Jan

12

 The recent events at Petrobras have taken the investment community by storm, and there is much discussion about when the right time is to get in. Bulls figure that given the reserves and the potential that the current price is cheap and will work out well in the long term despite the current scandals. I am usually an "asset based" contrarian, but in this case I am not so sure. Let me give you my perspective:

I've worked at both Devon and Kerr-Mcgee and had many friends at Chesapeake.

To preface this post, I have never been a fan of "management guru" books and find them to mostly be trash with little insight. That being said, an excellent book could be written about the resurgence of Oklahoma City and the contrasting fortunes of Kerr-McGee, Devon, and the one-time high-flying Chesapeake Energy over the years and the differing management styles at each company. Perhaps I should write it. However with the protagonist of this post now working for one of the antagonists the final chapter cannot yet be written.

If you don't want to read a few thousand words and just want the punchline it is this: Management and management culture matters, and Devon's former CFO Jeff Agosta is one of the main reasons for Devon's success whereas Kerr-McGee has disappeared and Chesapeake goes through recurring crises. Interestingly enough, Jeff is no longer at Devon and now works for former Chesapeake founder Aubrey McClendon's new company, American Energy Partners. I will write more on that later on in this post.

The story for me begins in the mid to late 1990's when I was working for my father's money management firm. Chesapeake (CHK) was a high flying driller based on horizontal drilling in the Austin Chalk.

Wall Street was heavily promoting CHK and it was one of the biggest "momentum plays" on the street. My father didn't believe it. Frankly, anyone with experience in the austin chalk knew that the decline curves were massive. This time it was supposed to be different because of CHK's horizontal drilling. Horizontal drilling, however, wasn't going to change the nature of the austin chalk as a play, it was just going to make the initial production bigger. The problem however was that these were new wells and there wasn't much history.

At the time getting well data was a pain. We had to subscribe to a Petroleum Institute service for around 10,000 dollars per year that sent us CD's with county well data from Louisiana which was months out of date. Sure enough, the decline curves were massive. We talked to wall street analysts, and of course they didn't care. CHK was everyone's favorite.

A few years later CHK almost went out of business as sure enough the decline curves were massive. That was the first time I heard the name Aubrey McClendon.

The next time was the summer of 2003. I was sitting at my desk at the Zurich office of Kerr-McGee Luxembourg, (thank you IRS for creating such inefficiencies). I had very little to do. I was in Zurich for 2 months for a paid internship that was put together at the last minute because the employee whose job I was doing had a stroke and Kerr-McGee needed someone to take his place while he recovered.

The head of the office was an American hired in 1999 (a rare outside the ranks hire). The rest of the staff was Swiss and/or German. The European marketing team from the Chemicals unit (later spun off as Tronox) also shared these offices. European Chemicals marketing was run by a Kerr-Mcgee old timer who was one of the few still around from the Karen Silkwood days.

The first sign that Kerr-McGee had issues was that I didn't really have anything to do all day. By and large I was done with my job by 10am. In addition to my day job I was given a project to research the possibility of issuing euro-denominated bonds in Europe. The project didn't take long. Other than that I had a lot of spare time. Someone in IT at the main office in Oklahoma City seemed to have the sole job of tracking my web surfing and blocking every site that wasn't work or finance related.

The Swiss like to take long lunches and usually have a few beers at lunch as well. A directive had come down from HQ that nobody was allowed to drink at lunch but my boss told us to do what I wanted as long as he didn't see it. So, sometimes we would take 90 minute lunches by the seaside and have a couple of beers, but that still left the entire afternoon with little to do. I had brought a lot of textbooks with me to Zurich to study finance and economics but I burned through those pretty quickly.

If I could do it all over again I would have spent the time learning German, although it was also when I first started to really study body language as I could not communicate verbally. It is really the subject of another post but from my time in Panama, Switzerland, Italy, Albania, Poland, etc. I have become somewhat of an expert in reading body language. Body language doesn't lie. People do. I now like to sit in restaurants and watch body language. It is fun to spot which woman doesn't like her date and just wants to get out of there as quickly as possible even vs. which guy is going to get lucky that night. I'm also good now at knowing when I am being lied to - although I have had a few spectacular failures in that regard.

Back to Zurich: So I started spending my spare time looking for a permanent job. Simply searching "energy companies in Oklahoma City" got by my IT censors and I quickly gathered up the names of all the big energies companies and their officers. By googling around the domain names you can always come up with the structure of corporate email addresses (i.e. firstname.lastname or whatever) because some employee somewhere has always used his or her work address to post on a random message board.

So I sent out some emails to some Oklahoma City energy company executives. The emails read as follows:

Hello, my name is Gordon Haave. I am currently working for Kerr-McGee in Zurich in the corporate Treasury department. Previously I have served as Vice-President of a $300 million money management firm and as the CFO of a $20 million residential construction firm. I am returning to Oklahoma City in August and am looking for a full time job if you have any available."

