“One Plus One Has Got to Equal Three”
Bob Simpson was a tax accountant who wore his slacks stuffed inside his cowboy boots. When he was a young boy, an aunt brought him periodically to downtown Fort Worth, Texas, to shop at Leonard’s department store, a wonderland of toys, sporting goods, and furniture. Crumbling brick buildings dating to the Texas oil boom of the early twentieth century surrounded Leonard’s. Simpson grew up in modest circumstances in a small town nearby, graduated from Baylor University, took an accounting job in Fort Worth, and never left. When he began to earn big money, he bought up and restored many of the decrepit buildings he had seen as a child. On one occasion he paid $160,000 for the grand-champion steer at the Southwestern Exposition and Livestock Show and donated the animal to the Fort Worth Zoo. Increasingly, he was one of the city’s most active patrons.
Simpson was a numbers man. He kept books and organized tax returns for others until 1986, when he founded Cross Timbers Oil. Over the next two decades he built the company into a Wall Street darling. He acquired onshore American natural gas fields abandoned by the large international oil companies as they moved overseas and into deep-water offshore oil drilling in search of large new reserves. He also managed operations and financial strategy very tightly; Simpson became a master at growing through acquisitions.
He renamed Cross Timbers as the more ticker-friendly XTO; its profits grew very rapidly, from $186 million in 2002 to $1.9 billion in 2008, which vaulted XTO to number 330 on the Fortune 500 list of the largest stock market–traded corporations headquartered in the United States. Barron’s named Simpson one of the thirty most-respected business leaders in the world for four consecutive years, alongside Warren Buffett and Steve Jobs.
His thinning hair had turned gray, and as he reached his sixties, he grew a not-so–Wall Street white beard. He gave up day-to-day management responsibilities at XTO, while remaining chairman, and the beard hinted that he might be ready for a further change of lifestyle. XTO now employed three thousand people, all of them in the United States, a third of them in Fort Worth. Simpson’s stock option–incented executives and his Wall Street shareholders had become used to rates of profit growth that could not go on forever, certainly not in an industry whose performance was tied to volatile commodity prices.
In the summer of 2009, Simpson and XTO’s senior executives and directors attended the corporation’s annual management retreat at the Fairmont Chateau Whistler, tucked beneath the mountains of British Columbia, Canada. Simpson repaired to the hotel bar with Jack Randall, an XTO director who was a partner in an investment bank that specialized in oil and gas mergers. As they munched bar food, they talked about the industry and options for future strategy, including the possibility of a merger or an acquisition of XTO by one of the oil majors.
The American natural gas business was in the midst of a historic boom as new drilling techniques unlocked huge reserves of domestic “shale” gas—natural gas trapped in shale rock formations—and other unconventional sources. XTO was a leading producer of shale and unconventional gas. It owned positions in most of the major shale gas plays in the United States, including the Marcellus Shale on the East Coast, which was exciting interest. The corporation’s headquarters in Fort Worth stood near the Barnett Shale, one of the country’s best-known shale gas reserves, where XTO owned a large and lucrative position. A natural gas rush gripped Fort Worth as drillers, land men (who specialize in leasing land for drilling), and financiers scoured the region to grab positions. The nationwide boom atmosphere meant that natural gas production would likely rise and gas prices would fall. The financial crisis and recession of 2008 to 2009 had also dampened total energy demand, at least temporarily. Also, some of XTO’s past success had been due to Simpson’s financial wizardry in the futures and derivatives markets—his ability to enhance profit by locking in hedges on high gas prices, to guarantee strong cash flow and protect against market price declines. If prices fell for a prolonged period, hedging wouldn’t produce the same degree of benefit. Big international oil majors continued to look at unconventional gas companies like XTO with avarice, despite the falling prices, because the majors had largely missed out on the domestic gas boom that XTO had ridden. For a wily numbers man like Simpson, these factors—prices past a peak, a boom mentality in the industry, and hungry, cash-rich corporate buyers—all flashed “sell.”
Who would be an ideal purchaser, Simpson and Randall wondered? Chevron was in the midst of a leadership transition, and the corporation was being sued in Ecuador over an oil spill that might produce a major financial liability—at a minimum, the lawsuit was a wild card. They considered Shell, too, which was active in onshore gas plays, and a few less likely contenders. Before the check for their snacks came, they had settled on BP and ExxonMobil, both cash-rich and highly interested in the unconventional gas market. Simpson told Randall to approach both corporations to see if they might be interested in a merger or other combination with XTO.
Randall owned a significant amount of stock in XTO—nothing as large as Simpson’s holding, but enough to motivate him. Simpson also agreed to pay Randall’s firm, Jefferies Group Inc., a transaction fee of $24 million if a merger were completed. Randall had previously worked at Amoco for fourteen years, landing in the company’s mergers and acquisitions group. He left to form an oil and gas advisory firm that later became part of Jefferies, an investment bank. He and his fellow directors at XTO had been thinking for years about how the corporation might eventually find an acquirer; almost all successful independents in the oil and gas business ultimately merged or were acquired. That was also the common exit strategy for a founder like Simpson, and a deal now would allow all of XTO’s shareholders to benefit from his foresight. Like a marriage broker of old, Randall had already been cultivating a courtship between Bob Simpson and Rex Tillerson at ExxonMobil.
Randall had a personal tie to Tillerson: They had belonged to the same marching band fraternity at the University of Texas. Randall played trumpet; Tillerson played drums. They had both been engineering students in the marching band—that is, double nerds. Randall was a couple of years ahead of Tillerson at U.T., and the men had not known each other well at the time, but the shared history reinforced their professional relationship when Randall became a Houston-based broker of oil and gas properties. At industry and university luncheons, Tillerson and Randall would occasionally run into each other and catch up on oil and gas matters or reminisce about university days.
