By Bradley Smahon (Singapore Management University), Rayan Vinsen-Singh (University of St. Gallen), Gleb Kuznetsov (University of Queensland), and Alex Ha (Ivey Business School)
Uncertainty. This has been the theme not just for the year of 2020, but also for Warren Buffett and Berkshire Hathaway. The “Oracle of Omaha” has had a turbulent 2020, to say the least as Berkshire Hathaway reported a record USD 49.7 billion Q1 loss for the year. Berkshire is America's largest and most diverse conglomerate, thus they have exposure to a variety of risks across vastly different industries. In hedging his risks, Buffett has decided that the attractiveness of acquiring undervalued assets, an approach he owes much of his investing success to, is outweighed by the uncertainty surrounding some of Berkshire's largest investments. In particular, Buffett has signaled concerns about his company's investments in the airline industry as its future remains up in the air.
Nowhere has this uncertainty been more greatly defined than in the oil & gas industry. Notwithstanding a supply glut and an infrastructural lack of storage for oil resources, oil & gas has been thoroughly rocked to its core by the coronavirus pandemic. WTI futures contract s nosedived into negative territory for the first time to USD -37.63 per barrel on April 20. Oil companies have been forced to continue pumping at a loss; this is comparatively less expensive to fully shutting production down. In spite of this, Buffett doubled-down on Berkshire Hathaway Energy’s existing oil & gas holdings with a massive USD 9.7 billion deal to acquire Dominion Energy’s as set s. This report seeks to reconcile the uncertainty surrounding the logic of expanding Berkshire Hathaway Energy’s portfolio with this acquisition.
"If we really liked what we were seeing, we would do it, and that will happen someday"
Warren Buffett, May 2020
Company Overview (Berkshire Hathaway)
Berkshire Hathaway Energy (BHE) is a subsidiary of Berkshire Hathaway. BHE operates a portfolio of regulated energy companies that generate, transport, and supply electricity and natural gas to approximately 12 million customer s across the US, UK, and Canada. The company operates through eight business segments, with the largest being PacifiCorp, an electric power company in Western USA. The Northern Natural Gas and Kern River Gas Transmission Company gas transmission systems are also subsidiaries of BHE.
Founded: 1971 as California Energy Company, Inc
CEO/Chairman: Greg Abel
Number of employees: 23,000
Key shareholders: Berkshire Hathaway (90% ownership)
LTM Revenue: USD 19.76 billion
LTM EBITDA: USD 7.26 billion
Company Overview (Dominion Energy)
Dominion Energy, Inc (NYSE: D) is an electricity and natural gas distributor in the USA, with a generating capacity of up to 32,000 MW. It serves approximately 7.5 million retail energy customers in eight states. In 2019, the company possessed approximately 10,400 miles of natural gas transmission, gathering and storage pipelines. In addition, they posses 88,700 miles of gas distribution pipelines. Dominion operates five business segments: Dominion Energy Virginia, Gas Transmission & Storage, Gas Distribution, Dominion Energy South Carolina and Contracted Generation. Out of these five segments, Dominion Energy Virginia is the largest, accounting for 46% of 2019 operating earnings and USD 934 million of NPAT.
Founded: 1983 by William Berry
CEO/Chairman: Thomas F. Farrell, II
Number of employees: 19,100
Market cap: USD 65.08 billion
EV: USD 106.27 billion
LTM Revenue: USD 17.21 billion
LTM EBITDA: USD 8.11 billion
LTM EV/Revenue: 6.2x
LTM EV/EBITDA: 13.1x
Figure 1: Comps Table: Dominion Energy (NYSE:D)
Berkshire Hathaway Energy (BHE) negotiated a deal to purchase Dominion Energy Gas Holdings and its gas transmission and storage assets for an approximate USD 9.7 billion. The other assets include the Iroquois Gas Transmission System, the Questar Pipeline, and Carolina Gas Transmission. Moreover, BHE acquired a lucrative 25% economic ownership interest in Cove Point LNG, of only 6 liquefied natural gas (LNG) export facilities in the US.
