Tom Brown Inc.: surviving in the oil and gas industry.

Jackson William T. ; Jackson, Mary Jo. ; Johnson, Larry A. 等

CASE DESCRIPTION

This case was developed through the use of secondary research material. The case has a difficulty level of five and is appropriate to be analyzed and discussed by advanced undergraduate and graduate students in a strategic management class.

The case allows the instructor the flexibility of concentrating on one strategic issue, or as a means of examining the entire strategic management process. The major focus within the strategic analysis as well as excellent stand alone modules is in the area of legal/political influence, economic, and as a means of discussing owner succession.

The instructor should allow approximately one class period for each element addressed. Using a cooperative learning method, student groups should require about two hours of outside research on each element researched. The case also provides an impetus to explore a critical industry in our world economy, yet one that has received minimal attention in most course coverage.

CASE SYNOPSIS

This case is a library, popular press and internet case which examines Tom Brown Inc. The review of annual reports, trade journals, government documents and proposed and enacted regulations must be accomplished carefully. While most students have a general understanding of the oil and gas industry, few have the current knowledge to compare this industry against more traditional production operations. A review of these resources should lead students in determining the future of the company and the current CEO, Tom Brown.

INTRODUCTION

Tom Brown sat at his desk staring out the window into the west Texas sky as a typical dust storm blew through the area. Brown could not begin to count the number of these storms he had endured over his near fifty years in the oil business in the Permian Basin. But, he really wasn't thinking too much about the weather right then, he was focused more on other storms that he had experienced in this industry, and how the horizon for the industry was as dark and uncertain as the Midland skyline had become.

With the industry experiencing a drastic slow down in prices what would the future hold for Tom Brown and his company. Was fifty years enough to ride the highs and lows of this ever changing industry, or was there one more wave to ride?

COMPANY HISTORY

"Tom Brown, Inc. is an independent energy company engaged in the exploration for, and the development, acquisition, production, and marketing of natural gas, natural gas liquids, and crude oil primarily in the gas-prone basins of the North American Rocky Mountains and Texas."

Tom Brown Inc.'s (TBI) beginnings date back to 1955 when Tom Brown and Droyle Scarber partnered to purchase a trailer mounted drilling rig under the name Brown and Scarber Drilling. After one year of operation, Tom Brown bought out Scarber's interest in the company. In 1959, Brown offered half the company, assets and debt to his rig supervisor, Joe Roper, for $2500. This established a partnership that grew to 12 rigs in the next ten years. In 1969, the partnership purchased an established corporation, the Gold Metal Consolidated Company. Under the corporate umbrella, the name was changed to Tom Brown Drilling Co., Inc. and it became one of the first publicly traded oil companies of the Permian Basin of West Texas.

The 1970's marked an important era in the company's history. They increased diversification and investments in oil and gas properties ultimately dropping the "Drilling" from their name and becoming Tom Brown, Inc. in 1971. A partnership with Adobe Oil & Gas developed significant oil reserves and gave the company a valuable cash stream used to finance additional gas exploration. A major oil find was made in 1975 when TBI discovered the Muddy Ridge Field. This field, part of the Wind River Basin of Wyoming, ultimately grew into the companies primary reserve base.

In 1979, TBI formed Oncor, a wholly owned subsidiary specializing in down-hole drilling tools. Oncor was profitable through 1981, but the beginning of the oil bust the following year led to a net loss of $25 million. This loss, along with increasing expenses due to rig purchases and continued oil and gas exploration, contributed to the $200 million debt TBI recorded in 1982. The company was forced to sell Oncor and interests in various oil fields during the next three years as they settled their debt.

Their willingness to honor their financial commitments earned TBI the reputation as a trustworthy company in the Permian Basin. But it also impacted the degree of risk the company would be willing to assume in the future. Fearful of debt exposure in the cyclical oil and gas industry, the company subsequently operated with minimal leverage and followed an unwritten policy to finance operations and acquisitions with the issuance of equity.

