GS and MS Dominion Buyout: Liar's Poker

"...and Alexander surveyed the length and breadth of his dominion and he wept, for he had no more lands to conquer."

We talked last night about poker and bluffers and, now that the hands are heating up and the pot is at risk, we are starting to see who the real players are and pick up a few of their tells.

I've been telling you Goldman Sachs Group Inc. (GS) is up to their eyeballs in oil manipulation for quite some time, but now we see my # 2 suspect, Morgan Stanley (MS), is in fact their actual partner as they are "quietly collaborating on a massive private-equity play for the oil-and-gas assets of utility company Dominion Resources Inc." This is a strange use of the word "quietly" (the cover of the WSJ) that I am unfamiliar with...

Dominion Resources Inc. (D) has a total market cap of $28B. And since they have a nice, steady energy business, they are looking to get rid of their volatile E&P segment.

"Dominion Exploration and Production segment explores and produces gas and oil in the U.S., the Gulf of Mexico, and western Canada. As of December 31, 2005, it had total proved gas reserves of 4,962 billion cubic feet and total proved oil reserves of 217,698 thousands of barrels."

Nothing says lovin' like massively overpaying for energy assets does it? What GS and MS love is finding some way to pretend the energy market is still exciting and viable as an investment vehicle. They love (pumping up the industry) it so much they are going to pay $15B for a smallish division of a company that earned, IN TOTAL, $1.6B last year.

While it is hard to get a handle on the exact portion of profits from the E&P division, the 10Q clearly shows Q3 revenues of $475M, just 12% of Dominion's quarterly revenues. Even if we were to assume that the E&P operation was running at a 100% profit margin, $15B would represent a paid P/E of 8. Should they actually have costs, we can easily see how GS/MS are paying 16-32 times earnings for this valuable resource!

This is an interesting strategy, as you can buy the whole of Dominion for a forward P/E of 14. Why would the brilliant financial minds of GS/MS want to overpay for this little Gas producer (the oil is insubstantial)? Because they (funds in general) already own hundreds of billions of dollars of other energy operations that are dropping like rocks! Paying top dollar for Dominion (or, better yet, pretending to want to pay top dollar) makes all their other mistakes seem in-line for another few months...

This is the beginning of the end, when the former enemies have to band together and circle the wagons to prop up the value of their holdings. It won't be long before one of them loses a wheel and the hostile forces swarm in and pick them apart.

What kind of asset is Dominion's E&P going to be for the new GS/MS partnership? Well according to the 10Q, in Q3 alone it caused:

• A $155 million decrease (in revenue) as a result of the impact of netting sales and purchases of oil and gas under buy/sell arrangements that were entered into or modified by E&P operations subsequent to April 1, 2006, in accordance with EITF 04-13
• A $121 million decrease as a result of the impact of netting sales and purchases of oil under buy/sell arrangements associated with the implementation of EITF 04-13
• A $28 million decrease in hedge ineffectiveness expense associated with our E&P operations, primarily due to a decrease in the fair value differential between the delivery location and commodity specifications of derivative contracts held by us as compared to our forecasted gas and oil sales and the increased use of basis swaps
• A $54 million decrease in revenue from sales of gas purchased by E&P operations, as the result of lower volumes and the impact of netting sales and purchases of gas under buy/sell arrangements associated with the implementation of EITF 04-13
• A $64 million decrease related to E&P operations, as the result of lower volumes and the impact of netting sales and purchases of gas under buy/sell arrangements associated with the implementation of EITF 04-13
• A $95 million increase attributable to higher production handling, transportation and operating costs related to E&P operations
• An $18 million increase in insurance costs for E&P operations due to higher insurance premiums incurred following the 2005 hurricanes

Wow! Where can I get me some of that?

It wasn't all bad news: oil was still over $60 in Q3, but I can't wait for Jan. 31 when we get a fresh look at what GS/MS are salivating over... Dominion is an ideal choice to pursue as they are regulated and any kind of deal could drag on for quite a while and, ultimately, fall apart due to "regulatory issues."

There's nothing better in poker than looking across the table at a big player who puts his cards down and pushes his chips all in when you know he's bluffing!

Read all of Phil Davis's articles on Seeking Alpha

Comments

[Monica Verma]

Hi, While I understand your frustration at how comments made by GS and MS tend to sway the commodities market, I'm not sure I understand your valuation methodology in this case. P/E ratios tend to have less value than the NPV value of the reserves, right? So, back of the envelope, if we take 5000Bcf in proved reserves times an acquisition gas price of $3/Mcf, higher than the real players just b/c we both agree that they want to justify exisiting valuations on their books by having a market transaction, we get a proved reserve value of ~$15B. Add in the value of the Oil reserves (also using a conservative long-term price) and apply a 10% discount NPV methodology and you've got them still paying a slight premium but not as gross as it might seem, especially if there are other assets thrown into the mix as well.

[Saul Sterman]

Monica,

You took the words right out of my mouth. Phil’s take on this is totally incorrect, but I forgive him because this is not his field of expertise. You have to admit though that Phil’s writing style is very entertaining!

When COP acquired BR, I was convinced that they had overpaid for the asset. Time will tell if my calculations were correct, in the interim it is beginning to look like they knew what they were doing. On a one to one comparison, the Dominion deal looks slightly better.

[Philip Davis]

You are both correct! But only if you buy into the arguement that nat gas is worth $5/Mcf as the rate of extraction and increasing costs over time push break even back much further than you think.

It's kind of the point I was making, everything seems like a bargain if you triple the price of everything else but what if gas is only worth $3/mcf and oil is only worth $40 a barrel? Will they extract and deliver it out of the goodness of their hearts?

The fact is this is a segment that is dragging Dominion's earnings DOWN and they are trying to get while the getting is good. The last thing GS/MS want is for KKR (the other bidder) to purchase an E&P asset for a discount to the "market" pricing because it automatically calls into question their current asset base as well as possibly putting a crimp into deals they may have in progress.

Saul, I will certainly credit you with being correct as to the amazing resilaincy of XOM, it does seem bulletproof - so I took the '08 puts!

- Phil

[Philip Adams]

MS bought a big chunk of producing assets from some company a few years ago, then sold three years of production in the futures market and the residual drilling rights and assets to Apache. It was a good deal for both MS and APA. I suspect a similar deal here. GS and MS will make money without exposing themselves to the vagaries of the oil and gas market.

[Monica Verma]

couldn't agree more on that one. VPPs all the way- monetize that future cash flow! Or they could set up their own and just IPO those.

And yes, definitely a fun-to-read writing style!

[jack lanza]

Dominion was stuck with bad hedges for 2006. They received half the market price for oil and natural gas. If nat gas averages $7.50 for 2009, D has a forward P/E of about 8.