PART II: The is the second article in a three-part series on strategic issues affecting the global hydrocarbon industry - an analysis developed following an interview with 70 major industry executives. Part I appeared in the previous issue and part III will appear in a following issue.
In the post-industrial information age, con solidations are ubiquitous. The trend toward consolidation is pronounced in the manufacturing sectors and in businesses that need to improve their intellectual capital quotient.
The same trend toward consolidation via mergers, joint venture, and strategic alliances is impacting the hydrocarbon industry. The reasons for the consolidations are mixed: some arrangements are for offensive purposes; others are defensive in nature. Unlike the 1980s, mergers and acquisitions are friendlier and certainly not hostile.
More consolidation ahead
The reasons for making use of organizational tools such as mergers, acquisitions, joint ventures, and strategic alliances vary. However, they all provide three potential and important benefits:
- Important reductions in G&A (cost savings): A reduction in general and administrative costs (G&A) was one of the driving forces in the recent European refining joint venture between British Petroleum and Mobil. A good joint venture of this type can lower throughput per-bbl costs. The same cost lowering reasoning led to the recent merger of independent petroleum companies such as Kerr McGee and Oryx.
- Leveraging of complementary assets to enhance growth rates: This is certainly an important factor behind the merger of Total and Petrofina, and Reading & Bates and Falcon.
- Size improves negotiating power and enhances strategic contractual relationships: Larger size can mean greater financial resources and more political punch. For example, the merger of Technip with KTI provides the financial size and political muscle to compete more effectively with titans such as Fluor and Bechtel. If deals are made between majors and OPEC producer countries for equity participation, overall size will be an important deciding criteria in selecting partners.
In a recent speech, the Chairman of Texaco, Peter Bijur, said that we are "living the last days of the traditional oil company." These were "revolutionary" times, he explained, and the "arguments for marginal incremental changes are not convincing." He added that "oil companies' values were shifting from the value of reserves to the value of knowledge."
Considering the implications of these remarks, and the fact that oil demand will likely increase by 25 million b/d in the next 20 years, one can safely conjecture that to meet future needs, much more consolidation lies on the horizon. This makes it imperative for strategists to think through the implications of consolidation for their specific industry and company to weigh out their best options. The following is a review of the drivers behind consolidations in various business segments.
This category includes pure exploration-production firms along with medium size integrated petroleum companies. Companies such as Anadarko Petroleum and Apache, as well as Arco, Conoco, Phillips, and Marathon make up this group. During the 1980s, this group of oil companies suffered disproportionately as oil prices crashed in late 1985. They did not have the financial strength and management talent to adapt to a radically lower price environment. Many simply disappeared.
In the late 1980s, the independents as a group experienced a renaissance. New technologies, such as 3D seismic and horizontal drilling, helped lower finding and development costs. These innovations, available at affordable prices, allowed the independents to once again compete with the majors even in deepwater zones. The independents once again flourished, and became a thorn in the side of the major producers.
The crash of oil prices, below $10/bbl, and the emergence of super majors contemplating alliances with oil producing countries pose a new strategic threat to the independents. Even with the advent of new technology, the independents cannot compete against cheap producer country finding and development costs - costs below $2/bbl.
Thus, most independents are now embarking on a defensive strategy of consolidation. For example, Seagull merged with Ocean Energy, Kerr-McGee with Oryx, and Arco may merge with BP-Amoco.
Major E&P companies
The reasons for consolidation by the major petroleum firms are clearcut. It is known that BP, Amoco, Chevron, Texaco, and Mobil, among others, were seeking mergers long before the crash in oil prices in 1998. BP was negotiating a possible merger with Mobil in early 1997, when oil prices were above $18/bbl. Why the intense search for a partner?
- Replacing reserves at acceptable cost levels is becoming increasingly difficult. It is becoming harder for the majors to find elephant fields open to their equity investments and capable of making a real difference. Mergers help solve the problem.
- Large size is important leverage in negotiating a strategic alliance with a producer country. Such strategic alliances might require investments of over $100 billion over a decade. Only a super major could support such a huge investment.
If one super major-producer country alliance is formed, three or four more are sure to follow. Of course, the consequences for other hydrocarbon players of any such type alliance are enormous.