The deal consists of a purchase price of USD 4.0 billion and the assumption of approximately USD 5.7 billion of long-term debt. Berkshire Hathaway will issue USD 3.8 billion worth of perpetual preferred shares to pay off 95% of the purchase price and pay the remaining USD 200 million with cash. BHE intends to pay off USD 1.2 billion of debt within the first twelve months of acquisition. Dominion Energy will retain a 50% partnership interest in Cove Point and a 53% non-controlling interest in Atlantic Coast Pipeline, an asset not included in the transaction. If the transaction is not approved within 75 days by the U.S. Department of Energy, Dominion Energy will have the option to terminate the Questar Pipeline asset sale; if terminated, the total purchase price will drop to USD 2.7 billion.
Figure 2: Comps Table: Dominion Energy (NYSE:D) Gas Transmission & Storage Segment and Valuation Summary of the Transaction
The rationale behind BHE’s acquisition of Dominion Energy assets, the firm’s first major investment in 2020, is driven by a motivation to horizontally expand the company’s natural gas midstream operations.
With regard to horizontal expansion, the acquisition will result in an immediate diversification of the firm’s geographical footprint. BHE’s portfolio company Korn River Transmission will be able to extend the network and outreach of its pipeline infrastructure by incorporating Questar Pipelines into its portfolio of operations. The added pipelines from Dominion Energy Natural Gas Transmission will also increase BHE’s market share within the Eastern part of USA, while also providing valuable access to Canada through New York and the Northeast. Furthermore, this consolidation may increase operational efficiency through pipeline integration, thereby providing cost synergies. Operational efficiency is projected to rise due to lowered admin/HR payrolls and the reduction of pipeline interface inefficiency between previously independent companies.
On the other hand, no significant source of revenue synergies is realized as a result of the acquisition because pipelines deal with largely fixed-rate, regulated contracts. However, the increased exposure to different states could enable greater capability to fulfill downstream industrial demand in the long-run, which might provide a boost to top-line revenue in the long run.
Figure 3: BHE’s Geographic Expansion of Midstream Operations
BHE’s second main motivation to purchase Dominion's assets is that the firm has identified a bargain for undervalued energy assets.
From an industry standpoint, the energy sector has experienced a rapid downturn due to the sharp decline in oil prices as well as the massive oversupply of crude, resulting in oil prices declining by more than 60%. This has invariably lowered the valuations of energy assets, making them ripe for bargain purchases. What is most intriguing is that demand for renewables has rebounded relative to traditional energy assets; in contrast, natural gas firms remain depressed with regard to demand.
Figure 4: Renewables vs. Natural Gas YTD Performance
Increased capital inflow to renewables equities suggests that capital markets anticipate an accelerated shift towards renewables as a result of the pandemic. However, BHE is betting on a future where this shift happens at a much slower pace than what markets are pricing in. According to the US Department of Energy Information Administration, renewables will overtake oil and gas in the future. However, natural gas will remain the largest contributor to electricity generation for the next 30 years; this is a trend that has started since 2018 where the USA has become a net exporter of natural gas energy. The 5 year forecast estimates that the USA will export an additional 3 quadrillion British thermal units. With this in mind, it is possible that BHE is betting on this trend continuing into the future.
The rationale compelling Dominion Energy to sell assets to BHE can also be separated into two distinct motivations:
To unload a substantial amount of debt through the sale of its subsidiaries
To streamline their operations towards state-regulated clean-energy development.
Dominion Energy has taken the effort to transform themselves from having been a competitive stalwart of the natural gas industry towards being an appropriate fit for the state-regulated renewables industry; this includes creating the objective of a comprehensive net zero emissions target by 2050. Thomas F. Farrell, Dominion Energy’s CEO, highlighted that ”between 2018 and 2025 we [Dominion Energy] expect[s] to retire more than four gigawatts of coal- and oil-fired electric generation”. The sale of assets has provided Dominion with more liquidity as USD 5.7 billion of the USD 33.8 billion of debt has been written-off, The company is also better equipped to weather diminished industrial energy demand due to COVID-19 and focus on its renewable energy development.