Around 2007, Randall had suggested that Tillerson invite Bob Simpson on a hunting trip, so the two men could get to know each other better. Tillerson agreed, and he and Simpson spent a few days shooting together on ExxonMobil’s vast ranch near Alice, Texas. They got along. Each had been reared in unglamorous circumstances in rural Texas and had now achieved transforming wealth and success. Each had put down roots in the Dallas–Fort Worth area and reveled in the region’s history and ranch culture. Each regarded himself as a disciplined leader devoted to operational perfection. Their corporations occasionally partnered on deals and worked compatibly.
After his Fairmont Chateau Whistler bar summit with Simpson, in late July, Jack Randall telephoned Tillerson.
“Rex, I need to come to see you,” he said. “It’s very, very important. It’s very confidential.”
Tillerson invited him to Irving, to meet in his office. When Randall arrived on August 6, he explained that Bob Simpson was thinking about a “strategic combination” between XTO and ExxonMobil. Might ExxonMobil be interested?
“Yes, I think we’ll be interested,” Tillerson answered. “Let me take some time to soak on it.”
In 1976, as a young Exxon engineer on his second assignment, in East Texas, Rex Tillerson was asked to work on a drilling technique known as hydraulic fracturing, which employs pressurized fluids to shatter rocks and unlock natural gas buried in complex geological formations. The drilling and engineering problems he wrestled with anticipated the shale gas boom that undergirded XTO’s success. In part because of his early, direct experience, Tillerson felt he understood the unconventional gas business. Not everyone in or around ExxonMobil thought Tillerson had the analysis right, however.
For most of Tillerson’s career, the exploitation of American onshore natural gas beds had not been a major priority for Exxon and other international oil companies. Alaska’s large gas fields attracted their attention, but the regulatory and political approvals necessary to pipe the gas to the Lower 48 continually eluded them. In Lee Raymond’s era, the big opportunities in oil and gas seemed to lie overseas, in new territories opened up by the cold war’s end, in Saudi Arabia, and in ocean waters, where a corporation like ExxonMobil could bring technological advantage to bear. For ExxonMobil, apart from its large projects in Qatar and Aceh, managing natural gas was often a by-product of exploiting oil. Natural gas associated with oil reserves in deep water and elsewhere could be a challenge because the gas was often “stranded” at the oil wellhead—there was no economical way to pipe it to a customer. One way to dispose of such stranded gas was to burn or “flare” it. ExxonMobil flared gas routinely at its offshore African wells. That exacerbated greenhouse gas emissions from oil operations, however, and it wasted a natural resource that might otherwise fuel, say, Nigeria’s moribund electricity sector. In some places, international oil companies, including ExxonMobil, built plants to extract from stranded gas commercial products known as gas liquids. In other cases they built plants to create liquefied natural gas that could be shipped globally. The focus had been on creating additional value (and as climate change worries rose, reducing pollution) from associated gas worldwide, not searching for new freestanding supply at home.
Shell, Chevron, and BP largely followed similar strategies—they ignored onshore, complex gas reserves in the United States, Europe, and elsewhere. They invested instead in liquefied natural gas. L.N.G. could soak up both associated offshore gas and bring some large, stranded “nonassociated” gas fields to market, such as the North Field in Qatar, while gradually creating a global gas market that looked reassuringly similar to the free-flowing, globally integrated oil market.
For years, to the international majors, the kinds of Texas and Oklahoma shale gas fields that Bob Simpson had scooped up while building XTO after 1986—and the kind of field in East Texas that Tillerson had been assigned to early in his own career—looked picayune, expensive to produce, and of doubtful long-term profitability. Still, ExxonMobil and other majors fiddled around some in these American gas fields over the years—they took leases and they drilled wells, but they did not invest at anything like the scale of their overseas L.N.G. and gas liquids projects.
Lee Raymond had declared in 2003 that American natural gas production had probably peaked. The Energy Department predicted that the United States might run out of domestic gas supplies, which were used mainly for heating and electric power generation, in just two decades. Alan Greenspan, educated by private conversations with Lee Raymond, urged Congress to consider fast-tracking the construction of liquefied natural gas import terminals around the United States to address this coming, widely predicted gas shortfall.
As it turned out, Lee Raymond had been wrong. Within a few years of his declaration, because of the emergence of unconventional gas drilling techniques that proved cost effective, the Energy Department revised its forecasts and now predicted that the United States had about a century’s worth of natural gas reserves. ExxonMobil and its international competitors had missed this mother lode lying beneath American soil.
Around the time of his visit to Tillerson in Irving, Jack Randall also met with an executive of BP’s division in the United States, headquartered in Houston. He asked his BP contact to explore whether the corporation might be interested in acquiring or merging with XTO to leap forward in the onshore American gas business. The executive told him, “Let us think about it.”
When the BP executive called back, however, he reported, “We actually like your gas assets better than we like our gas assets. But the timing is just bad for us.”
Tillerson called in mid-August. “I think we are seriously interested. What do you think the next step is?”
Simpson and Tillerson booked a private during room at the Fort Worth Club, in an early-twentieth-century building on Seventh Street. On a drizzly evening, they staggered their arrivals so club members might not notice them. If word of their discussions leaked, XTO’s share price would soar, making a merger price negotiation all but impossible.
One question about power and prerogatives in a merged company proved easy to set aside. Randall assured Tillerson, “Bob isn’t looking for a job at ExxonMobil.”