During this time, TBI also underwent a corporate restructuring. The drilling operations were spun off from the exploration and production activities and began operation as the "Tom Brown Drilling Company". The drilling company purchased Sharp Drilling Company in 1986, forming TMBR/Sharp Drilling, a nationally recognized leader in the drilling business. Joe Roper served as President and CEO of TMBR/Sharp Drilling until his death in 2001. At that time, Tom Brown replaced him as CEO.

The exploration and production activities remained under the "Tom Brown Inc." organization. Tom Brown Served as President until 1987, Chairman of the Board from 1987 to 1995, and as Director from 1995 until the present. Tom Brown Inc changed its state of incorporation from Nevada to Delaware in 1987. At this time, declining stock prices due to the industry bust in the 1980's forced the company to offer a 20 - 1 stock split. It was not until 1990 that the company reported positive operating revenues.

The vast majority of TBI's growth that relates to its current operations has taken place over the past decade. To understand and appreciate the magnitude of this growth and the changes that have taken place, a year-by-year breakdown of operations and activities is given below.

As is evident from the table above, TBI engaged in considerable exploration and investment in land and other assets during the 1990's and early 2000's. Prices began to fall drastically during the end of 2002 and early 2003. Even during these times, the company's financial standing remained strong.

INDUSTRY ENVIRONMENT

Natural gas is one of the most versatile energy sources in the world. It is a clean burning, safe, and useful fossil fuel extracted from within the earth's crust to help power the world's economy. This gaseous fossil fuel is composed of a combustible mixture of hydrocarbons--primarily methane, but also to a lesser extent ethane, propane, butane, pentane, and variable amounts of inert gases including CO2 and nitrogen.

Once it is extracted from the ground, natural gas is processed such that the inert gases are removed and the pure forms of methane, ethane, propane, butane and pentane are separated from one another. Each of these gases, in their pure forms, has their own different applications. For example, methane is the primary component used to heat houses as well as to generate electricity at gas-fired power plants. The heavier components of natural gas (i.e. propane) are used in specialty applications including barbeques, industrial engines, and specialty home furnaces.

The production of natural gas has occurred for centuries dating back as far as 500 B.C. when the Chinese first built a small pipeline out of bamboo shoots to transport natural gas seeping from the surface to a seawater distillery. The first well in the U.S. was drilled in 1821. However, it wasn't until 1859 that commercialization of this gas was developed. Colonel Edward Drake drilled this famous Pennsylvania well that year and piped the gas 5 1/2 miles to the city of Titusville, where it was used to light houses and streets.

For the most part, unfortunately, many of the natural gas discoveries made while drilling for oil wells in the 1800's and early 1900's were capped (flared). In those days, very few pipelines existed to transport this energy source to areas where it could be used. As a result, this gas was essentially worthless to oil producers.

It wasn't until the 1920's that significant effort was put into developing the natural gas pipeline infrastructure. Welding technologies resulting after World War II added to the ability to advance the construction of reliable pipelines even more. In addition, the advent of better compressors allowed gas to be transferred over long distances through these pipelines. During the 1960's, thousands of miles of pipeline were laid. These lines created the backbone of the natural gas infrastructure that our country enjoys today.

The history of the natural gas industry is filled with market regulation. Possessing significant competitive advantage and the ability to monopolize markets, capital intensive pipelines were recognized early on as a threat to vital public interests. In fact, local governments regulated the sale of natural gas as early as the mid-1800's. Sales eventually grew out of local jurisdiction districts and into the state arenas. As such, states began regulating natural gas sales in 1907. As pipelines grew to incorporate interstate dealings, it was only a matter of time before the federal government took complete control.

In 1938, the Natural Gas Act was passed, which gave the Federal Power Commission (FPC) jurisdiction to regulate interstate natural gas sales as well as new pipeline construction. Even though regulating the sales price that pipelines could charge consumers, the NGA did not regulate the price in which gas producers could sell their commodity to pipelines. But this changed in 1954 with the passing of the Phillips Act.