Short and simple appeals work with some people and not with others. I got replies from both Jeff Agosta (then SVP of Finance and Treasurer of Devon) and Aubrey Mclendon (CEO of Chesapeake) Aubrey was very nice as everyone always says he is. We had a brief back and forth and after inquiring around the company he told me that there was nothing available but to stay in touch.

Jeff responded basically with a "yes we are looking for someone, come and see me when you get back to Oklahoma". That's how I ended up working for Devon.

However, I was still working at Kerr-Mcgee. Every day was frustrating as there was little to do, and everything I did have to do basically had zero value added. Let me explain:

My primary job was ensuring the accurate cash forecast of Kerr-McGee's North Sea oil and gas operations, and to ensure that cash balances were kept at a minimum so that they could be invested in time deposits. In the morning I had to make sure time deposits were properly received that were due that day, and in the afternoon all cash had to be swept up into new time deposits. These were often overnight or just 2-3 day investments.

The process was based off of the weekly cash forecast which was stored on the Kerr-McGee mainframe and accessed by everyone via Citrix. The weekly forecast started on Monday at the operating units. The operators would have to forecast DOWN TO THE PENNY every single expenditure or receipt they knew about. At the end of the day Monday the information would go to one higher level up, where it would be compiled. It would then move on to one level higher up on Wednesday to a treasury analyst for that unit. On Thursday morning I had all of the information for every unit and would complete the overall spreadsheet which presumably someone reviewed on Friday. It was a pain-staking process that took the time of at least 10 people over the course of the week to do. And to what end?

Of course a Treasury department needs to be able to forecast cash, but down to the penny? There were times where somewhere along the way the info would be recalled because someone let out an anticipated $500 expenditure. What difference did it make if $500 was invested one day or two days?

Ideally if you have the exact cash balance down to the penny you can invest better. For example, if you have $1 million dollars extra and you know you can invest it for and extra 4-5 days instead of just overnight you will earn more interest. But how much? Enough to have 10 people working on the thing? Enough to harass operating units into worrying about that instead of worrying about their operations? Of course not.

I once said something to my boss about it and his response was "you are lucky, when I first started here they were doing this by carbon paper and fedexed around. We only changed to spreadsheet because they couldn't buy the carbon paper anymore".

I was in a good position to learn many other things about the corporate culture. As the young American guy there by myself the chemicals sales force guys would take me out at night on their expense accounts when they passed through town and they expressed how hampered they were by the corporate culture.

Also, at the time, Kerr-McGee was spending literally millions of dollars per year on outside consultants whose job it was to change the corporate culture. One of these consultants spent a week or so in Zurich and I went out to eat and have a few drinks with him a few times. I'll spare you the details of the horror stories but his conclusion was pretty straight-forward: "It's utterly hopeless."

I don't want to name names but I remarked to him once that a certain person in our division seemed to be the real brains of the operation, yet he was not the head of it and I was wondering why. The answer: "Because X joined the company two weeks later than Y 20 years ago".

So let's review what I learned about Kerr-Mcgee:

A. A massive number of employees doing useless jobs.

B. A culture where seniority is all that matters.

C. The corporate tail wagging the operating dog.
After Kerr-McGee it was on to Devon in Jeff Agosta's unit. I ran the "cash management" function which included the investment of excess assets as my primary job but I also performed as somewhat of an overflow worker for other corporate finance projects as needed.

What was the corporate culture at Devon? Well, it depends on what part of it you worked in. In accounting it was just as bad as as Kerr-McGee. There were massive, bloated staffs of people who did their job the way they did it and simply wanted it to stay that way and didn't want anything to change. That didn't really matter too much except that corporate expenses were higher than they should be and landowners would be pissed off because they got their checks late. More than a few times in social settings when telling someone I worked at Devon the response would be "why can't you send your checks on time?"

Corporate finance, however was a lean and mean operating machine. We had less people performing the finance and treasury functions than Kerr-McGee had working on the weekly cash forecast - and we did a good job of it too. This was all under Jeff's leadership and direction.

How did the cash forecast work?

When I started there was already a cash forecast spreadsheet which I later revamped. Here is how it worked:

We pulled production estimates from an existing database. We pulled gas and oil prices from Bloomberg and applied a discount to them for what Devon would actually receive for oil and gas sales.

We knew corporate overhead data and when payroll was due, and we knew interest and swap payments already.

As to the level of accuracy achieved it was pretty straightforward. The conversation went something lie this:

Me: "Jeff, given interest rates and what we can do with extra cash in terms of investments (or lack thereof) and the manpower that we will have to expend in order to get a more detailed forecast it is cheaper to just leave an extra 100 million laying around than expend the effort to harass people so that we can do more detailed forecasts like Kerr-McGee does. Plus, we don't have to harass people who have other things they are working on."

Jeff: "Agreed"

And that was that.

A rational and efficient decision was made, without regard to "how things are always done" and taking into account that there is no need to be harassing operating units.

Not harassing the operating units was a theme that Jeff reinforced a few times.

