PETROLEUM COMPANIES IN 1998 turned again to mergers and joint ventures to cope with a period of low profitability.
A merger and acquisition (M&A) trend in effect for a number of years gained force in response to an oil price slump with roots in an economic downturn that began in Southeast Asia the previous year.
Mergers, acquisitions, joint ventures, and alliances provide companies a means of improving efficiency and achieving scale economies.
"This trend will continue in all segments of the industry," predicted William Beisswanger, Ernst & Young LLP`s national director of energy services, late in 1998.
Portfolio sculpting
In the 1990s, most companies identified core strengths and sold noncore assets.
By 1998, the most successful oil firms had divested themselves of most noncore assets, said PIRA Energy Group, a consulting firm based in New York City.
PIRA said that what it called the "asset-focusing step" to achieving financial strength was largely complete across the industry, "at least until some change in perspective leads to a revised assessment of what is core and what is not." As a result, the leading firms were concentrating on their core assets, investing aggressively in high-return sectors, and further streamlining or reducing costs in underperforming areas.
These companies turned to joint ventures (JVs) for the next phase of portfolio restructuring, said PIRA. According to a publication by the firm, "Most of the significant, unilateral, direct cuts in fixed costs have been achieved. In the drive for leadership in cost and efficiency, JVs therefore have become the preferred way to maximize the return on underperforming assets.
"Some of the corporate structures resulting from JVs are quite revolutionary, at least in terms of who is involved," said PIRA. "For example, although JVs are common upstream, the Shell/Amoco Corp. JV that created Altura Energy Ltd. from a pooling of the companies` long-established interests in the U.S. Permian basin broke new ground.
"Similarly, the drive to achieve cycle-long cost reductions in the downstream sector that outstrip the fall in the long-term margin has produced some unexpected, large-scale bedfellows, such as BP and Mobil in Europe and Shell, Texaco and Saudi Aramco in the U.S.
"All are clear examples of the power of the bottom line to overcome the long-entrenched dogma that the ability of the majors to be partners upstream could not successfully be transferred to the downstream."
The merger trend
Since 1986, most companies had continuously rearranged their asset portfolios and reorganized to unlock "latent internal value," said a McKinsey & Co. report by Scott Nyquist and Chris Friedemann of the firm`s Houston office. The next step was a wave of M&A activity.
The merging of two former competitors was an even more drastic step than asset-focusing or joint venture formation. And this bold move was increasingly common in the energy industry during the late 1990s.
"We are seeing unprecedented volume and unprecedented size (in M&A transactions)," said Eric Mullins, a vice-president at Goldman Sachs.
The McKinsey report said that changing industry dynamics and growing pressure to increase share prices made M&A a strategic tool not only in the petroleum industry but throughout the business world.
Boards of directors were asking executives to consider all options for increasing revenues, reducing costs, and boosting stock prices, said McKinsey. And, as much of the potential for achieving these goals through internal restructuring had already been realized, external options such as mergers and acquisitions were the next obvious choice.
Driving increased M&A activity in all industries were deregulation, privatization, and the opening of formerly closed markets. These trends had increased the size of the market, but the capital and personnel required to compete in this more-global market challenged even the biggest firms.
In addition, said McKinsey, excess capacity in many sectors and weakened demand in Asia had held prices in check.
Rich Langdon, chief financial officer of EEX Corp., said increased competition was behind the merger trend for upstream independents. "There are only two significant excesses left," he said. "There is too much oil in the world, and too many players (are) chasing too few opportunities."
Among independent companies, major transactions included:
- Burlington Resources Inc. and Louisiana Land & Exploration Co.
- Mesa Inc. and Parker & Parsley Petroleum Co., which formed Pioneer Natural Resources Corp.
- Sonat Exploration Co. and Zilkha Energy Co.
- Flores & Rucks Inc. and United Meridian Corp., which created Ocean Energy Inc.
- Ultramar Inc. and Diamond Shamrock Corp., then the announced merger of Ultramar Diamond Shamrock Corp. with Phillips Petroleum Co.`s refining and marketing division.
These mergers of equals were a strategic means of achieving growth in a mature industry, said McKinsey. They also improved the scale of the partners` operations and enabled them to mesh complementary skills.
Major oil companies were also turning to mergers for growth. Texaco Inc.`s acquisition of Monterey Resources Inc. strengthened its position in California heavy oil. And ARCO`s acquisition of Union Texas Petroleum Holdings extended its international resource holdings.
Meanwhile, British Petroleum Co. plc and Amoco Corp. chose a merger as a means of creating a third "supermajor" to compete with Exxon and Shell. After the McKinsey report, Exxon raised the hurdle by agreeing to a merger with Mobil Corp. worth $70-77 billion. Separately, France`s Total and Belgium`s Petrofina SA also agreed to merge.