The founder’s departure would clear the way for ExxonMobil to take full control of XTO, as was its traditional method. Yet unlike in the case of the Mobil merger a decade earlier, Tillerson made clear that for the deal to work, he needed XTO’s top management and technical talent, other than Simpson, to stay on.
“I’ve got to do something about natural gas,” Tillerson explained. All of ExxonMobil’s corporate forecasting pointed toward rising gas demand during the next two decades and beyond, in the United States and globally. Shale or unconventional gas discoveries had upended American markets, flooding the country with apparently durable sources of supply. New discoveries were being announced around the world. ExxonMobil had no global organization dedicated to the full gamut of the emerging unconventional gas challenge—exploration, technology, engineering, drilling, finance, and marketing. Unconventional gas required new thinking in many of these disciplines. “I’ve either got to build my own or I’ve got to buy somebody with expertise,” Tillerson said. They discussed how ExxonMobil’s vast financial resources could bankroll a worldwide expansion of the business and drilling strategies Simpson had developed in the United States.
With XTO, ExxonMobil would buy some attractive American gas properties, yes, but the larger purpose would be to convert the acquired corporation into a new gas division inside ExxonMobil. The deal would not be driven by prospective cost savings. It would be a way to buy depth in the natural gas sector faster than ExxonMobil might create such capability on its own.
“One plus one has got to equal three or more,” as Simpson and Randall put it during the early talks, summing up the shared Exxon and XTO view of the merger’s goal.
An agreement to merge with XTO would be the most important decision so far of Rex Tillerson’s tenure as ExxonMobil chief executive. The corporation had not made an acquisition worth more than $2 billion since the $81 billion merger with Mobil a decade earlier. An XTO deal would likely be worth only about half of the nominal value of the Mobil transaction, before accounting for inflation since then, but even so, it would constitute a major bet placed on behalf of ExxonMobil shareholders.
Until now, Rex Tillerson had presided competently over strategies, projects, and plans bequeathed to him by Lee Raymond. Arguably, the only major strategic shift Tillerson had steered since taking over was in politics and public policy, by repositioning ExxonMobil on climate change and carbon pricing, and by seeking, however quixotically, to improve ties to Washington’s ascendant Democrats. Tillerson could be sure of one thing: Once news of his talks with XTO became public, his strategic business judgment would be scrutinized as never before.
By the time Tillerson and Simpson moved into full-blown merger talks during the fall of 2009, it had become common for industry analysts to attribute the unexpected American natural gas boom to technological innovation—that is, the discovery, refinement, and implementation of new techniques to extract gas previously thought unrecoverable. There was truth in this, but the “eureka” explanations masked a long history. Engineers at Exxon and many other companies had known for decades that the United States had large amounts of gas trapped in sand, shale rocks, and coal beds. They had also long known that certain unconventional drilling techniques—horizontal drilling and techniques to inject pressurized fluids to fracture rocks to release and join isolated pockets of gas—might allow these reserves to be exploited. The obstacles to refining these techniques mainly had to do with their costs. During the 1980s and 1990s, the wellhead price of natural gas in the United States hovered at or below two dollars per thousand cubic feet. The drilling techniques required to unlock unconventional gas were often too expensive to justify at that price.
If the United States had possessed a national energy policy that emphasized domestic supply even when such supply might cost extra, the government might have stepped in to conduct advanced research. There was no such policy. The government-funded institute that studied unconventional onshore gas drilling technologies and techniques—the Gas Research Institute—had withered by 2000, for lack of industry, congressional, and White House interest. After 2001, American natural gas prices moved up, toward four dollars and then five dollars per thousand cubic feet, and later toward seven dollars. The price rises, not any fresh thinking in Washington, changed incentives.
One of the Gas Research Institute’s directors was a Texas natural gas wildcatter named George P. Mitchell, the founder of Mitchell Energy. His firm produced gas from a conventional field in the Barnett Shale, in North Texas, but his field was aging and its rates of production were in decline. Mitchell knew there was more gas beneath his leased ground, but the gas was trapped in shale rocks. As American gas prices finally rose, he galvanized his engineering staff, with aid from the research institute, to revive and improve drilling techniques to fracture rocks and pull gas from difficult beds. As he succeeded and proved the viability of this approach, others joined in—among them, XTO. Record-high gas prices and tax incentives that allowed for recovery of research costs forgave expensive learning and mistakes.
Unconventional gas drilling damaged the environment. The techniques could contaminate groundwater, if carried out improperly, by causing chemical-laced drilling fluids and natural gas to leak into aquifers. Drilling companies did not typically disclose the chemical makeup of fluids used to fracture rocks, for competitive reasons, so the public could not easily judge whether the fluids were dangerous to human health. The onshore gas rush also had sizable impacts on land use and development in rural areas—it turned pristine spaces into industrial zones. In the early days of the onshore gas boom, however, the drilling took place mainly in oil-patch states like Texas, Oklahoma, and Louisiana, whose populations and political classes had long ago decided that the economic benefits of oil and gas exploitation, properly managed, outweighed the environmental risks.
Geologists wielding modern computer software and ground penetration radar had not previously devoted themselves to looking for “tight” or trapped unconventional gas beds in the United States. When they did in earnest, after 2003, they reported large finds. As early as 2003, the Gas Technology Institute, successor to the Gas Research Institute, revised past estimates upward to report that America’s total natural gas resource base was about 2,000 trillion cubic feet. Americans consumed a little more than 20 trillion cubic feet of natural gas in 2003, roughly the equivalent of 8 million barrels of oil per day, or nearly the amount of the country’s actual liquid oil imports. (These numbers explained the very rough, back-of-the-envelope forecast that the United States had a century’s gas supply under the ground: One hundred years of consumption at 20 trillion cubic feet per year equals 2,000 trillion cubic feet.) As the years passed and other government and industry panels considered the matter, they published similar top-line figures. But the estimates proved shaky; there was no doubt that there was a lot of unconventional gas in the United States, but exactly how much could be recovered as commercial fuel involved engineering questions that had barely been studied. The most bullish forecasts sounded like hype because they lacked a solid scientific basis.
