The Boom (20 page)

Before he presented his new thinking to Nichols, Hall decided to learn all he could about these shale rocks. There wasn’t much in the petroleum libraries. “It could fit in my briefcase. There were three books and a few publications,” he said. This was a little nerve-wracking, but production numbers don’t lie. Mitchell Energy was getting a lot of gas out of these rocks. When the time came to make a recommendation to Nichols and other executives, Hall’s message was different from a year and a half earlier. “This looks like a real good opportunity,” he told his bosses. Expecting Hall to advise against a deal, the management team sat in silence for a few seconds. Then Nichols spoke: “There’s a deal to be done here. Let’s go after it.”

Devon had bought many companies, and Nichols knew how to close a deal. There were teams of employees ready to conduct due diligence. Devon moved quickly, worried that someone else might see what it now saw in Mitchell. Within three months after the bankers approached Devon for a second time, the outlines of a deal came together. But another realization tempered Nichols’s enthusiasm. Mitchell had been drilling vertical wells. Extrapolating the amount of natural gas available from these wells made the $3 billion cost to acquire Mitchell a “full price,” said Nichols. However, Devon had used horizontal wells elsewhere and thought that these wells, which descended vertically and then bent underground to run parallel to the surface, might be able to access more gas. But it was all paper calculations. Mitchell had tried a handful of horizontal wells without much luck. There was no way to know if horizontals could turn a Mitchell acquisition into a great deal until Devon could try a few. It would have to wait until it owned Mitchell’s assets.

Devon made an offer and then bumped up the price it was willing to pay after Mitchell Energy’s bankers said the initial offer wasn’t enough. The bankers again asked for more, and Nichols balked. Its bluff called, Mitchell Energy acquiesced. Lawyers and bankers worked through the weekend at the law firm Vinson & Elkins’s offices in a Houston skyscraper, finalizing details. On Tuesday, August 14, 2001, before the stock markets opened, both companies issued press releases announcing the deal. Devon’s stock rose that day as analysts absorbed details of the transaction and concluded it had bought a lot of gas on the cheap. A month later, after the terrorist attacks on the United States, Devon’s stock would fall along with the price of oil and natural gas, making many in its Oklahoma City headquarters nervous. But it was a temporary blip. Better days for the company were ahead.

Larry Nichols was born to be an Oklahoma City oilman but tried his best to avoid his fate. When he was ten years old, a prolonged drought prompted his father to drill a water well in the backyard of the family home. The future CEO was fascinated by the drilling rig. He spent the afternoon watching the work. When it started producing water, he ran into the house and exclaimed, “They’ve struck oil, but it looks like water to me!”

The Nicholses were a well-to-do, respected clan, part of the Sooner State elite. His father, John W. Nichols, was an accountant and a financial genius with an inclination to use every conceivable trick in the book to avoid paying taxes. When there weren’t enough tricks, he invented new ones. After graduating from the University of Oklahoma, he went to work on the New York Stock Exchange in the midst of the Great Depression. He returned to Oklahoma City in 1936, humbled but with a firm understanding of tax law.

In November 1950 he created the world’s first drilling fund registered with the Securities and Exchange Commission. Before this time, money to drill wells was often raised from wealthy investors on handshake deals. The oil business was rife with swindles and outlandish promises of easy money. The SEC regarded the formalized drilling fund as a way to protect small investors. But John Nichols wanted to tap the wallets of some of the richest men in America, not small investors.

Less than two months after the SEC approved the new fund, the thirty-five-year-old Nichols convened a meeting at the University Club of Chicago. In a private room, several wealthy industrialists gathered with their accountants and lawyers around linen-draped tables. The president of the Joseph Schlitz Brewing Company was there, as was the chairman of Bethlehem Steel, and meatpacking magnate Phillip Armour. You are “plagued” by the 90 percent federal tax on income, Nichols told the assembled members of the corporate elite. His new drilling fund exploited the tax code’s allowance for a well’s expenses to be deducted in the year it was drilled. Expenses often made up 70 percent of the cost of a successful well, he explained, allowing for investments to generate large tax deductions as well as ongoing income from the wells. The result was little taxable income for the investors. “Nichols explained how his plan could almost miraculously save high-income investors up to half their annual income tax bill,” wrote John Nichols’s biographer Bob Burke in
Deals, Deals, and More Deals
. Years later, Congress would close the loophole that Nichols had opened, but at the time, it was all perfectly legal and rather ingenious.

In broad terms, here’s how it worked for a fund that raised $1 million. About 40 cents of every dollar raised through Nichols’s investment fund was used to drill wells in counties where there was already significant energy production. Three in four wells would strike oil and gas. The cost of drilling the three successful wells would be about $300,000 and generate tax credits of $240,000. The $100,000 spent on drilling one duster was lost. The remaining $600,000 was used to drill wildcat wells. If those six wildcats were dry, it created another tax credit for writing off the value of exploration. For rich investors with a lot of income, they could generate plenty of tax credits to lower their IRS bill and gain a potential dividend from future production out of the successful wells. Investors in Nichols’s first fund included the Badenhausen family, which owned the P. Ballantine & Sons brewery, as well as top executives from both Chrysler and General Motors. The Pillsbury family also invested, as did Hollywood stars Ginger Rogers and Barbara Stanwyck. The first fund delivered the tax credits as promised, and the technique began to spread. By the 1980s, when a change in tax law ended these drilling funds, billions of dollars had been raised through the investment vehicle pioneered by Nichols.