The Phillips Act called for a maximum price on what producers could charge based on the producing company's cost to extract the gas. Due to the paperwork and manpower nightmares that this created, the FPC decided to institute regional price ceilings in 1960. Unfortunately, these price ceilings were extremely low and were not increased between 1960 and 1974. As such, producers stopped developing natural gas reserves, which instigated the natural gas shortage in the 1970's.

In an attempt to change the system, the Natural Gas Policy Act of 1978 was passed in an attempt to deregulate the industry and to bring supply and demand into equilibrium. Around this time, pipeline companies were also allowed to change their business scope and charge a "transportation fee" for use of their pipelines, instead of purchasing gas from the producer and selling it to the customer. This allowed the consumer and producer to come into better contact with one another and negotiate delivery contracts on a direct and personal level.

Deregulation was completed with the passing of the Natural Gas Wellhead Decontrol Act of 1989. This act called for all remaining areas of regulation to be freed from constraints and subjected to market forces in their respective regions, effective January 1, 1993. Therefore, all natural gas producers operating in today's industry are subject to no government regulation, rather to the forces of supply and demand that exist in their respective areas of operation.

While the industry is relatively free of government intervention today, it is difficult to predict forthcoming legislation and changes in governmental regulations that may impact the industry. Both the President and Congress see the need for a change in U.S. energy policy. The U.S.'s dependence on foreign oil has adverse economic and geopolitical consequences. Government and industry view natural gas as an alternative to fuel oil and a clean fuel for the generation of electricity.

The natural gas production industry sells a relatively undifferentiated commodity. There is no proprietary product difference or brand identity associated with natural gas. Depending upon the nature of the project, capital requirements associated with domestic natural gas production are also fairly low. Because single-person independent exploration companies can purchase most undeveloped acres for around $50/acre, drill a single well for $300,000 to $5,000,000 (depending on the area and targeted depth), prove the reserves and then sell those reserves to other parties, they represent real and legitimate forms of competition.

THE ENVIRONMENT

Throughout the history of the oil and natural gas industry, the market value of the commodity has been the single most important determinant of a firm's profitability and market capitalization. Stock prices generally follow very closely natural gas wellhead prices. Although the correlation is not exact, evidence from most companies within the industry point to the fact that spikes in gas prices do correspond to general increases in most stock valuation.

The correlation is exemplified starting in 1998 when Wall Street suddenly realized that low-cost natural gas reserves were no longer being discovered in North America and that demand for natural gas is continually increasing. The shortage of natural gas in 2000 sent prices, and thus profits for companies producing natural gas, skyward. Realizing natural gas's increased value as a limited resource; the stock market deservingly increased most companies' market capitalization value.

There is no dispute that natural gas prices impact the performance of companies producing this commodity--that relationship would be apparent to any onlooker. However, the real economic analysis revolves around what factors influence the price of natural gas.

Long-term commodity prices are subject to basic supply and demand economic principles. Therefore, when determining industry attractiveness, it is important to analyze both the production and consumption characteristics affecting the industry in order to estimate long-term commodity prices. As the North American economy grows, there is a direct increase in the demand for natural gas, either in the form of raw methane to fire industrial engines and to heat homes or in the form of electricity needed to build new products. In fact, according to the Department of Energy, consumption of natural gas in the U.S. is expected to increase from 24.6 TCF (trillion cubic feet) in 2005 to 32 TCF in 2020, representing an annual growth rate of 1.8 % per year.

Natural gas reserves are plentiful when looking at worldwide volumes. It was estimated by the Oil and Gas Journal that in 2001 the worldwide gas reserves equaled 5,288 trillion cubic feet of gas (TCF). During the same year, worldwide consumption totaled 90.27 TCF. This equals a reserve life of 58.6 years. With new discoveries in the Middle East, Nigeria, and the Former Soviet Republic (FSU), this figure is expected to grow. However, these gas reserves are concentrated mainly in the FSU and Middle East countries. Of the 5,288 TCF of gas reserves, North America represents only 5.3% of the total (281 TCF).

