Anadarko Could Slip Further On High-Profile Mess

| About: Anadarko Petroleum (APC)

The lawsuit brought against Kerr-McGee by the United States Justice Department on behalf of the Environmental Protection Agency over legacy clean-up costs related to Anadarko's acquisition of Kerr-McGee's oil and gas holdings in 2006, began on May 15 with the dropping of a bombshell. In its opening statements, the Justice Department accused Anadarko of deliberately concealing material knowledge about the clean-up problems through the spin-offs of Kerr-McGee's business.

The Justice Department is seeking $25 billion in damages from Kerr-McGee, and Tronox, which acquired Kerr-McGee's chemicals business when Anadarko acquired assets from the now-defunct company. Matters are complicated by the fact that Tronox is now bankrupt. As the only solvent company involved in the litigation, Anadarko faces the potential of shouldering substantially all of the $25 billion burden if the Justice Department can prove that Anadarko possessed knowledge of the problems and intentionally conveyed Kerr-McGee's assets in a way that would obscure liability.

Anadarko legal expert Thomas Lotterman gave Anadarko's opening statement in the case, indicating that the Justice Department was attempting to recoup the costs of clean-up through manipulation of the facts by making it seem as though normal business activities were attempts to defraud. An expert in environmental and toxic tort law, Lotterman has experience defending against high-profile federal enforcement actions. Fortunately for Lotterman and Anadarko, the judge in the case ruled that he would not hear testimony related to medical damages from those living in the vicinity of Kerr-McGee's alleged dump sites. This emotional testimony would damage Anadarko's public image, and possibly its case.

A week of good news for Anadarko's exploration activities

Anadarko enjoyed a spate of positive news releases on its exploration activities across the world this week, with multiple projects ramping up.

On May 15, Anadarko announced that it added substantially to its recovery possibilities off the shores of Mozambique, with 7 to 20 tcf of natural gas uncovered only ten miles offshore in the Rovuma Basin. According to Anadarko Senior Vice President, Worldwide Exploration Bob Daniels, Anadarko is "very excited about this new discovery and…look[s] forward to continuing an active exploration program in the highly prospective northern and southern portions of the Offshore Area 1". The new discovery could almost double previous estimates of Offshore Area 1's proven reserves.

On May 9, Anadarko's plan to construct 1,500 well pads that could eventually support over 3,500 natural gas wells in Utah was approved by the Obama administration. It won approval through its proposal to include strenuous environmental safeguards and an agreement to delay drilling in wilderness areas. Individual drill permits will still need to be approved, although the project has the support of the Interior Department's Bureau of Land Management and certain Utah environmental activist groups.

Getting to know the new CEO

On May 15, R.A. (NYSE:AL) Walker officially began his tenure as President and CEO of Anadarko, taking over from retiring James Hackett. Walker is not new to Anadarko, and has extensive experience in the banking and energy sectors, which I think will serve him well in his new position.

In an April interview, Walker indicated that the "values-based" approach Anadarko inaugurated under Hackett will continue under his leadership. He also committed to taking advantage of future opportunities to the benefit of shareholders, "whether through select monetizations or joint-ventures".

On May 15, Walker made some of his first public comments as CEO, which included potential interest in acquiring struggling Chesapeake Energy's (NYSE:CHK) assets. As Walker said, "Chesapeake has a lot of attractive assets, including the Permian…we will take a look at those".

I believe that Chesapeake's Permian assets are underdeveloped but potentially resource rich. Chesapeake has already rejected an offer on the assets from competitor Occidental Petroleum (NYSE:OXY). It is rumored that Oxy offered around $3.5 billion for the acquisition, but Chesapeake is holding out for $5 billion. Given Chesapeake's debt woes and the rapidly falling confidence in its CEO, Aubrey McClendon, I sincerely doubt Chesapeake will get $5 billion as its competitors know that if they wait, the asking price is bound to come down. I do not believe that Chesapeake will have a choice in the matter if the summer passes without significant asset sales from its holdings. Chesapeake is down 13% in the last five days alone, from $16.41 on May 14 to $14.36 at the market's close on May 18.

Outlook: Long-term potential overshadowed by Kerr-McGee case

Shares of Anadarko are tracking down since the opening statements of the Kerr-McGee suit on May 15, when they opened at $66.86. Shares are now changing hands around $62, a 7% decline even despite the positive news on its exploration activities. At $62, Anadarko has a price to book of 1.5 and a forward price to earnings of 11.8. This is significantly cheaper than at the beginning of this month, when Anadarko was trading at $73 with a price to book of 1.8 and a forward price to earnings of 14.0.

Competitor Chesapeake is trading around $14, with a price to book of 0.7 and a forward price to earnings of 7.7. Its recent trading volumes are significantly above average volume, but given the company's multiple leadership and balance sheet issues I do not think the share price is suffering from overselling; instead it more likely represents understandable concern over the company's future.

By comparison, Oxy is trading around $80 with a price to book of 1.7 and a forward price to earnings of 8.6, while Devon (NYSE:DVN) is trading around $61 with an attractive price to book of 1.1 and equally reasonable forward price to earnings of 8.9. Anadarko's perennial rival Apache (NYSE:APA) has also taken a tumble this week, currently trading around $81 with a price to book of 1.1 and a forward price to earnings of 5.9, beating out the rest of the field on value.

The potential $25-billion price tag on the ongoing Kerr-McGee litigation is a source of worry, and rightly so, considering Anadarko's market cap is $31 billion. However, in my view, it is unlikely that even if the Justice Department argues its case successfully, such a massive fine would be assessed.

There are a few points working in Anadarko's favor, not least of which the fact that Kerr-McGee ceased to exist in the spinoff and was further dissolved in Tronox's bankruptcy following the acquisition. Furthermore, it is possible Anadarko was not fully aware of the problems, meaning its obligations should be wiped clean according to legal theory. Either way, shareholders are sure to be watching the case closely.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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