How long unconventional gas resources might truly last would depend, for example, on the pace of geological depletion in gas beds. This was a matter with which drillers had relatively little experience because the techniques were so new. Other factors would include the pace of demand for natural gas in electricity generation, particularly as a substitute for coal; the future of carbon pricing and greenhouse gas regulation; the trajectory of natural gas prices; and the pace of technical innovation. The idea that the United States truly had enough of its own gas to last a century seemed optimistic, but equally, the forecast in 2003 by Alan Greenspan that America might have only two decades of domestic supply remaining, and that “we are not apt to return to earlier periods of relative abundance and low prices” had clearly been proved incorrect.
ExxonMobil reentered American unconventional gas exploration and production on a modest scale after prices rose enough to meet the Management Committee’s rigorous return-on-capital guidelines. After Tillerson took charge, he pushed into onshore unconventional gas leasing more aggressively. The environmental issues did not seem to concern him greatly. He conceded that there had been cases where the handling of fluids used to fracture rocks had “not been done as well as it could be,” but the “incidents” constituted a “very, very, very small percentage” in the context of total production. He also declared that the threat to underground drinking water from such drilling was “very low.” Tillerson’s emphatic tone echoed Lee Raymond’s early confidence about the evidence on climate change, but he was unabashed. Within ExxonMobil, there was controversy about shale gas, but it did not involve environmental issues. It concerned the company’s strategies for replacing the amount of oil and gas it pumped and sold annually.
ExxonMobil’s huge investments in liquefied natural gas showed the corporation’s bias toward “manufacturing drilling,” a phrase that referred to producing oil and gas through industrial prowess rather than wildcatter guile. “We had become a very big company that did very big projects,” said a former executive. To win in unconventional gas, could ExxonMobil now adapt to the more classical land scouting, exploration, and entrepreneurial tactics required to outfox sellers and competitors? Some of the prospective challenges in unconventional gas played to ExxonMobil’s strengths in manufacturing—such as the need to develop engineering innovation that would improve the rates of early depletion in unconventional gas fields. But to apply its skills ExxonMobil needed big properties at a reasonable price.
ExxonMobil’s profitability reflected in part the deliberate, return-on-investment-driven decision making of its Management Committee. The upside was rigor and high rates of return on capital invested; the downside was caution and missed opportunity. How much of a flyer was ExxonMobil willing to take to get in on the gas rush, and how fast could the corporation move? Was it really possible for the corporation to replace reserves, capture the sudden emergence of the domestic unconventional gas play, and raise worldwide oil and gas production each year, all while demanding exceptionally high rates of return for every new project investment? In a perfect world, an oil corporation with cash flow like ExxonMobil’s would pour its cash into new oil and gas reserves when commodity prices were low and milk them when prices were high, as Raymond had done with the Mobil merger. But the opportunity emerging in American unconventional gas seemed to be now—when prices were high. Should ExxonMobil compromise its profit standards at least a little to make a strategic shift?
Tim Cejka, a round-cheeked Pittsburgh native who had studied geology and risen through Exxon’s exploration division, ran the company’s upstream operations at the time of the XTO merger talks. Cejka was an oil and gas hunter who had served as an exploration adviser to various ExxonMobil divisions before reaching the Management Committee. He oversaw ExxonMobil’s leasing in search of unconventional gas loads—250,000 acres in the Horn River Basin in British Columbia, 400,000 acres in Hungary, and 750,000 acres in the Lower Saxony Basin in Germany.
Cejka knew that the risks in such exploration ran high and that ExxonMobil’s record was unproven. About the Hungary leases, he told Russell Gold of the Wall Street Journal in July 2009, just as secret talks between ExxonMobil and XTO were about to start, “Depending on how that goes, we’ll either be patting ourselves on the back or walking away.” Tillerson kept the XTO negotiations so secret that even Cejka did not know about them. Cejka kept working to compete with XTO on North American gas leases even as the merger talks ripened.
Tillerson faced a clear choice: Would it be smarter to keep trying to find North American unconventional gas, or would it be better to use ExxonMobil’s massive cash and treasury share positions to buy in?
ExxonMobil brimmed with cash. The corporation carried more than $30 billion in cash on its balance sheet. Plus, by 2009, it held in its “treasury” more than 3.2 billion shares of its own stock, with a market value of more than $220 billion, which it had repurchased over the years from the open market and set aside for possible use in acquisitions. During the great recession and financial panic that followed the collapse of Lehman Brothers in 2008, many American banks, corporations, and their employees worried week by week about whether their businesses might go under. Rex Tillerson’s greatest worry during the dark September of Lehman’s collapse, he later confessed, was whether ExxonMobil’s massive cash deposits were parked in banks that would survive the crisis. As the global financial system teetered, ExxonMobil shuffled its billions to safe havens and waited for the economic storm to pass.
Good morning, and I want to thank all of you for joining us today,” Rex Tillerson said into a speaker set before him. “ExxonMobil and XTO Energy Inc. have announced an all-stock transaction valued at $41 billion. . . .
“This is not a near-term decision, obviously. This is about the next ten to twenty to thirty years of what we believe has now emerged as a very important part of the global resource portfolio. . . . It’s going to be important to meeting energy supply, and that’s the real value creation that we see.”