The current problem with the world's supply of natural gas is the mismatch between reserves and consumption. Although North America only accounts for 5.3% of the reserve base across the world, it currently consumes 29.8% of the world's produced gas. Whereas the world has a reserve life in 2001 of 58.6 years, North America has a reserve life of only 10.0 years. (Reserve Life is a measure of the total developed reserves compared to current production rates-assuming an absence of future drilling. Therefore, reserve life = reserve base/current production rate).

Unlike oil, natural gas is not easily transferred across long distances. Naturally, gas occupies more space than oil in its natural form and cannot be economically shipped by tanker in conventional means. Currently pipelines are the most economical form of transporting natural gas, but this method is not economically feasible for trans-oceanic transport.

The only means of transporting natural gas from the oil-rich regions to the U.S. is via Liquefied Natural Gas (LNG) tankers. LNG is created via a freezing and condensing process, whereas the impurities of the gas and the majority of heavy hydrocarbons are removed to obtain a near 100% methane mixture. The methane is then condensed by freezing it to minus 280 degrees Fahrenheit. Then the LNG would be shipped via the special tankers to regasification facilities to convert back to gaseous methane. This entire process is not typically economically feasible. Currently there are only four such plants in the U.S. These plants exist in Everett MA, Lake Charles LA, Elba Island GA and Cove Point MA.

The current plan for meeting U.S. demand will come from three sources. First, Canadian exports to the U.S. are expected to increase drastically from 3.69 TCF in 2001 to 5.08 TCF in 2020. Canada relies primarily on hydroelectric plants for its energy needs and has an over abundance of supply. Secondly, actual production in the U.S. is expected to increase through 2012. Finally, unconventional sources of energy such as coal bed methane, shales, and tight sands are expected to increase. Much of the increase, however, is directly related to the escalation of prices.

Drilling activity becomes more economical when natural gas prices increase, as was evident during the early months of 2000 when the number of rigs increased from around 300 to upwards of 1,000 when natural gas increased from $2.00/mcf (million cubic feet) to $8.00/mcf. As prices reached these historic levels, unconventional gas reserves suddenly became economical to develop, sparking a rapid increase in drilling activity.

Because both quantities supplied and quantities demanded change in direct response to the price of natural gas, each tends to be very dynamic. It is this dynamic behavior that leads to the cyclical nature of energy prices. As prices fall due to an existence of excess supply or a decreased level of demand, exploration and development companies stop or slow down their drilling programs. This decrease in drilling causes a decrease in production (supply). As the demand side exceeds supply prices increase. After analyzing whether prices will remain high, drilling increases-most companies follow this approach and thus supply quickly exceeds demand and drilling slows. Thus, the cycle begins again.

As the natural gas industry continues into the 21st century, these cycles will be even more pronounced. Instead of the average fluctuation of +/-$1.00/per mcf, fluctuations similar to those witnessed from 1999 to the present will be the norm.

For independent natural gas producers the projections for future growth are encouraging. Major integrated companies such as ExxonMobil, BP, ChevronTexaco, ConocoPhillips, and Marathon Oil Company continue to exit the domestic energy market in search of the high-volume, low-cost oil reserves found abroad. Therefore, while the exact figure is not known, market increases for independent natural gas producers are expected to increase at a rate significantly higher than the 3.51% average for the industry as a whole.

Fixed cost as a percentage of value added is negligible for natural gas producers. Unlike manufacturing industries, where firms battle each other for market share in order to capitalize on their high fixed-cost structures, the natural gas production industry realizes relatively low fixed costs. Because these firms sell a commodity product, market share is of little consideration and price wars are never witnessed. Although independent natural gas producers do have fixed costs in terms of company overhead, these costs are relatively insignificant compared to the variable costs associated with drilling, completing, and producing wells.

Natural gas is a non-branded product that has little to no product difference. As such, competition between firms to differentiate their products and gain market share is of no concern. Again, natural gas is a traded commodity, in which prices are dictated by simple supply and demand principles. Therefore, competition between firms is negligible with respect to sales volumes and prices of natural gas.

The complex nature of the natural gas industry does lead to competition amongst firms with respect to industry-specific knowledge. Competition, in general, exists only in regard to leasing new lands and employing the expertise necessary to develop those projects.