Several smaller integrated players, including Kerr-McGee Oil Corp., Unocal Corp., and Pennzoil Co., broke up their upstream and downstream operations in order to focus on segments in which they could beat competitors, said McKinsey.
In some cases these "de-merged" entities operated alone; in others they subsequently merged with other firms. Ashland Petroleum Co., for example, joined its downstream operation with that of Marathon Oil Co. to gain scale in U.S. Midwest refining and marketing. And Kerr-McGee agreed to merge with Oryx Energy Co.
Even some state oil companies were active on the M&A scene.
After Argentina`s YPF SA was privatized, it bought independent Maxus Energy Corp. Saudi Aramco had been acquiring downstream assets in Europe and Asia and, through its Star Enterprise venture, was part of the two regional Shell-Texaco downstream JVs in the U.S.
Venezuela`s Petroleos de Venezuela SA became the largest net holder of U.S. refining capacity as a result of its acquisition of the U.S.-owned shares in Citgo Petroleum Corp. and Uno-Ven Corp. and its acquisition of a 50% stake in Amerada Hess Corp.`s St. Croix, Virgin Islands, refinery. Pdvsa also struck a number of joint venture arrangements, both upstream and downstream, related to the production, upgrading, and refining of extra heavy oil from the Orinoco belt.
The oil field service-supply sector also underwent big changes as a result of mergers and acquisitions.
Sonat Inc. and Transocean SA merged their deepwater drilling businesses to gain scale in this high-growth, capital-intensive segment. And Halliburton Co. merged with Dresser Industries Inc. and acquired Landmark Graphics Corp., expanding the scope of its services and giving it an integrated services package.
To keep pace, Baker Hughes Inc. agreed to acquire Western Atlas Inc. in a $5.5 billion stock deal.
Deal structures
McKinsey said the M&A deals in the late 1990s differed in structure from those that took place during the 1980s M&A wave. For the most part, "friendly" stock-swap mergers replaced hostile, cash-based takeovers, which required significant stock premiums to execute and diligence to recoup, said the firm.
Mullins of Goldman Sachs disagreed. "Hostile activity is on the rise," he said. In fact, in 1998, it reached about 80% of its peak level in the late 1980s.
Trends supported Mullins`s assessment. In 1998, Union Pacific Resources attempted a hostile takeover of Pennzoil Co., but Pennzoil successfully resisted. In Canada, Sunoma Energy Corp. launched a bid for Barrington Petroleum Corp. After searching unsuccessfully for an alternative buyer more to its liking, Barrington eventually accepted Sunoma`s offer.
"We`re going to see more of that," predicted Mullins.
McKinsey and Mullins agreed on the point that the premiums required to execute M&A transactions were lower in 1998 than in the mid-1980s, while the number of deals being made was greater.
Deals in the more recent period had been increasingly financed through equity and stock transactions, said Mullins, because companies couldn`t access the cash necessary for debt-financed transactions.
Calgary`s Sayer Securities Ltd. noted the same trend but expected it to change.
The firm`s president, Frank Sayer, said, "While most corporate deals completed over the previous 2 years have involved share exchanges, as opposed to cash, we are likely to see a shift towards more cash deals, given the fall in share prices for previous buyers.
"There are also likely to be more financially distressed companies being purchased by companies with strong balance sheets," he predicted.
Value created
Although it was difficult to calculate the value created by petroleum industry mergers and acquisitions, published figures on anticipated savings could provide some idea of the magnitude of savings, said McKinsey.
Regional downstream joint ventures, such as Mobil and BP in Europe, were projected to save about $1/b/d of distillation capacity, according to McKinsey. And regional upstream JVs, such as the Shell-AmocoAlturaEnergyventure, announced annual savings averaging $0.85/bbl of oil equivalent (boe) of production.
Extrapolating these average savings to the global assets of the 15 largest U.S.-based petroleum companies implied a hypothetical potential value creation of nearly $8 billion/year ($4 billion for U.S. assets only), or about 20% of the 1997 pretax operating incomes of these companies, McKinsey said. If extended to smaller or non-U.S. companies, the value creation could be substantially higher.
Steve F. Venner, vice-president of Bonner & Moore Associates Inc., Houston, said he had seen estimates of savings resulting from downstream mergers in the range of $0.25-1.30/bbl. Because merged companies would need to rely on expensive outsourcing, however, Venner speculated that the actual savings were 15-50% less than the estimated amount.
Wall Street took serious note of these projected savings. The planned merger of BP and Amoco set an important precedent in this respect, said Mullins of Goldman Sachs.
