An Oil Giant Springs a Leak

ChevronTexaco trails its peers--and has a Dynegy dilemma

On July 23, Dynegy Inc.'s (DYN ) troubles deepened as the energy trader yanked a $325 million bond deal intended to shore up its finances and cut its cash flow expectations. With gas and power prices low and plenty of debt on its books, the company's $800 million cash hoard has been declining quickly. The bad news drove the stock down 64%, to $1.26 a share. And trading down along with it were the shares of its biggest supporter: ChevronTexaco (CVX ).

For ChevronTexaco Corp., which owns a 26% stake in the company, the questions raised by Dynegy run deep. Most immediately, it's unclear what will happen to its $2.8 billion investment, especially if the trading house does run out of cash. That won't imperil ChevronTexaco, but it heightens questions about CEO David J. O'Reilly's decision last winter to pump an additional $1.7 billion into the troubled concern.

More pressing are the questions the Dynegy debacle is raising about management's judgment. At a time when ChevronTexaco must convince analysts and investors that a much bigger and more complicated bet will pay off--the $38 billion merger of Chevron and Texaco--support is eroding fast. "People are beginning to say these guys are not as shrewd or as good as we thought," says Fadel Gheit, a senior energy analyst at Fahnestock & Co. "Dynegy definitely took some sizzle out of the stock."

Last fall, when oil giant Chevron Corp. tied the knot with Texaco Inc., little of this could have been expected. Dynegy was then seen mainly as a smart doorway into the energy trading business. At the time, the usually soft-spoken O'Reilly boasted confidently of the benefits the merger would bring. With $100 billion in revenues, O'Reilly promised, ChevronTexaco Corp. "would be positioned for stronger financial returns than could be achieved by either company separately."

But that promise has proven difficult to keep in the wake of Enron. In truth, little less than a year later, ChevronTexaco not only finds itself wrestling with the usual problems of a multinational oil company--such as finding more oil and gas--but it's also stuck with the Dynegy burden. The result? Chevron, once one of the most profitable Big Oil companies, has become a laggard.

Its return on capital is lowest among the five biggest integrated oil companies--five years after Chevron on its own was second-highest (chart). Its stock, recently at $69, trades at a noticeable discount to its peers: 14 times 2002 expected earnings per share, vs. 16 times for BP PLC and 17 for Exxon Mobil Corp. Political unrest in West Africa and a fire that shut down production in mid-July threaten a critical region for the company.

The merger gave Chevron the bulk O'Reilly felt was needed to compete against larger rivals. But Texaco had a serious shortcoming: It had spent billions on international energy projects, yet was never able to boost oil and gas production as profitably as its peers. Says O'Reilly: "We knew when we put the two companies together the combined returns would be lower. The great opportunity is to capture the synergy between the two businesses." He says that is already happening. He expects his big exploration projects to pay off, while he slashes at costs during the integration.

O'Reilly has begun ChevronTexaco's turnaround with some aggressive cost-cutting. Chevron and Texaco had overlapping facilities in 14 major producing areas worldwide. At an investors' meeting in mid-June, O'Reilly said the company's expected savings from the merger would increase to $2.2 billion a year by April, 2003, nearly double original estimates. O'Reilly is also cutting capital spending by 22%, to $9.4 billion this year. All told, it should boost the company's return on capital two or three percentage points, bringing it more in line with peers.

Then comes the second stage of O'Reilly's strategy. Starting in 2004, he expects new oil and gas projects to give the company the sort of boost Chevron got in the '90s from its 9-billion-barrel Tengiz field in Kazakhstan. But to nudge growth of oil and gas revenues beyond the 1% increase he's projecting for this year and next, O'Reilly needs to get lucky. Part of his cost-cutting binge includes reduced spending on exploration. What he is spending will be focused on three key areas: More than half of ChevronTexaco's $650 million exploration budget will be spent in the Gulf of Mexico and in the waters off Brazil and West Africa.

All three regions carry big risks. Chevron and Texaco each got a late start in the Gulf of Mexico, notes Richard G. Gordon, an analyst at John S. Herold Inc., an oil and gas investment firm. Even after the merger, ChevronTexaco still trails BP (BP ), Royal Dutch/Shell (RD ), and ExxonMobil (XOM ) in expected production from the gulf. No foreign company has yet had a major new field come on line in Brazilian waters. And while ChevronTexaco has had some success in West Africa, the region has become a headache recently. In mid-July, hundreds of women occupied the company's Escravos crude-oil distribution facility in Nigeria, demanding the construction of schools, clinics, and water systems. The protests, which coincided with an unrelated fire that shut down production, underscored the difficulties of doing business in a country where local villagers have long felt they aren't sharing in the nation's oil riches.

Meanwhile, O'Reilly's commitment to Dynegy, in which Chevron first acquired a stake in 1996, continues to confound Wall Street. Despite the demise of Dynegy's online trading operation, O'Reilly is confident that there will always be opportunity in linking buyers and sellers of electricity and natural gas. The federal government, after all, has deregulated much of the utility business in the past 20 years, allowing a freer market between big users and producers. Indeed, Dynegy markets all of ChevronTexaco's U.S. natural gas production.

But the collapse of Enron Corp. has been bad news for all energy traders, and Dynegy shares have fallen more than 90% on concerns of trading and accounting shenanigans. Few see a chance of serious damage to ChevronTexaco, even if it has to write off all of its $2.8 billion Dynegy investment. But some wonder why O'Reilly hasn't done so already. Fahnestock's Gheit estimates that a write-off would erase $2.75 from its book value per share, minor compared with the $26 a share the stock has dropped since early October, largely on concerns about Dynegy.

What worries Wall Street most is that O'Reilly might sink more money into Dynegy or buy it outright. That would lower ChevronTexaco's returns and could also bring legal liabilities stemming from the California electricity crisis. O'Reilly says he hasn't decided which course to take. "The whole sector is struggling, but there is a business there," he says. "We're not sure how it's going to play out."

O'Reilly's image on Wall Street remains as unclear as ChevronTexaco's future with Dynegy. The son of a department store manager in Dublin, Ireland, O'Reilly graduated from University College there with a chemical engineering degree and joined Chevron California right away. He made his mark running its troubled refining operation in the mid-1990s. By focusing on a few key areas, like safety and customer service, he helped boost refining profits from $75 million in 1995 to $633 million three years later.

As CEO, however, O'Reilly has yet to spell out a management style that defines ChevronTexaco. ExxonMobil's Lee R. Raymond is seen as the strong, silent bull that always delivers industry-leading returns. At BP, John Browne's rep is that of an environmentally sensitive visionary. When asked what ChevronTexaco stands for, O'Reilly says: "We are the company that delivers on its commitments." Wall Street is saying that delivery seems a long way off.

By Christopher Palmeri in New York with Stephanie Anderson Forest in


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