REFERENCES

Center for Energy and Economic Development, http://www.ceednet.org/.

Department of Energy, Annual Energy Forecast 2002.

Department of Energy, http://www.netl.doe.gov/scng/explore/low-perm/detect.html.

Department of Energy, http://www.netl.doe.gov/scng/explore/low-perm.html.

EIA Data, http:www.eia.doe.gov/emeu/international/LNGimp2001.html.

Energy Information Administration/International Energy Outlook 2002, 2003.

Halliburton, http:www.halliburton.com/news/archive/2001/esgnws_043001.jsp.

NaturalGas.org, http://www.naturalgas.org/overview/history.asp

Newfield Exploration, Inc. 10K (2002).

Office of Management and Budget, http://www.whitehouse.gov/omb/budget/fy2002/msr04.html

Tom Brown, Inc., http://www.tombrown.com/corporate/whoweare.htm

Tom Brown, Inc. 2002 Annual Report.

Tom Brown, Inc. 10K (1994, 1995, 1996, 1997, 1998, 1999, 2000, 2001, 2002).

"Worldwide Natural Gas Supply and Demand and the Outlook for Global LNG Trade." Energy Information Administration, Natural Gas Monthly, August 1997.

William T. Jackson, University of South Florida at St. Petersburg

Mary Jo Jackson, University of South Florida at St. Petersburg

Larry A. Johnson, Dalton State College

Table 1: Tom Brown Inc. Activity: 1992-2002

Year Investment Divestment Source of Funds Amount

1992 Willingston ($7.0 M)
 Basin (ND,
 Montana)
 Arkoma Basin (AR) $1.6 M

 Wyoming's Wind $3.4 M
 River Pavilion
 Field

1993 Wind River $2.2 M
 Pipeline
 Stock Issuance ($38.6 M)

 Val Verde Basin $1.6 M
 of South West
 Texas

1995 Presidio Oil & Bank Loan $56.0 M
 Gas Index notes ($56.0 M)

 Renegotiated bank ($65.0 M)
 loan $56.0 M

 Arkoma ($9.0 M)

 Stock Issuance ($47.0 M)
 and paid loan $65.0 M

1996 K. N. Production $36.25 M
 Co.

 Preferred Stock ($25.0 M)
 Issuance
 Common Stock ($11.25 M)
 Issuance

 Finalized $206.6 M
 remaining
 purchase of
 Presidio

 Stock Issuance ($46.4 M)

1997 ND Properties ($11 M)

 Stock Issuance ($121 M)

 Genesis Gas & Oil $35 M

 Interenergy Corp $23.4 M

1998 Sauer Drilling $8.1 M
 Co.

1999 Relocation to CO $2.1 M

 Unocal Rocky $60.9 M
 Mountain assets

 Stock Issuance ($55.9 M)

 Greater Green $7.7 M
 River Basin of WY

 DJ Basin of ($2.3 M)
 NE Colorado

2000 Wind River $15.2 M
 Pavilion field

2001 Stellarton Energy $94.8 M
 Inc.

 Canadian Loan ($94.8 M)

 Don Evans (CEO) $1.5 M
 resigned to
 become Sec. of
 Commerce and
 receives bonus
 and non-cash
 stock option
 charge of $3.8 M

 Oklahoma ($24.5 M)
 Assets

 Wildhorse ($24 M)

 Deep Valley $8 M
 Project

2002 Wyoming ($7.2 M)
 Power River
 Basin

 Louisiana ($2.0 M)
 Holdings

 Colorado ($1.6 M)
 Holdings

 Green River Basin $14.9 M

Table 2: TOM BROWN, INC. BALANCE SHEET
($ thousand)