Immediately after the merger was announced, both firms` stock prices jumped. This increase indicated that the market believed their projected cost savings figure of $2 billion, said Mullins. Not only that, he added, the market had already given the companies credit for the achievement before the merger closed, although it would take a few years for the companies to realize the savings.
Reaping the rewards
Although the potential cost savings attributable to M&As were impressive, achieving the projected savings depended on the success of integrating the partners` operations after mergers occurred, said Deloitte & Touche Consulting Group. In a publication by Barry Brunsman, Scott Sanderson, and Mark Van De Voorde, Deloitte & Touche stressed that, in order for mergers to be successful, firms with different strategies, management schemes, and organizational structures had to be quickly pulled together to work jointly toward achieving objectives of the deal.
Deloitte & Touche estimated that 60% of mergers failed largely because of inadequate integration. The firm said that successful mergers required "focused and thorough pretransaction strategy development, strong pretransaction analytical effort, and comprehensive management of the integration effort."
The integration phase was most often underestimated or unappreciated, said the firm.
Oil and gas industry mergers, acquisitions, and joint ventures were increasingly complex, said Deloitte & Touche. "Not surprisingly, the integration effort required to create the enterprise that results from these deals is also increasing in complexity.
"Unfortunately, history suggests that, while significant effort will be given to the development of the merger strategy that results in these deals, and (to the) transaction mechanics that support them, relatively little effort will be given to planning and managing of the integration effort that ultimately achieves the benefits of the transaction."
McKinsey & Co. also saw the post-merger stage as crucial. It said that the most successful firms would "plan for and execute the post-merger integration process with the same zeal as the actual transaction."
It was also necessary, throughout the process, to recognize and adjust to the many obstacles that often derailed even the most compelling combinations, said McKinsey.
M&A outlook
The probability of continued strong merger activity depended heavily on oil and gas prices, said most observers.
According to a quarterly report by Randall & Dewey Inc. in 1998, "The downdraft in oil prices and the weak demand for energy shares have caused industry leaders from large and small companies alike to seek nontraditional avenues for growth opportunities in the continuing quest for increased shareholder value.
"From another perspective, the upward trend in (U.S.) finding and development costs, coupled with the deteriorating market performance for the mid-size and small (U.S.) exploration and production (E&P) companies, underscores the fundamental changes under way in the industry: e.g., domestic consolidation and expansion to deepwater and international opportunities."
As of mid-1998, Randall & Dewey considered more than 50 transactions, with a total value of well over $5 billion, pending.
EEX`s Langdon agreed. Although he expected E&P firms to experience continued intense competition for investment opportunities, he saw additional chances for cost savings in the industry, making further consolidation inevitable.
Hal Miller, managing partner with Cornerstone Ventures LP, Houston, predicted that, as oil prices remained in the $13-16/bbl range, "the high level of M&A activity in the upstream sector should continue unabated.
"E&P companies that are the most highly leveraged, or the higher-cost producers, as well as those that are most heavily weighted toward oil instead of natural gas, are among the most vulnerable to the stronger companies who view the low commodity prices as an opportunity to step up their acquisition efforts," said Miller.
He added that independents` finding and development costs had spurted, compared with the cost of growth through acquisitions. Therefore, said Miller, "the relative cost of growth through the drill bit vs. acquisitions may now be tilting even more favorably toward acquisitions during the near term."
Downstream, the outlook was similar. J.L. "Corky" Frank, president of Marathon-Ashland Petroleum LLC (MAP), said that increased environmental regulation and continuing capacity creep in the U.S. refining industry would put further pressure on companies to save costs by finding partners.
But, at some point, said Frank, "The attractiveness of (mergers) will begin to decline as people pick the low-hanging fruit."
Calvin Cobb, managing director of Ernst & Young Wright Killen, Houston, predicted that the continued formation of joint ventures would eliminate average-sized refiners. "Our current future industry model suggests that 12 companies will have 80% of crude processing capacity and one half of the refineries," he said.
McKinsey`s view
McKinsey analyzed the merger trend as it stood in 1998 and its possible implication for the future. The results varied by company size.
The majors, who tended to believe that "broader is better," could increase their scope of operations through expansion into complementary businesses, said the firm.
"Some might choose to integrate along the natural gas chain by acquiring a power developer or electric utility. Others might acquire an integrated oil field service company to become a `one-stop shop` for all E&P services. Others might extend their positions within particular segments, such as financial services or deepwater E&P (by acquiring a deepwater driller and floating production system fabricator)."
McKinsey saw the same potential that Cobb did for mid-sized integrated firms, such as Marathon and Phillips.
"M&A could significantly reshape the mid-sized integrated petroleum sector. As a group, they have underperformed, on a return-to-shareholder basis, both the majors and the smaller petroleum specialists over the last 7 years.
