More incentive than ever for producers to merge

How second and third tier oil companies move up

William Furlow
Technology Editor

The supermajors¹ Reserves² vs. market capitalization³ [46,634 bytes]

The long-term effects of the BP offer to buy Amoco and the underlying market pressures that caused it may take years to sort out. The resulting merger, to be known as BP Amoco, will create the UK's largest company and the oil industry's third largest player - behind Exxon and Royal Dutch Shell.

There are three distinct tiers of major oil companies, according to Amoco historian and business professor Joseph Pratt of the University of Houston. The BP Amoco deal demonstrates the colossal task of jumping from the heavily populated obscurity of the second tier to the exclusive ranks of Exxon and Shell.

Prior to the BP/Amoco announcement, Royal Dutch Shell and Exxon were in a league of their own, with oil and gas reserves in the neighborhood of 13 billion boe to 20 billion boe and net incomes around $8 billion. This was the top tier of the industry and the distinction between these giants and the other players was significant.

Second tier

The second tier, which included BP and Amoco, had reserves in the 6-7 billion boe range and net incomes of around $3 billion. As Pratt points out, in a mature market it would be difficult for a single company, such as Amoco, to more than double its reserves and net income without a merger.

Even more unlikely is the prospect of third tier companies with reserves around 4.5 billion boe and net incomes below $3 billion getting a seat at the big table. Clearly the only way any of these companies could hope to compete with Exxon and Shell on a level field was through merger.

This has happened with BP/Amoco. The question is: will it happen to Chevron, Mobil, ENI, Texaco, or Arco? Pratt said there are always talks going on between these second and third tier players, but with the top tier now grown to three, there is increased incentive for the other players to merge into a first tier giant.

Size does count

With oil prices dancing around what some consider to be an all-time low, corrected for inflation and other factors, now will be the time for more of these mega-ultra-super mergers.

According to Pratt, such mergers are nothing new and actually make up the basis of the modern oil company. The last round of monster mergers came in the 1980s, fueled by a need for assets. Oil companies at that time were cash rich and found the prospect of buying a company for its reserves more attractive than looking for new reserves.

The current trend, if that is what this merger predicts, will be driven by the age-old concept "bigger is better."

Such scale thinking can be especially wise as profit margins shrink. True, the BP/Amoco deal was more than a response to low oil prices, but the fact remains that a company with such a massive combined capitalization, estimated at $110 billion, can hang on a lot longer at $14/bbl oil than a BP or Amoco on its own. Also there is the benefit of diversity that comes from this particular match.

Pratt said BP/Amoco will benefit greatly from the differences in their previous strengths. The merged company is better balanced globally and will finally allow Amoco to take its domestic strengths overseas. Amoco missed out on earlier opportunities to be one of the first truly international oil companies after its fields off Iran were expropriated in 1978.

By the time it had a second chance, Amoco was relegated to the fringes of this market. With this merger, Amoco can finally take the strengths it has developed in the Americas overseas. BP, on the other hand, will benefit from Amoco's natural gas operations and strong presence in the US downstream market.

JVs take a back seat

Pratt said mergers have been around as long as oil companies (for example, Royal Dutch and Shell), but the more recent phenomenon of alliances and joint ventures is relatively new. He said it will be interesting to see what affect this recent merger will have on the proliferation of alliances. "There's nothing like a merger to clear the decks and establish who's in charge," Pratt said.

A merger is an opportunity for a company to make some dramatic corrections in direction. At the same time, mergers offer many of the advantages that have been fueling recent alliances - mainly a sharing of risk and technical expertise. In such a case, companies not only combine their strengths, as they do in an alliance agreement, but also their weaknesses.

Even in a good fit, which Pratt said he believes the BP/Amoco deal is, there are redundancies that can be trimmed and efficiencies that make the deal more attractive than an isolated JV or alliance. Another advantage is that in a merger there is none of the ongoing negotiations and give and take companies must live with when forming an alliance. Such interaction may be good for the individual companies in the alliance but overall subtract from the effectiveness of the effort.

Impact on alliances

One of the aspects of this pending merger that Pratt said he will be eager to follow is the effect on existing alliances the merger partners are involved in. For example, BP's European alliance with Mobil would mean an implied relationship now between Mobil and Amoco. By the same token, the Altura company recently formed by Amoco and Shell to oversee activities in the Permian Basin of West Texas may imply a relationship between BP and Shell. How such alliances will survive and what role they will play in the new companies are questions only time can answer.

As far as the effect of this merger on employees, Pratt said it should not be viewed as a bad thing. While such a dramatic move can be unsettling to employees who wonder if they may be laid-off or re-assigned, ultimately those who remain will in effect benefit from the same jump in status that the companies have enjoyed. These workers will now be part of a first tier organization and will thus have greater resources to draw on and a more stable employer when facing hard times.

The bottom line will always dominate in a tight market. With oil prices near an all-time low, and exploration costs in deepwater areas rising, oil companies will tend to abandon such innovative concepts as strategic alliances in favor of the tried and true method of merging, as a form of belt tightening. Pratt said there is no more reliable way to rationalize resources and cut costs.