It was December 14, 2009. The secret talks with Simpson and the senior team at XTO had not leaked. ExxonMobil retained the investment bank J.P. Morgan and the Wall Street law firm of Davis Polk & Wardwell to lead its side of the negotiations; XTO retained Barclays Capital and the longtime mergers law firm Skadden, Arps, Slate, Meagher & Flom. Tillerson initially proposed to pay a modest 15 percent premium over the market price for XTO shares; Simpson said that “would not be acceptable.” Each side prepared valuation ranges based on forecasts of varying natural gas prices in the future, and their merger bankers prepared charts showing prices paid in comparable mergers in the energy industry and in other sectors. Once the deal became public, another acquirer might swoop in to try to overbid ExxonMobil, so in one of their periodic meetings, Tillerson extracted an agreement from Simpson that XTO would pay a breakup fee of $900 million to ExxonMobil if the merger were not completed. In the end, they circled in on a price agreement by which ExxonMobil would pay about 25 percent above XTO’s average stock market price during the month before the announcement. That seemed an uncontroversial compromise—it was the median premium above-market price paid in U.S. corporate transactions greater than $10 billion since January 1, 1998, according to a Barclays analysis. In a tax-free exchange of shares, ExxonMobil effectively paid $51.69 per share for XTO. During the final weeks, they had also wrestled over the employment terms required to retain top XTO executives and engineers, who had grown accustomed to the get-rich stock options doled out by Bob Simpson; they would now have to adjust to the more conservative compensation rules at ExxonMobil. To retain XTO’s top five executives long enough to manage a smooth transition, Tillerson restructured their compensation contracts and wrote rich new consulting agreements that linked performance to millions of dollars in stock and cash over the next several years, including a total of $84 million for Simpson; $48 million for XTO chief executive Keith Hutton; and $37 million for senior executive Vaughn Vennerberg.
Tillerson said he decided to buy XTO in part because ExxonMobil’s corporate planning department forecasted rising natural gas demand. Climate change legislation in Congress was collapsing, and it was not easy to see when it might be revived, but in the medium run, higher carbon prices imposed by regulators—as already had been laid down in Europe and announced in Australia—still seemed very likely. If enacted, they would hurt coal and help natural gas. Mandates in the United States for more renewable energy such as wind and solar power also complemented natural gas investments because gas-fired electric plants could address, with relatively low emissions, the “intermittency” problem posed by renewables. (Intermittency referred to the fact that the wind did not always blow and the sun did not always shine, and so electricity generated from those sources could be erratic. Complementary gas-fired electricity could keep currents flowing on calm, rainy days.) Also, the megawatt-per-hour cost of gas-generated electricity looked favorable when compared with nuclear and unsubsidized renewable sources.
Tillerson insisted that ExxonMobil’s shift toward natural gas through the XTO purchase was not a “deliberate strategy” to favor natural gas over oil. In fact, however, ExxonMobil was nearing the point where it would own, on its books, more natural gas than oil. During the decade leading to 2010, ExxonMobil had replaced, on average, only 95 percent of the oil it pumped out and sold each year, but it had replaced, on average, 158 percent of the gas it extracted and sold. After incorporating XTO’s reserves, 45 percent of ExxonMobil’s reported reserves would be gas. Tillerson claimed that ExxonMobil’s disciplined systems could extract high profits from either oil or gas, but in the industry, gas was often less profitable to produce than oil, for a host of reasons—not least, the low prices plaguing American gas producers after 2008. Conoco forecasted that American gas prices would remain mired at relatively low levels and would not return to the boom prices of 2007 and 2008 anytime soon. Shell’s forecasters were a little more optimistic, but cautious.
A PowerPoint produced by analysts at the Society of Petroleum Evaluation Engineers in Houston noted that ExxonMobil’s purchase of XTO was “based on the assumption that much higher natural gas prices” were coming in the future, and yet, there was “considerable risk in shale plays” because of uncertain geological and commercial factors. “Reserves are overstated,” the presentation continued. “Costs are understated. . . . The gold rush mentality destroys capital and ensures the rule of expediency over science and risk management.”
Uncertainty and skepticism of this kind leached out from geological engineers in the form of unfavorable press reporting, some of which went so far as to ask whether the American shale gas boom was some sort of Ponzi scheme in which early investors bid up faulty assets and lured in big-money suckers like ExxonMobil. Unconventional gas wells behaved unlike other wells, and their decline and production rates could be hard to calculate—much about the drilling patterns in these fields still remained to be discovered. An individual gas well might lose its productivity much more rapidly in the first year of drilling than an oil well would, “but the decline rate on the [total] field is nil, because you continue to drill” in other sections of the field, as Shell’s Simon Henry put it. Yet there was evidence to support the doubters, too. At a minimum, shale gas producers were going to have to communicate with investors more forthrightly than they had done early on about their costs, risks, and profit potential.
Wall Street swiftly made clear that it did not approve of Rex Tillerson’s decision to buy XTO. It looked to analysts and investors that Tillerson had overpaid for Simpson’s company and that ExxonMobil had made risky assumptions about future natural gas prices. Investors hammered ExxonMobil’s share price, relative to its peer group, in a way the corporation had not experienced for many years. Instead of the premium price that ExxonMobil shares had long enjoyed, ExxonMobil stock soon sold at a discount. As analysts at Reuters Breakingviews pointed out, during the seven months after the merger announcement, adjusting for the average 4 percent decline in the share prices of its peers Royal Dutch Shell and Chevron, ExxonMobil shareholders saw $41 billion disappear from the corporation’s total market price—an amount that eerily matched the price Tillerson had paid for XTO.