"While majors returned nearly 16% and selected specialists over 20%, the mid-sized firms returned just 8% to their shareholders.
"Industry trends do not suggest that the competitive pressures on the mid-sized companies will abate. Mature-market joint ventures among the majors, in both the upstream and downstream, further enhance their scale-driven advantages. In emerging markets, the mid-sized firms frequently lack the `brand cachet,` scope of capabilities, and relationships required to seize the most attractive opportunities, as well as the deep pockets needed to fund a diversified, capital-intensive project portfolio.
"Moving forward, M&A activity among the mid-sized players could increase. Some might follow the paths of Unocal, Ashland, and Pennzoil and de-integrate," said McKinsey.
"Some might merge within the sector to gain scale and breadth comparable with the smaller majors. Others might divest of businesses in which they lack distinctiveness and increasingly focus on a smaller number of segments in which they are advantaged. Still others might `merge into` the majors in friendly stock deals."
For the smaller independent firms, McKinsey said continued strong M&A activity was a possibility, especially in E&P.
"Many might merge simply to increase their domestic reserves base and net income. Others might use M&A to fatten their balance sheets and launch into higher-risk, cash-intensive international ventures. Some could pursue regional consolidation strategies to acquire fragmented `mom and pop` producers.
"A limited number of advantaged regional specialists like Devon Energy Corp. and Meridian might strike stock-for-asset deals with larger players looking to reposition. The remainder might follow Monterey`s path and exchange their resource holdings for stock in regionally advantaged majors and midsized players."
McKinsey said some of the Middle East producers might further integrate downstream by acquiring regional R&M assets. "A global partnership between an R&M specialist like Tosco (Corp.) and either Saudi Aramco or Kuwait Petroleum Corp. could provide a significant U.S. market outlet for these Middle East NOCs (national oil companies) and allow the venture to tap undermanaged or undersupplied global R&M assets."
The same sort of tactic might be seen upstream, said McKinsey.
"Some reserve-long but capability-short NOCs could pursue ventures with independent E&P firms that possess the requisite exploration, field development, and reservoir management skills. In return for skill transfer, the independents could be given privileged access to resource development opportunities in the NOC`s home market.
"Alternatively, some NOCs could sell stakes in themselves to larger players to raise capital and tap world-class management and technical talent."
Another possibility, said McKinsey, was that some state firms might form alliances on a regional basis. A hypothetical consortium comprising the Argentinian, Brazilian, Venezuelan, and possibly Spanish state firms would likely change the shape of energy development in South America. Similarly, a combine of Indonesia`s Pertamina and Malaysia`s Petronas could do the same in Southeast Asia.
"Other NOCs might align to pursue market segments where they have complementary assets, capabilities, or relationships. As an example, Norway`s Statoil and Petrobras have extensive deepwater offshore operations and could form a venture (potentially with a deepwater drilling company or offshore fabricator) to capture a leading position in global deepwater development."
Despite its broad predictions, McKinsey cautioned that mergers and acquisitions were not the best choice for all companies.
"Deals don`t always create the value expected," it said. "Bigger is not always better. And growth can come through internal actions that do not require a transaction.
"While winners in the petroleum end game might participate in deals or opt to sit on the sidelines, all players would be well served to assess how M&A could reshape the industry and examine their strategies for competing within it."
For petroleum companies, identifying the options for M&A required answering several fundamental questions, said McKinsey:
- What is the value of integration both in existing businesses (e.g., E&P with R&M) and in potentially complementary ones (e.g., E&P with power generation or E&P with oil field services)?
- Is our firm best positioned to achieve global dominance by getting bigger, by getting broader, or by getting more focused?
- How big and broad can our company get through organic, internal actions, and how does this compare with our options to grow through M&A?
Companies that found success through such deals would fully integrate M&A into their strategic thinking and plans for growth, said McKinsey. They would know where value was created in their industry and where it remained to be created. They would carefully assess how to complement their existing operations with synergistic assets, relationships, and capabilities. And, they would readily anticipate the moves of their competitors.
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Shell Europe Oil Products Inc.`s 260,000 b/d Stanlow refinery in the U.K. is part of Shell`s European refining and marketing merger with Texaco Inc., announced in 1998. Photo courtesy of Shell.
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Oryx Energy Co. agreed to merge with Kerr-McGee Oil Corp. in 1998. Shown here is Oryx`s Neptune production spar (center), flanked by J. Ray McDermott SA`s DB-50 derrick vessel (left) and Diamond Offshore Drilling Inc.`s Diamond Ocean Lexington drilling rig (right). Photo courtesy of Oryx Energy.
