Reserve Judgment In Deal for Unocal, Chevron Gambles On High Oil Prices

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.

But behind this victory 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 are expected to approve the deal today, giving Chevron access to oil and gas fields across Asia and North America. Mr. O'Reilly needs the new supplies: Chevron's production has fallen 14% 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 $64 a barrel this week, will retreat over the long run and 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 Mr. O'Reilly hasn't said that oil production is peaking, he believes that 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. Mr. O'Reilly, 58 years old, declined to be interviewed before Chevron completes its Unocal acquisition.

When Unocal became available, Mr. 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 U.S.

Chevron, San Ramon, Calif., posted net income of $13.3 billion in 2004, up 85% 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 Mr. O'Reilly took over, Chevron's total shareholder returns have been neck-and-neck with Exxon and outpaced big competitors Royal Dutch Shell PLC and BP PLC.

But the strong results 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% -- 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.

Poor results in exploration are just one of several problems Mr. O'Reilly has faced since he took over five years ago -- including one of his own making. In 2001, Chevron lent $1.5 billion to Dynegy Inc. to help it buy Enron Corp., right before Enron collapsed. Chevron eventually had to accept $850 million in cash and stock from Dynegy and write off the rest of the loan.

More importantly, Chevron's 2001 merger with Texaco has faced more troubles than most of the other megamergers that reshaped the oil industry around that time. Some of Texaco's oil fields had less oil than expected or faced political hurdles to development.

Even as Chevron's production of oil and gas has slid in the past five years, most major oil companies have raised production, according to John S. Herold, the research firm. Exxon suffered a decline but of only 2%. Chevron says the figures don't include some affiliated production that would moderate its overall decline.

Chevron Vice Chairman Peter Robertson says the company is carrying out a long-term strategy that will result in industry-leading profitability and strong production growth. He says it has warned investors that there would be a period of flat production as it sold off some assets and refocused its capital on several multibillion-dollar projects still in development.

The company has several giant development projects -- dubbed the "Big Five" -- nearing completion and expects dramatic improvement in its replacement rate. Mr. Robertson told analysts in December 2004 that the failure to book a large chunk of new reserves during 2004 was "strictly a function of project timing."

Chevron notes that in some overseas fields in which it has invested, it is entitled to recover the money it spent developing the field in barrels of oil. As the value of each barrel rises, it gets less oil under such contracts, pushing down production statistics. Chevron also cites asset sales, hurricanes and political unrest in Nigeria for the 6% decline in production last year.

Chevron isn't the only Western oil company scrambling to boost production. The fields that once transformed oil companies into leviathans are petering out. The best remaining opportunities are in the Middle East, West Africa and the former Soviet Union, regions with unstable political situations.

Mr. O'Reilly argues that the industry has entered a new era of high prices. "The time when we could count on cheap oil and even cheaper natural gas is clearly ending," he told industry executives in a February speech that he wrote himself. Some in the oil industry started calling it the "Brave New World" speech. Not long afterward, the company started an advertising campaign with a similar message. The new era, Mr. O'Reilly writes in a letter featured in the ads, will be defined by "more competition for the same resources."

In early January, Chevron's top executives gathered to hear a presentation from Matthew Simmons, a Houston investment banker and author of a book arguing that Saudi Arabia's oil output, vital to global production, will soon head into "irreversible decline." At the end, Mr. O'Reilly praised the presentation, calling it most interesting.

Even if Mr. O'Reilly's forecast of a grim future is accurate, it remains to be seen whether Chevron has the operational adroitness to exploit the resources it expects to be so valuable.

Months after closing the $38 billion Texaco deal, Chevron took a $1 billion charge to write down the value of a Texaco oil field in California. Before the merger, Texaco projected that a field off the coast of Nigeria called Agbami would begin flowing in 2003 and turn into a gusher. Now Chevron has pushed back the start date to 2008. It says the date is firm, but tensions remain with the Nigerian government over tax bills and the use of local companies as contractors. A project to increase output from the giant Tengiz field in Kazakhstan, another "Big Five" project, has been pushed back a year from its original completion date.

To turn around its lackluster production trend, Chevron spent much of 2003 pursuing a deal to buy a stake in Russia's OAO Yukos. But Yukos's maverick chairman, Mikhail Khodorkovsky, ran afoul of the Kremlin. In October 2003, he was arrested by Russian authorities and charged with failure to pay billions in back taxes. Yukos was later pulled apart and sold to state-controlled companies.

Chevron wasn't the only company surprised by this turn of events. Exxon also had been negotiating to buy a stake in Yukos. But while Exxon turned to gas-rich Qatar for new reserves, Chevron didn't have a way to prevent its reserves from slipping.

In January, Mr. O'Reilly shared some good news with his board: He believed Unocal was open to an acquisition. "There was not a lot of whooping and hollering, but there was a lot of quiet satisfaction," recalls J. Bennett Johnston, a former U.S. senator who retired from the Chevron board this year. The board quickly gave approval for Mr. O'Reilly to pursue Unocal, which is based in El Segundo, Calif.

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.

Sensing a strategic opportunity, Mr. O'Reilly pushed ahead with merger talks and made an all-stock $15.8 billion offer for Unocal in late February. Unocal said it wasn't enough and went to Cnooc and its other suitor -- Italy's Eni SpA -- seeking bids. Cnooc offered $17 billion in cash. Eni, willing to offer only $16 billion, backed out. Chevron increased its stock bid to $16.5 billion -- as high as the board had authorized Mr. O'Reilly to go. "He put it all on the table," says Mr. Johnston, the former board member.

Hours before Cnooc's final bid was due, the Chinese company told Unocal it wasn't going to bid. Chevron signed the merger papers at 4:30 a.m. on April 4. Chevron's stock took a hit because investors feared it was overpaying. Then the deal got more expensive. In late June, Cnooc made an $18.5 billion counter bid. On July 19, as the Unocal board flirted with Cnooc, Chevron sweetened its bid to $17.7 billion, of which 60% is in stock and 40% in cash.

Most analysts say that Unocal's assets fit nicely with Chevron's portfolio. Both companies own assets in similar regions, making it easier to cut duplicate costs. And the deal will turn Chevron into the top international oil company in fast-growing Southeast Asia.

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. Since some of Unocal's reserves still require more investment before they can be extracted, that suggests Chevron's $10.30-per-barrel price is above the going rate. However, others have paid even more: Kerr-McGee Corp. this week announced a $3.5 billion deal to sell oil fields in the North Sea to European buyers. That amounted to $13.42 per barrel, although North Sea oil fields carry a premium because they are close to the European market.

Factoring in production costs and the time it will take to get Unocal's reserves out of the ground, some analysts believe oil prices would have to stay at around $40 or so for Chevron to receive a decent return on its investment. Chevron believes it could do well on the deal even if prices fall into the $20-$30 range.

"If prices turn out to be where they are today for a long time, we'll have a great win," says Mr. Robertson, Chevron's vice chairman, in an interview.

Write to Russell Gold at russell.gold@wsj.com