This $20 Billion Oil Bet Looks Like It Blew Up

By Markets Fool.com

In 2013,Freeport-McMoRan Inc bought two oil and gas companies. With oil prices down materially from 2014's highs, those acquisitions are looking increasingly like a big mistake. And according to the company, if oil prices don't pick up soon, there's more pain to come.

Continue Reading Below

How much for that puppy?
The acquisition of McMoRan Exploration Co. and Plains Exploration--two companies in which Freeport McMoRan already owned stakes--roughly two years ago cost about $9 billion. However, if you add in the $11 billion of debt Freeport took on in these transactions, the miner paid a grand total of about $20 billion to get into the oil and gas business. That's a lot of money, particularly since Freeport's market cap is currently about $20 billion.

Analysts and market watchers questioned the deals from the get go, butbecause oil prices were lofty management was able to highlight the financial benefit for the company. That was particularly true since oil managed to avoid the price declines experienced by many other commodities. But in the middle of 2014, everything started to change, and in a big way. Brent crude, which was trading in the $110 a barrel range in mid-2014, has fallen to the mid-$50 a barrel area in recent days. That's a roughly 50% decline that materially changes the dynamics of Freeport's new oil business.

Brent Crude Oil Spot Price Chart

Brent Crude Oil Spot Price data by YCharts.

The first hit
With oil off so much from its highs, you have to wonder about the impact it will have on Freeport's big purchase in the sector. The answer isn't a good one. In 2014, the company wrote off $1.7 billion of goodwill. Goodwill refers to the amount a company pays for an acquisition that exceeds the value of an acquisition's assets (you can think of it as the amount it overpays). And according to Freeport, "Crude oil prices and our estimates of oil reserves at December 31, 2014, represent the most significant assumptions used in our evaluation of goodwill." In other words, falling oil prices led directly to that write-off.

Continue Reading Below

But that's not the end of the story. The company also took an impairment charge of $3.7 billion because of weakening oil prices. This essentially means Freeport doesn't expect to make as much from its oil and gas properties as it had before, requiring that it write down the value of those assets. Put the goodwill and the impairment together, and you get $5.4 billion worth of write-offs on a deal that cost $20 billion. That math isn't looking so good.

More pain to come
Sadly, the pain may not be over yet for shareholders. In fact, the miner warned in its 2014 annual report that "the effect of weaker oil prices than the 2014 average is expected to result in significant additional ceiling test impairments of our oil and gas properties during 2015." There could be additional goodwill write-offs, too.

Freeport McMoRan isn't so happy about its oil anymore. Source: Public domain, via Wikimedia Commons.

How big are these additional costs going to be? That all depends on what happens with oil. But Freeport is clearly telling you to expect painful asset impairment costs at the end of this year. And to understand just how painful it could be, consider that the value against which it's comparing oil prices is roughly $95 a barrel (this is based on an SEC required calculation). To be fair, a rise in oil prices would make these assets more valuable again, but right now that's not the direction things appear to be going.

Freeport has a little more leeway on the goodwill side of things, where it has used future oil prices in the $60-$80 a barrel range over the next five years, putting prices at least closer to current levels.

At the end of the day, however, if you own Freeport McMoRan shares, expect 2015 to have some nasty impairments, and possibly more goodwill write-offs if oil doesn't rebound strongly. This is one acquisition that doesn't appear to be turning out as well as management originally hoped.

The article This $20 Billion Oil Bet Looks Like It Blew Up originally appeared on Fool.com.

Reuben Brewer has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold,. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.