Had ExxonMobil unwisely bought XTO at or near the top of the boom? It was certainly becoming clear that the peak years of 2007 and 2008 had led to reckless overinvestment in American gas leases by large, debt-burdened companies such as Chesapeake Energy. As that excess investment unwound, there would likely be opportunities for bottom-feeders to sweep up unconventional gas leases at lower prices than were reflected in the price ExxonMobil paid for XTO. That didn’t necessarily mean the merger was a mistake. That would depend on how ExxonMobil exploited XTO’s properties and expertise over time. Yet it was another basis for doubt. John Watson, the chief executive of rival Chevron, slipped the knife in: “We saw valuations for unconventionals that were a bit out of line with our view of value,” he told Wall Street analysts. “So our view wasn’t so much that shale gas wasn’t a good place to be. It was just the valuations at the time [of ExxonMobil’s purchase of XTO] were strong, so we waited.”
Mark Gilman, the oil industry analyst at Benchmark Capital, regarded the XTO purchase as a sign that ExxonMobil’s long-term failure to build upstream reserves—which Gilman laid mainly at Lee Raymond’s door—was at last coming home to roost. Tillerson had little choice but to buy new reserves in a high-price environment because otherwise, he would be presiding over a shrinking corporation, which could reduce ExxonMobil’s share price, which could further limit its ability to buy its way out of its dilemma. The price paid for XTO might mean a reduction in ExxonMobil’s historical rates of return, but that, too, was inevitable and even welcome, in Gilman’s view, if it led to a more successful long-term performance in reserve replacement. On XTO’s purchase price, “I don’t fault Rex,” Gilman said. “It’s what you have to do when you have a weak hand.” He objected, however, to the specific choice of Simpson’s company, which he believed Tillerson had selected too much for “cultural and geographic” reasons, meaning the similarities in Tillerson’s and Simpson’s personal backgrounds, and the Fort Worth location of XTO headquarters. There were other unconventional gas owners—Devon Energy, for example— that might have paid off better.
Dissent bubbled about the XTO deal within important sections of ExxonMobil’s executive ranks and alumni networks. Like many acquisitions in commodity industries, the deal’s payout would depend substantially on future prices, which nobody could forecast with certainty. According to a valuation prepared by Barclays Capital, without accounting for ExxonMobil’s potential to extract extra value from XTO’s reserves through engineering prowess, if natural gas prices remained as low as $5 per thousand cubic feet through 2014 and beyond, XTO might be worth only between $21 and $30 per share, a fraction of what ExxonMobil had paid. At least a few current and former senior executives worried about whether ExxonMobil could produce XTO’s gas profitably, even if gas prices did break out of their doldrums.
Privately, according to some accounts, Tim Cejka argued that if he had been allowed to pay for exploration leases at the high per-unit prices that ExxonMobil had accepted in the price it paid for XTO, he would have more “organic” or ExxonMobil-discovered gas to show for his efforts. Cejka denied in a brief telephone interview that any serious dispute developed over this rate-of-return issue. In any event, ExxonMobil’s record during his time as head of exploration, at least toward the end of his tenure, was poor, whether it was his fault or not. By late 2009, it became apparent that Tim Cejka’s big forays into exploration and land leasing in Europe, at least, would not produce any early bonanzas. ExxonMobil’s early drilling yielded many dry holes. As Tillerson admitted, “Quite frankly, no one has enough information at this point to know” whether European unconventional gas would ever pan out. Overall, the corporation’s struggle in exploration and development showed no signs of turning around—its well-drilling failure rates rose by more than a third during 2007 and 2008. Cejka retired, leaving the company soon after the XTO deal closed.
“The mainstream belief that shale plays have ensured North America an abundant supply of inexpensive natural gas is not supported by facts or results to date,” wrote an analyst at The Oil Drum, an independent online energy journal. “The supply is real but it will come at higher cost and greater risk than is commonly assumed. The arrival of ExxonMobil and other major oil companies on the shale gas scene is positive because they will not follow the manufacturing approach, and will do the necessary science that should make shale plays more commercial. This does not, however, ensure success. ExxonMobil has come late to the domestic shale party. . . . It is also possible that XTO has already drilled the best areas in more mature shale plays, while the potential of newer plays has not yet been established.”
An unsigned memo carrying similar doubts circulated among retired ExxonMobil executives. “It is a really tough job to figure out if ExxonMobil management is doing a good job of enhancing shareholder value, given the inherent limitations of its already huge size and inevitable momentum,” the memo noted. “Sure, you can make comparisons with competitors (which ExxonMobil has tended to lag in recent years) but given that ExxonMobil is fully a third larger than its nearest competitor, one is dealing with apples and oranges to some extent.”
The memo continued, “One has to respect and acknowledge the positive things that ExxonMobil does on a daily basis, such as:
On the other hand, “one has to ask, do the shareholders pay Rex Tillerson $29 million a year to be a caretaker? . . . Lee Raymond, former ExxonMobil C.E.O., notwithstanding his dour personality and penchant for trying to control every detail of a huge company’s operations . . . at least knew that when oil prices were at nine dollars a barrel, it was time to buy a company with good upstream assets, which he did when he bought Mobil corporation. Rex Tillerson, on the other hand, with less exquisite timing, agreed to pay . . . an expensive 25 percent over market premium [for XTO]. Had the deal been struck earlier, at the end of March 2009, the purchase price, with the same market premium percentage, would have been a very palatable $38.23 a share.”
The memo concluded: “The stock’s performance in recent years accurately reflects their less than mediocre business capabilities. To call them incompetent may be to go too far, but it is close . . . mighty close. . . . Given the peaceful slumber this Board of Directors has enjoyed for the last twenty years, one has to ask a closing question: Why would anyone want to be an ExxonMobil shareholder?”