I recall one event when a decision was made by an operating unit to bid on some blocks off of Brazil. The email I got was basically "We have to have $40 million dollars in an account in Brazil in three days". The $40 million wasn't a problem - remember we always had more than that just laying around. The problem was opening the account. This is was after 9/11 and the government was imposing all sorts of new Know Your Customer rules on the banks.

To open the account Bank of America wanted endless documentation that there was basically know way I could do within 3 days. In the end I just said to our representative at B of A "look, this is Devon energy opening an account for a Devon subsidiary, we have 120+ accounts with you. This account need to be opening tomorrow. I will send you whatever documentation you want later, but this account has to be open tomorrow. If you don't know your customer well enough to open the account then we will have to find someone who does".

He opened the account.

At some point during or after this event I said to Jeff "Hey, these guys (the operating unit) really have to give us more heads up next time". Jeff's response was "It is fine for you to send them an email asking them to give you a better heads up when they can, but always remember they are the one's who make the money. We work for them, not the other way around".
Meanwhile let's get back to Chesapeake. Aubrey McClendon the well liked and flamboyant founder had his own management approach. I can't speak too much to the internal culture as I was not a part of it, but Aubrey was generally highly regarded by his employees. The problem was as follows: He ran the company like it was his own as opposed to running it on behalf of the shareholders.

Although it is difficult to quantify this was apparent by the massive amount of money that Chesapeake through around the community in what appeared to me to be one big dose of self-promotion. Chesapeake funding was all over Oklahoma City, and the news articles praising McClendon were legion as he achieved celebrity status. Companies need to distribute money in their communities from time to time for their long run success, but Chesapeake's giving far outstripped anything Devon or Kerr-McGee was doing. I was constantly thinking to myself "I wonder how any of this benefits shareholders"?

Later events that are quantifiable proved me correct that indeed the company was being run in his own interested instead of the interest of the shareholders.

In short, McClendon has a sweetheart deal where, after shareholders paid to acquire land McClendon got an ownership stake of 2.5% of every well drilled. He had to pay 2.5% of the drilling costs. How did he come up with the 2.5%? He borrowed against his interest in the wells.

Here is the problem with that:

1. McClendon was competing with Chesapeake for access to capital.

2. Let's say the price of natural gas goes down and Chesapeake needed to curtail it's drilling or shut-in some wells. What decision should be made? Well, if McClendon has massive personal interest payments to make on his personal debt, he suddenly has a conflict of interest with the company.

McClendon of course denied any conflict of interest, but it is ludicrous to believe that shareholders ever would have approved such a situation had they known about it. One defense perhaps is that the board of directors (who represent the shareholders) knew, but this is the same board of directors that bailed McClendon out of his personal financial problems buy buying his private map collection from him and awarding him a massive bonus while Chesapeake's own fortunes were in decline.

In addition McClendon was using CHK employees to do personal work for him and also never disclosed that he had a hedge fund on the side which traded in the same energy markets that CHK did.

In short, he ran the company on behalf of himself, instead of on behalf of the shareholders.

To contrast this behavior to what I saw at Devon: One time a senior manager operating out of Houston donated $10,000 to a charity without prior approval. As Jeff relayed to me the manager was told "that is the shareholders money, either get it back or pay it back yourself".

All of this leads to an interesting situation:

Aubrey McClendon is the last person in the world I would want to look after my interests as a shareholder. Jeff Agosta is the first.

Now, Jeff works for Aubrey.

In January 2014 Jeff was fired as the CFO at Devon. I don't know the scoop and have not spoken to Jeff in 6 years, but as someone with more knowledge than I do tells me:

"He f****d up on a forecast/reporting issue, plus he alienated virtually everyone who worked under him with his management style, it seems."

I have no idea myself, but that he might have alienated people under him would not be a surprise. I for one liked working in his unit. With Jeff would always knew where you stood. If you did a good job you knew it, and if you did a bad job you knew it. Not everyone is like me however. Some people care more about the 5 minutes of pleasantries that need to occur when a conversation starts and need criticism of their idea in a roundabout manner. Jeff was not that guy.

More importantly, I would bet that Jeff attempted to impose his efficiency viewpoint on the rest of the company and got a lot of pushback.

American Energy Partners is said to be getting ready for an IPO. My advice: figure out who is really calling the shots on the finances. If it is McClendon then take a pass. If it is Agosta then go for it if you otherwise like the company and it's valuation.

Postscript:

So what does all this have to do with Petrobras? In the end and after years and years of attempted reform Kerr-McGee called it quits. The stock had basically gone nowhere for 20 years and eventually the chemicals unit was spun off and the Oil & Gas assets sold to Anadarko. The archaic corporate culture just couldn't be overcome.

In all companies the allocation of capital is incredibly important. The difference between Energy companies and many other companies is that the economic consequences few key decisions will be apparent in short order. Proctor and Gamble can make bad decisions and the result will just be a slow decline in overall market share over a long period of time - this is not the case with an energy company.

Petrobras can have all of the reserves in the world, but if management and the corporate culture are no good shareholders will never realize a profit from it.


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