Upon the completion of the acquisition, BHE will look to integrate its newly purchased pipeline assets with its existing portfolio. Korn River Transmission’s pipeline’s reach will double by incorporating Questar’s pipelines into its infrastructure, allowing it to connect from California to states including Colorado and Wyoming. The acquisition of Dominion’s Natural Gas Transmission gives BHE access to Ontario, Canada, through its pipeline network throughout New York, in addition of the increased market exposure BHE gained in the East United States
In fact, there will not be any major changes to any of the pipelines’ operations due to the similarity of the infrastructure. As these pipelines connected, cost-savings in labour will be realized as less operators are required to operate an extended pipeline than two separate pipelines. BHE could also improve its portfolio companies' operational efficiency by having Dominion Energy Gas Transmission management over to monitor.
Figure 5: YTD Performance: Dominion Energy vs. NYSE ARCA NATURAL GAS INDEX
Unlike most oil & gas firms that implement generous dividend policies, BHE retains most of its cash flow for new capital investments. These investments include pipeline construction projects, renewable energy investment and acquisitions. BHE’s focus on investments, rather than dividend returns, will enable substantial cost savings as Dominion Energy spent USD 2 billion on dividend distributions in 2019, representing 66% of its net income. The amount paid out in dividends could have been reinvested into operations and new investments.
The additional 5,600 miles of pipelines have strengthened BHE’s transmission connectivity across the US and enhanced its capability to deliver energy. In the future, BHE’s expanded pipeline network will help the firm secure more contracts from upstream operators and maintain a stronger presence in the midstream market.
Figure 6: YTD Performance: Berkshire Hathaway vs. S&P 500
BHE’s long-term strategy is driven by its track record of acquiring assets at discounted values to fuel the growing electricity demands of the American consumer, rather than a focus on a permanent shift towards renewables. BHE, as a subsidiary of Berkshire Hathaway, does not face anywhere near as much outside pressure from shareholders to make near-term shifts towards renewables compared to public energy companies. Warren Buffett himself was quoted in 2016 saying that “global warming is something that should cause [Buffett] to change [his] prices a lot or even a small amount”.
The acquisition of Dominion Energy’s assets is seen as more of a value-oriented deal rather than solely an investment into the future of natural gas. BHE believes that LNG will continue to displace coal-powered energy generation, along with wind and solar. Through this acquisition, BHE is hedging its bets against any radical shifts towards renewables by ensuring dominance over the LNG market. BHE is favorably positioned to do so compared to other energy companies due to the lack of external pressure about shareholder returns in the form of dividends.
Figure 7: Breakdown of 2015 vs. 2019 Total Generation Capacity: BHE
Despite BHE’s USD 9.7 billion investment in non-renewable assets in this deal, changes in the energy sources for BHE’s total generation capacity from 2015 to 2019 suggests an ever-increasing shift towards renewables. Wind and solar grew by 11% to become the company’s largest energy source for its generation businesses, whereas coal and natural gas fell 7% and 3% respectively (Figure 4) highlights that BHE is making massive cuts to their coal energy generation, but their modest reductions in LNG as an energy source suggests that BHE will largely fill gaps left by renewable sources with LNG. Compared to other energy alternatives, LNG can be stored and used effectively and is produced in a more environmentally friendly manner than oil and coal. BHE’s portfolio investments year to year adjust according to the growth, production, and development of different energies.
Interestingly, Berkshire Hathaway’s expanded portfolio, through the acquisition of LNG assets, grants it exposure towards the growing electric-vehicle market. Despite Buffett’s skepticism towards the effect of climate change on his holdings, Berkshire Hathaway has made numerous diversified investments to address growing climate-oriented trends.