Was this criticism of Rex Tillerson’s leadership fair? During 2010, Tillerson completed his fifth year as chief executive. That was long enough to begin to judge his record. The numbers showed a mixed but far from disastrous performance. Many of the critical questions about his decision making post-Raymond would require a decade or more to measure. The fairest grade was probably “incomplete.” Whether the price Tillerson paid for XTO was too high or not, his essential theory of the purchase was the same as Lee Raymond’s theory about the enormously successful Mobil merger: Exxon would exceed Wall Street expectations over time by extracting value from the acquired assets that no other company knew how to extract. Raymond had paid a 15 percent premium for Mobil’s shares at a time when oil prices were so low that oil doomsayers ruled, just as doomsayers about shale gas were prominent in late 2010. Perhaps the XTO properties would yet perform under Exxon’s management as the Mobil properties had.
ExxonMobil earned $30.5 billion in profits during 2010, short of the Tillerson-overseen record of 2008, but stunning nonetheless. The corporation had earned more profit than any publicly traded corporation in America in each year of Tillerson’s reign so far. In a sign of the times, ExxonMobil jockeyed occasionally with PetroChina, the state-owned oil company, for the status of the world’s largest corporation by stock market value, but ExxonMobil was valued highest more often than not. Much of the corporation’s top-line profit reflected soaring commodity prices over which it had little control. Yet ExxonMobil also remained at the top of its industry class, judging by return on capital employed, or R.O.C.E., the metric by which the corporation preferred to compare itself with its closest American peers, Chevron and Conoco, and the most closely comparable overseas competitors, Royal Dutch Shell and BP. The corporation’s R.O.C.E. was 22 percent during 2010, about where it was after the Mobil merger, and higher than the next-best performer, Chevron, by 5 percent. In all, the numbers showed Tillerson had not allowed financial, investment, or operating discipline to slip during his five years in charge.
ExxonMobil’s lead over one competitor, Chevron, had narrowed, however, to the point where, by market and financial performance measurements, the two companies were about tied. By 2010, ExxonMobil’s R.O.C.E. topped Chevron’s largely because Exxon’s huge chemical and downstream operations performed twice as well as Chevron’s did. Certainly Tillerson and his team deserved credit for maintaining the high margins Raymond had delivered in these notoriously difficult businesses. Yet the downstream business looked increasingly uneconomic in the long run because governments in emerging economies were installing new refineries and petrochemical complexes, backed by state subsidies, for reasons other than profit making—to ensure energy security, for example, or in the case of Saudi Arabia, to create better jobs and promote scientific education. This glut of subsidized capacity would challenge ExxonMobil in the long run. Yet in the oil and gas upstream, where the great majority of profits earned by fully integrated oil companies resided, and where the greatest future profit opportunities lay, Chevron had now about caught up with ExxonMobil; Chevron’s upstream R.O.C.E. in 2010 was a robust 23 percent. The average barrel of oil or equivalent amount of gas produced by Chevron was more profitable than a barrel produced by Exxon, according to Chevron’s calculations. Moreover, using other metrics often highlighted by Wall Street analysts—total stockholder return and cash flow per share, for example—Chevron now substantially outperformed ExxonMobil. Chevron’s shareholders did better than ExxonMobil’s during 2010. (The rest of the peer group lagged.) Tillerson and his colleagues might rationalize their slippage by blaming a short-term herd mentality on Wall Street that turned hostile to ExxonMobil’s shares because of the XTO deal, and indeed the corporation’s shares did bounce back after the initial XTO hangover, but the numbers spoke clearly enough of a tightening competition.
Tillerson deserved credit for accomplishments not visible on ExxonMobil’s balance sheet. His Hamlet-like performance on carbon taxation and climate change did him little credit, but he had led a determined drive to reduce the greenhouse gases emitted by the corporation’s own operations and had delivered real improvements. On his watch, ExxonMobil had reduced gas flaring—the wasteful burning of natural gas produced during oil extraction, which contributed to global warming—by more than half. In Nigeria and other countries with weak governments, the corporation had missed announced targets for the elimination of flaring; it blamed the failure of its partner regimes. Still, between the progress it did make and greater energy efficiency, ExxonMobil had reduced its total direct greenhouse gas emissions by eleven million metric tons, a significant achievement.
Tillerson had also taken steps to address ExxonMobil’s fudging about whether the corporation was finding enough oil and gas each year to replace the amount it pumped and sold. Under Raymond and again during Tillerson’s first years, ExxonMobil had declared publicly through press releases and at Wall Street analyst presentations that it had found enough new “proved reserves” of oil and gas to replace each year’s production and sales. But in making this claim, the corporation ignored the accounting methods required by the Securities and Exchange Commission. In some years, ignoring the S.E.C. reporting rules allowed the corporation to sidestep embarrassment. In 2008, using S.E.C. rules, and based on the corporation’s limited public disclosures, ExxonMobil’s reserve replacement would have been below 75 percent, an alarming rate. But instead of accounting forthrightly for this failure, the corporation issued a press release that quoted Tillerson boasting, “ExxonMobil . . . has replaced an average of 110 percent of production over the last ten years.” That was a defensible claim only if one preferred ExxonMobil’s self-regulation to federal rules.
On December 31, 2008, the outgoing Republican-led Securities and Exchange Commission revised its reserve reporting rules to allow the counting of oil sands, shale gas, and other previously banned categories of reserves. The commission also changed other reporting rules that Raymond and Tillerson had found objectionable. The changes, achieved by oil industry lobbying, liberated ExxonMobil from spinning. The corporation ceased double counting: From now on, it would report only numbers authorized by the S.E.C. It did not retract its previous claims to Wall Street and the public, however, noting only that its long reserve replacement “streak” was based on some years when the S.E.C. rules were not used.