After raising money from the nation’s entertainment and industrial elite, Nichols signed up smaller but still quite affluent investors with promotional sales brochures. On the cover of one, a picture of an oil well blows a black cloud of oil into the sky. “Oil: The Last Frontier for High Tax Bracket Wealth,” the brochure crowed. Inside was more heady prose: “The arithmetic of riskless investment” and “Big projects for big profits.” His son Larry would later chuckle about his father’s sales strategy, telling a group of Oklahoma businessmen in 1996, “The SEC would send you straight to jail for that now.”

Larry Nichols graduated from Casady School, a relatively new day school formed by the Episcopal Diocese that became the place for Oklahoma City’s elite to educate their children. From there, he studied geology at Princeton University. Then he decided to leave the oil track and headed to Ann Arbor to complete a law degree at the University of Michigan. A top student, he served as an editor of the law review and clerked for Supreme Court Justice Tom Clark. Not long after Nichols arrived in Washington, DC, Justice Clark resigned from the court after his son, Ramsey, was nominated to be US attorney general. Nichols transferred to the office of Chief Justice Earl Warren for the remainder of his clerkship. This new assignment brought little meaningful work, and he drafted no opinions. When his clerkship ended, he joined the US Justice Department as special assistant to Assistant Attorney General William Rehnquist. In 1970 his father lured him back to Oklahoma City with the promise of creating an oil company together. Larry Nichols decided to try it for two years. He figured he could always return to Washington, DC, and a profitable law career. He got out of the capital just in time. A couple years after he left, the Watergate break-in and cover-up began, a scandal that would reach into the Justice Department offices where he had worked.

The company that John Nichols built was called Devon International. Like his earlier work, it was craftily constructed to avoid taxes. The parent company was incorporated in Luxembourg, which had no income tax on corporate profits. Nichols set up a subsidiary in Oklahoma to own oil and gas properties in the United States, and profits flowed through Saxon Oil, a Panamanian corporation, and a United Kingdom subsidiary. In a nutshell, the complex structure allowed rich Europeans to invest in US oil and gas properties at a low tax rate. “Financial creativity,” Larry Nichols said later, “is part of our heritage.” Larry served as the new company’s in-house lawyer.

If John Nichols was an innovator, ready and willing to take risks to create wealth and tax shelters, Larry Nichols tended to be careful. With a lawyer’s conservative bent, he focused on making sure that the new Devon didn’t succumb to the wild vicissitudes of oil and gas prices. Mary Nichols, John’s wife and Larry’s mother, summed up the longtime working relationship that emerged between the two men. “John was always the dreamer. He could figure out new deals, and Larry, often taking a devil’s advocate position, could tell him if they would work. John was the accelerator. Larry was the brake,” she said.

In 1986 Ronald Reagan signed into law a simplified federal income tax. One change ended the investor-backed drilling funds that John Nichols had pioneered. Shutting this loophole could have been catastrophic for Devon, but Larry Nichols believed that it created a new opportunity. The end of the tax-advantaged drilling funds dried up a large source of funding for many of the four hundred publicly traded oil and gas companies in the United States, many of them small. Larry Nichols, already the CEO of Devon, realized that many of these companies wouldn’t be able to survive. The oil industry would enter a period of consolidation. He wanted to be a consolidator, picking up assets from distressed companies and swallowing other troubled companies entirely.

Within a decade, Devon had doubled in size and then doubled again. It developed a reputation as a ravenous acquirer of assets. Larry Nichols became known as an oilman who spoke softly and carried a large checkbook. Devon also developed a reputation as a company that could handle unconventional assets. Devon acquired a large acreage position in the San Juan Basin in northern New Mexico. The area had been drilled for decades. Part of John Nichols’s first drilling fund, in 1951, had been used to acquire leases and drill in the basin. These older wells had targeted a deep rock formation. Above that was the Fruitland coal formation. There was a lot of gas in the coal seams, but also water. Three companies hit upon a new approach to this so-called coal-bed methane: Amoco, Burlington Resources, and Devon. They would create a cavity in the coal and pump out thousands of gallons of water. After the water pressure was lowered, gas would flow out of the coal. It was laborious work, but it was supported by a nice tax credit that the government had created to help companies develop new gas sources.

Of the three companies, Devon was most intent on acquiring new acreage in the San Juan Basin. When property came up for sale, by the time Amoco’s team in New Mexico had sent the particulars of the deal to headquarters in Chicago for consideration, Devon had already closed the deal. “That we could compete with Amoco was a revolution in my mind,” Larry Nichols said. “We could move faster on little deals, right under the nose of the big guys.” The lesson that he took from the San Juan Basin was that Devon could compete with anyone, even a progeny of Standard Oil. He also realized that oil-field technology was being democratized. In the past, Big Oil companies such as Amoco had a lock on research and development. They patented and controlled the major breakthroughs. But most of these companies had slashed their research budgets. The technology game was much more wide open by the early 1990s. Even a middling Oklahoma City company could compete on cutting-edge exploration that required a new approach and new technology. He would apply this lesson in the Barnett Shale.