The firm has spent over USD 1 billion for 25% of BYD Company, a Chinese battery producer that has recently set up a joint venture with Toyota Motor Corporation. The electrification of vehicles and increasing market share of EVs will contribute to higher electricity demands. Due to the fluctuating and volatile nature of renewable energy sources, LNG energy can be used to supply electricity to the grid in times of low renewable energy production. In theory, the acquisition could uniquely position BHE to fuel a growing EV market, especially during periods of low renewable energy output.
Industry / Economic Implication
The midstream sector is much more resilient to changing commodity prices compared to upstream operators and consequently has a lower risk profile. The majority of midstream and transmission operations are rate-regulated, and are therefore unaffected by commodity prices directly. Most of the midstream operators’ revenue is generated through the transportation of energy and is primarily measured in terms of volume. However, massively depressed volumes caused by lower household and industrial electricity demand have placed increased financial pressure on the sector.
Figure 8: Covid-19 Lockdowns Impact on U.S Energy Demand
This acquisition does not necessarily imply that BHE is betting on a sharp recovery of energy demand. Instead, BHE is certain that natural gas supply expansion, especially within the trade sector, is going to continue moving forwards. The acquired pipelines remain a relatively safe asset class because transmission prices do not fluctuate much. Therefore, the risk associated with the acquisition of Dominion’s transmission assets remains fairly low.
Additionally, Dominion is not the only company in the industry that is working towards shifting their energy supply from oil & gas towards clean-energy. Factors for this shift include the current technological advancement of renewable energy generation, an ESG-focused investing environment and the sustainability of renewable energy. During the pandemic, many energy companies are suffering from liquidity problems due to difficulties in financing. Numerous industry competitors have begun to divest from these assets to weather the pandemic, including the largest natural gas transmission company Enbridge, largest oil distributor ExxonMobil and oil producer giant Chevron.
Figure 9: U.S. Primary Energy Consumption by Major Sources, 1950-2019
Oil & gas companies will also have to face increasing regulatory pressure from the carbon tax system, which has discounted their current and future profitability. Dominion Energy’s sale of assets fits within a massive divestiture trend in the industry. The trend is a result of a combination of the aforementioned factors and there are nuances to each sector.
Barriers to Deal Closure
BHE is expecting the deal to close in Q4 2020. At present, there are two primary barriers to BHE closing the deal: 1) the transaction price and 2) the availability of alternatives. Both barriers exist as a result of COVID-19 depressing prices for oil & gas companies downwards significantly over the course of 2020. With regard to the transaction price, more than half of the USD 9.7 billion deal (USD 5.7 billion) is allocated to debt associated with the equity. The comparable companies analysis in Figures 1 and 2 suggest an acquisition premium ranging from 34% to 94%. However, if energy demand remains slumped in the next few months, BHE may attempt to renegotiate for a cheaper price - precedence for this would be in the form of a MAC clause, which may prolong the closure of the deal and prompt a revaluation of what the fair value of this transaction is. However, this remains theoretical at this point in time.
The deal also needs regulatory approval from the U.S. Department of Energy. The U.S. Department of Energy’s approval is likely since BHE already has significant midstream operations in the U.S. and prices in the sector are majority rate-regulated, thereby quelling anti-competition concerns. If the transaction is not approved within 75 days by the U.S. Department of Energy, Dominion Energy will have the option to terminate the Questar Pipeline asset sale; if terminated, the total purchase price will drop to USD 2.7 billion. In such an event, a termination would still be unlikely, as Dominion’s business strategy no longer includes midstream gas pipeline operation.
Within the oil & gas space, other companies with liquidity needs may be looking to make strategic divestitures. There are not any distinguishable factors in the operation of pipelines; BHE chose Dominion Energy specifically because of its geographical fit. However, there might be other companies also willing to offer BHE their assets at even cheaper prices, which would reduce the comparative benefit of geographic synergies in this deal.