The cleaner 2010 reserve replacement numbers looked good on the surface, but were concerning underneath. When the XTO gas properties were incorporated into ExxonMobil’s resource base, the corporation reported that it had replaced an extraordinarily strong 209 percent of the oil and gas it produced that year. Yet XTO’s purchased properties accounted for four fifths of the corporation’s new reserves. Without XTO, according to Barclays, ExxonMobil would have replaced only 45 percent of its 2010 oil and gas production—a performance so abysmal that if it continued for a prolonged period, ExxonMobil would be on a path to liquidation. By comparison, Conoco’s “organic” or internally generated reserve replacement rate in 2010 was 138 percent. Shell’s was 133 percent. Of course, ExxonMobil had always been better at buying other people’s oil than at finding it. Arguably, from a shareholder’s perspective, it made no difference whether the oil and gas ExxonMobil pumped and sold so profitably each year had been discovered because of geological genius or bought with piles of cash generated by financial and operating acumen. If Tillerson could maintain the financial performance that made the XTO acquisition possible, he might continue to buy what he could not find. But at a minimum, the numbers made clear how important the XTO purchase would be to Tillerson’s legacy on Wall Street and in the oil industry: If the deal underperformed, the corporation would be hard-pressed to maintain its superiority.
Tillerson promised when he took charge to increase ExxonMobil’s annual production of oil and gas to 5 million barrels per day by 2009. The actual number was 3.9 million—more than 20 percent short. Tillerson promised again that ExxonMobil’s production would grow steadily until 2014, but the trailing numbers showed the corporation in a long, flat pattern—its annual production in 2001, after the Mobil merger closed, was 4.3 million barrels per day. Tillerson had not cracked the challenge of reserve replacement that had also daunted Raymond.
Before Tillerson, dissent and hard feeling inside ExxonMobil often traced to Lee Raymond’s blunt manner. Under Tillerson, ExxonMobil might be a kinder, gentler place to work, yet some of the old guard feared a loss of the toughness and discipline they had valued in Raymond. Retired executives of the Raymond era took one another out to dinner in Houston, Dallas, and elsewhere and talked about whether Tillerson had enough of the guts and firmness that Raymond had mustered to drive ExxonMobil’s financial performance.
Tillerson’s remarks to Wall Street analysts increasingly made it clear that he was aware of these dissenters. It required the equivalent of Kremlinology to perceive Tillerson’s public replies to these dissenting factions, but his rejoinders were detectable. At analyst meetings, Tillerson started to use 2006, the year he took the top job, as the basis for reporting about—and boasting about—ExxonMobil’s financial performance. He ignored the Raymond years, and he went so far as to explain how his leadership had extracted profitability from one tough project, the Kearl oil sands play in Canada, because he had made flexible analytical judgments about projected rates of return that would not have been taken “five, six, eight years ago,” when Raymond was in charge.
On April 19, 2010, Tillerson arrived at the Hilton Americas-Houston hotel and convention center to receive the Jesse H. and Mary Gibbs Jones Award for contribution to the international life of Houston. It was a typical appointment in an oil industry chief executive’s diary—a short hop on a corporate jet, a prepared speech before a sympathetic audience, a lunch of Cornish game hen and vegetables, and a roundtable talk with students from the University of Houston, Rice University, and the University of St. Thomas.
As the students snapped pictures of him on their cell phones, Tillerson was relaxed, giddy, and self-deprecating about his looks. One student asked if it was true that he and his wife rode motorcycles for fun.
“Pass,” Tillerson said, smiling.
Another asked about solar and wind power.
“ExxonMobil is not really against renewables,” Tillerson replied mirthfully. “We sell a lot of lubricant oil to the windmill operators. . . . The more windmills are built, the more oil we sell.”
To the larger audience of about 750 Houstonians seated at banquet tables, Tillerson read out a philosophical defense of capitalist private enterprise and an explanation of ExxonMobil’s mission in the world. Job losses, bank layoffs, and housing foreclosures had swept the American heartland since 2008. Tillerson’s words reflected his Boy Scout optimism and Christian faith.
“The ‘service we render’ and the ongoing investments we make from our earnings are critical,” Tillerson said. “Simply put, delivering energy in a safe, secure and responsible manner improves the lives and opportunities of billions of people the world over. . . .
“When government and industry respect the rightful role of the other—and trust each other to faithfully fulfill their respective roles—progress is possible. . . . Deepening understanding and building trust between the public and private sectors is more important than ever. . . .
“Service . . . responsible . . . respect . . . trust . . . faithfully . . .”
He seemed to wish for ExxonMobil to be considered as a kind of public trust. He used the words “trust” or “mistrust” five times.
“Often the policy changes that are most damaging to entrepreneurs and innovation flow from a fundamental mistrust in the private sector,” Tillerson declared. He concluded, “Leaders in the private and public sector both have a responsibility to challenge the basis and perceptions for the mistrust.”
He took in applause, shook more hands, and departed the Hilton in the midafternoon.
The next morning, April 20, 2010, at 8:52 a.m., on an offshore oil rig called the Deepwater Horizon in the Gulf of Mexico, a drilling engineer working for BP, Brian Morel, e-mailed his office in Houston, not far from where Tillerson had delivered his speech about trust between government and business.
“Just wanted to let everyone know the cement job went well,” Morel wrote.
David Sims, a BP drilling operations manager, e-mailed Morel and his colleagues at 10:14 a.m.: “Great job guys!”