Oil and gas? Freeport knows exactly what it's doing

Wall Street has misunderstood the mining company's acquisition of two energy producers, says one expert.

By Minyanville.com Dec 14, 2012 1:38PM
Image Natural gas plant copyright Kevin Burke, CorbisFreeport-McMoRan (FCX) has gotten a lot flak since announcing it would reenter the energy business after spending decades specializing in precious metals. But this doesn't mean the company is clueless. In fact, Freeport might be so far ahead of the game that no one can recognize the significance of what it's doing.

Shares of the leading gold and copper producer dropped 17% last Wednesday, driven by the company's acquisition of two U.S.-based oil and gas producers, McMoRan Exploration Co. (MMR) and Plains Exploration and Production Company (PXP).  

Considering that FCX's pre-acquisition assets are wholly centered around precious metal extraction -- it already owned the highly prized Grasberg minerals district in Indonesia, the Morenci mineral district in North America, the Cerro Verde and El Abra mines in South America, and the Tenke Fungurume mineral district in South Africa -- the mining megalith's move into the energy sector has, to no surprise, left Wall Street scratching its head.

"Pure play on copper, strong balance sheet, growth story, strong project pipeline, safe dividend, and yet a foray into a sector with little if any synergies, why would you do that Freeport?" wrote one investor at Seeking Alpha.

Doubts over whether or not Freeport's decision to diversify its assets was a sound strategy drove the stock to a 15-month low. A number of downgrades followed.

Standard & Poor's cut its rating outlook from "stable" to "negative." Analysts at Deutsche Bank (DB), BMO (BMO), Citigroup (C), Macquarie (ASX:MQG), and Goldman Sachs (GS) all downgraded their outlooks on the company, too.

In a research note, one Goldman Sachs analyst wrote: "We believe that Freeport's stock will remain in the penalty box for the foreseeable future and multiples will remain depressed on the back of these acquisition announcements, given investor uncertainty on the strategic merit."

The "forseeable future" might not be what this move is totally about, however.

Freeport's acquisition of McMoRan, whose Gulf of Mexico oil and gas operations are valued at around  $1.4 billion, will return the precious metal miner to its early days as a fuel producer, for those who remember. In 1994, Freeport spun off McMoRan, the former subsequently selling its substantial oil and gas operations to the latter. However, in the interim the two remained very close, with McMoRan CEO James Moffett serving as chairman for both companies, reports Benzinga. The two companies have even shared the same office buildings.

Throw Plains Exploration into the mix, and the the relationship between these three companies begins to look like a corporate ménage à trois. PXP, which recently acquired oil and gas fields from BP (BP) in the Gulf, has a 31.5% stake in McMoRan, and a Chief Executive on MMR's board.

McMoRan's stock price has been up roughly 75% since the announcement, while Plains Exploration has jumped around 24%.

According to FCX's press release, the acquisition will give Freeport a number of oil production facilities and fields in California, Texas, and the Gulf of Mexico. But these aren't what investors should be paying attention to. What really deserves more attention is the following sentence: "The MMR portfolio is expected to provide a large, long-term and low cost source of natural gas production." Plains Exploration's natural gas assets in the Haynesville, Louisiana, are worth noting, too.

"Clearly, the sentiment of the market has been: 'Why are they doing this?' It seems to make no sense," Rob Lax tells Minyanville. Lax has been a business consultant focusing on trade mining and private equity in emerging markets for the past 19 years. His law firm, Lax LLP, is based in New York City.

"But FCX is so far ahead of the curve, people don't see how key this move really is....Freeport has taken a bold strategic step: [It's] planning to sell natural gas to Asia."

Wall Street's got it all mixed up
Lax believes that viewing this deal as a move for FCX to leverage oil and gas assets in the U.S. and the Gulf is backwards. It's the other way around: Freeport is leveraging Asia's demand for liquid natural gas (LNG).

"Asia is where this company sees its future customers," Lax says. "They're leveraging every other opportunity but the U.S."

Chinese demand for copper is what attracted FCX to the region in the first place. Asia's leading economy currently consumes 40% of the precious metal's global output, and, in 2011, 78% of Freeport's revenue was driven by copper sales. 32.4% of Freeport's revenues came from Asia last year.

Asia is always where FCX saw its future customers, Lax says. Now, he believes demand for LNG in that region, coupled with Freeport's close association with two natural gas producers, has driven it to compete in that marketplace.

Japan is the world's largest LNG importer, its interest in the clean-burning fuel further amplified by the 2011 Fukushima nuclear disaster.

Chinese demand for LNG is expected to grow 13% per a year, doubling by the end of 2017, according to the International Energy Association (IEA). In 2013, China will become the third world's largest consumer of LNG, behind South Korea. North America is expected to become a net exporter of natural gas over the next five years.

"No one imagined what energy powers countries like the U.S., Brazil, and Canada would become. [The US] is all of the sudden producing a massive amount of energy, much more than it needs," Lax says. "It's nicely timed for the growth of Asia, which needs as much energy as it can get."

Recently, Asian countries have been demanding cheaper natural gas prices, reports Reuters. LNG can cost up to five-times as much in Asia versus the U.S., and prices there have nearly doubled since May 2011 to $18 per mmBtu. Cheniere Energy Inc (LNG) -- currently the only U.S. company licensed to export liquid natural gas -- has suggested there will have to be a shift in how natural gas is priced. ExxonMobil (XOM) and GDF Suez (GDFZY) have expressed concern over their customers' ability to pay if prices remain so inflated. 

Japan and South Korea have traditionally purchased their LNG through long-term contracts linked to the price of oil. A move to what's known as hub-pricing -- set by the volume of gas moving through a regional distribution hub -- would reduce the price of LNG in the area.

This would undermine Qatar, currently Asia's largest source of LNG, which has championed tying natural gas prices to oil (hence, making it more expensive) for several decades.

With tides shifting toward the opening of that market, demand for LNG growing without a conceivable short-term clip, and a glut of available resources in the U.S. (U.S. LNG reserves have increased over 35% since 2006), FCX will conceivably use its new acquisition to become a competitive player in the industry. 

A study completed by the U.S. Department of Energy last week determined that allowing exports of LNG would benefit the U.S. economy. This means that the handful of refiners whose applications were put on hold until the study was complete are now one step closer to joining Cheniere in the U.S. natural gas export game. 

The last and most vital key is transportation, i.e. shipping resource where it matters. 

"After the expanded Panama Canal is built, 90% of the LNG tanker fleet will be able to fit through it," say Lax. 

Set to be completed in 2015, the expanded Panama Canal will shorten the trip between FCX's newly acquired natural gas fields in Louisiana and the Gulf of Mexico and the Asian markets desperate to fuel their growing economies.

So while investors are focusing on FCX's short-term deleveraging, longer-term exposure might just be the play on this stock.

More From Minyanville
Dec 15, 2012 9:14PM
I'm sure these guys are far smarter than I, but what happens when shale and fracking become globally common?
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