 2002 2001 2000 1999

Cash & Equivalents 13,555 15,196 17,534 12,510
Accounts Receivable 47,414 63,745 95,878 53,646
Inventories 1,808 1,689 521 829
Other 3,988 2,332 2,307 1,625
Total Current Assets 66,765 82,962 116,240 68,609
Property & Equipment, at
 cost
Gas and Oil Properties 959,807 849,628 575,991 470,461
Gather & Process & Plant 101,054 89,343 81,873 71,657
Other 35,930 33,689 28,746 23,027
 Depreciation -320,306 -234,134 -176,848 -133,342
 Net P&E 776,485 738,526 509,762 431,803
Other Assets
Deferred Income Taxes, net 0 0 0 28,625
Goodwill, net 0 18,125 0 0
Other Assets 7,702 5,362 3,533 35,887
 Net Other Assets 7,702 23,487 3,533 64,512
Total Assets 850,952 844,975 629,535 564,924

Accounts Payable 42,773 59,172 55,982 39,489
Accrued Expenses 21,993 12,512 22,119 9,763
Fair Value of Derivative 10,886 0 0 0
 Instruments
 Total Current Liabilities 75,652 71,684 78,101 49,252
Bank Debt 133,172 120,570 54,000 81,000
Deferred Income Tax 73,967 75,194 5,475 0,000
Other Non-Current 4,543 2,299 3,066 3,950
 Liabilities
Total Liabilities 287,334 269,747 140,642 134,202
Stockholder's Equity
Convertible Preferred Stock 0 0 0 100
Common Stock, ($0.10 par 3,926 3,913 3,835 3,531
 value)
Additional Paid-in Capital 537,449 534,790 516,911 495,817
Retained Earnings 29,678 37,855 -31,648 -97,351
Accumulated Other Comp. -7,435 -1,330 -205 0
 Loss
Total Stockholder's Equity 563,618 575,228 488,893 402,097
Equity & Liabilities 850,952 844,975 629,535 536,299

Table 3: TOM BROWN, INC. INCOME STATEMENT ($ thousands)

 2002 2001 2000 1999

Oil, Gas & Liquid Sales 194,276 274,031 216,968 104,431
Gathering & Processing 20,467 23,245 18,283 11,968
Marketing & Trading 5,276 1,891 5,841 -786
Drilling 14,347 14,828 11,472 5,645
Gain on Sale of Property 4,114 10,078 0 1,265
Change in Derivative Fair Value -2,406 897 0 0
Loss on Marketable Securities -600 0 0 0
Interest Income & Other 171 1,345 1,346 888
 Total Revenues 235,645 326,324 253,910 123,411
Costs and Expenses
Gas and Oil Production 32,151 32,060 25,488 18,446
Taxes on gas & oil 16,621 21,020 22,105 9,934
Gathering & Processing Costs 6,918 10,855 7,212 5,853
Drilling 13,763 11,851 9,715 5,237
Exploration Costs 22,824 34,195 11,001 10,013
Impairment of Leasehold Costs 5,564 5,236 3,900 3,600
General & Administrative 18,413 22,742 11,614 9,203
Depreciation, Depletion, & 91,307 74,371 50,417 44,215
 Amor.
Bad Debts 5,222 1,043 0,133 n/a
Interest Expense & Other 9,726 7,347 5,967 5,860
 Total costs and expenses 222,509 220,720 147,552 112,361
Income Before Taxes & Cum 13,136 105,604 106,358 11,050
 Effect of Change in Acct.
 Principle
Current Income Tax Provision 0,229 1,200 1,968 0,903
Deferred Income Tax Provision 2,981 36,927 37,812 3,390
Cum Effect of Change in Acct. -18,103 2,026 0 0
 Principle
Net Income -8,177 69,503 66,578 6,757
Preferred Stock Dividends 0 0 875 1,750
N.I. Attributable to Common -8,177 69,503 65,703 5,007
 Stock
Weighted Average # of Shares
 outstanding
Basic 39,217 38,943 36,664 32,228
Diluted 40,327 40,227 37,897 32,466
Net Income/Share (Basic) -0.21 1.78 1.79 0.16
Net Income/Share (Diluted) -0.20 1.73 1.73 0.15
Earnings/Share (Basic) 0.25 1.73 1.82 0.21
Earnings/Share (Diluted) 0.25 1.68 1.76 0.21

** Note: Earnings/Share strips out the cumulative effect of accounting
change.