama, "Agency Problems and the Theory of the Firm,"Jour- nal of Political Economy (April 1980).

4. M.C. Jensen, "Agency Costs of Free Cash Flow, Corporate Fi- nance, and Takeovers,"American Economic Review (May 1986), pp. 323-328.

5. - "The Takeover Controversy: Analysis and Evidence," Midland Corporate Finance Journal (Summer 1986), pp. 6-32.

6. M.C. Jensen and W. H. Meckling, "Can the Corporation Survive?" Financial Analysts Journal (January/February 1978), pp. 31-37.

7. - "Theory of the Firm: Managerial Behavior, Agency Costs, and Ownership Structure," Journal ofFinancial Economics (Oc- tober 1976), pp. 350-360.

8. M.C. Jensen and C.W. Smith, Jr., "Stockholder, Manager, and Creditor Interests: Applications of Agency Theory," in Recent Advances in Corporate Finance, E.I. Altman and M.G. Subrah-

manyam (eds.), Homewood, IL, Richard D. Irwin, 1985, pp. 93- 131.

9. "The Kennecott Blunders," Financial World, March 1, 1978, pp. 10-14.

10. "Kennecott Renews Itself With Sohio's Oil Money," Business Week, April 26, 1981, pp. 76-77.

11. J.W. Kensinger and J.D. Martin, "Royalty Trusts, Master Part- nerships, and Other Organizational Means for Unfirming' the Firm," Midland Corporate Finance Journal (Summer 1986) pp. 72-80.

12. R.H. Litzenberger, "Some Observations on Capital Structure and the Impact of Recent Recapitalizations on Share Prices," Journal of Financial and QuantitativeAnalysis (March 1986), pp. 59-71.

13. R.W. Masulis, "Stock Repurchase by Tender Offer: An Analys- is of the Causes of Common Stock Price Changes," Journal of Finance (May 1980), pp. 305-318.

14. J.J. McConnell and C.J. Muscarella, "Corporate Capital Expen- diture Decisions and the Market Value of the Firm," Journal of Financial Economics (September 1985), pp. 399-422.

15. W.H. Meckling and M. C. Jensen, "Reflections on the Corpora- tion as a Social Invention," Midland Corporate Finance Journal

(Fall 1983), pp. 6-15. 16. P.D. Phillips, J.C. Groth, and R.M. Richards, "Financing the

Alaskan Project: The Experience at Sohio," Financial Manage- ment (Autumn 1979), pp. 7-16.

17. B. Picchi, "Structure of the U.S. Oil Industry: Past and Future," Salomon Brothers, July 1985.

18. M.S. Rozeff, "Growth, Beta, and Agency Costs as Determinants of Dividend Payout Ratios, Journal of Financial Research (Fall 1982), pp. 249-59.

19. T. Vermaelen, "Common Stock Repurchases and Market Sig- nalling: An Empirical Study," Journal of Financial Economics

(June 1981), pp. 139-183.



investing the alaskan project cash flows: the sohio experience

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