Technical service firms
There is an enormous amount of consolidation and reshaping occurring in the petroleum service industries. One can point to recent mergers between Halliburton and Dresser, Schlumberger and Camco, and Baker Hughes and Western Atlas. Among the drilling companies, there is a similar wave of consolidations. The reasons behind the sudden spate of recent consolidations are many and complex:
- Changing client needs: As clients downsize, they are outsourcing more technical services and often demanding integrated type services. Therefore, the merging of petroleum service suppliers such as Halliburton and Dresser allows them to provide a form of "one stop shopping." Furthermore, increased size and financial capability are comforting factors to owners now placing larger contract awards with one supplier.
- Outsourcing innovation: Another key factor driving consolidation is that most technical innovation is coming from outside the oil companies. Previously, the majors were doing most of the industry research and development. Today, it is the supplier industry performing the bulk of industry R&D. This research is very expensive and it makes sense to try to spread out the research costs over a larger base of revenues. Thus, it is likely that much more consolidation lies ahead for the technical service companies.
- Limiting suppliers: The smaller technical service firms are finding it increasingly difficult to market to owners seeking integrated services and wanting to limit the number of suppliers they use. As a defensive measure, many small and medium size technical service and equipment suppliers are selling out to bigger competitors. This is certainly the story behind the acquisitions of Weatherford, Camco, and Western Atlas.
It is important for any strategist to consider the large number of potential strategic permutations emanating from the petroleum service industry. The industry will continue to consolidate and create three or more behemoths, however, it is also possible that this industry might marry into the engineering contractor industry.
For example, a merger between Schlumberger and Aker Maritime, or even Fluor, to create a new hybrid organization is not impossible. Halliburton, in merging with Dresser, is creating such a creature through its Kellogg and Brown & Root units. The firm is even adding to it by forging equity ties with Japanese engineering contractors Chiyoda and JGC.
For some time, the engineering contracting industries serving the downstream and upstream hydrocarbon industries have been consolidating. The consolidation process is producing a few very large global engineering contractors and a large number of niche specialty contractors. Gradually, medium size engineering contractors such as Litwin, Davy, and Krebs are being absorbed into larger entities.
A primary reason for the disappearance of medium size engineering contractors is that they lack the financial size to support the overhead costs of globalization. Such firms cannot profitably spread their global business costs over a too-small revenue base. The results are always insufficient profitability, leading some engineering firms to undertake risky lump sum projects in a desperate attempt to keep up.
Another important reason pushing for further consolidation is the fundamental changes taking place within hydrocarbon companies. The petroleum and chemical companies are continuing to downsize technical staffs and limiting the number of technical purveyors they will deal with. This evolution favors the larger contractors and equipment companies adding further impetus to consolidation.
The likely next stage in the evolutionary process of consolidation is a growth in the number of arrangements between Asian, European, and US engineering contractors.
The recent technology alliance between Parsons and Uhde and their new strategic alliance for Asia with LG Engineering is a case in point. Another is the recent equity investment by Halliburton-Dresser through its Kellogg Brown & Root engineering division in the equity of the major Japanese contractor Chiyoda. On the owner side, there is the recent arrangement allowing Stork Engineering & Contracting to take over Dow's European engineering office, in return for a guaranteed project workload.
This continuing consolidation will hold opportunities, but also mortal danger for most players in the industry.
Consolidation in the refining industry is driven by a pressing need to cut costs. The refining industry is very mature and dominated by technologies that are quite old. Therefore, there is a need for economies of scale best achieved by increasing market share.
These circumstances helped trigger the recent European refining joint venture between BP and Mobil, and in the US between Texaco, Shell, and Pemex. It is clear that many more consolidations are needed to bring returns on capital up to acceptable levels. The near term future should witness more combinations among independents of the Ultramar Diamond Shamrock variety, and new attempts by the majors to either sell off or combine assets for cost saving purposes.
Increasingly, the petrochemical and basic chemical businesses are being labeled as cyclical commodity industries. Wall Street investors have tagged them as low growth and unexciting industries, with dismal futures and equally dour valuations (price-earning ratios). Some of these manufacturers are re-engineering their operations and merging with similar firms to bring down costs and increase market share. For example, this is what Akzo did in combining with Nobel Chemical to create Akzo-Nobel. Dow Chemical is also following this tack, by acquiring Union Carbide and building up its core basic chemical businesses while divesting itself of non-core assets such as Radian Corporation (an environmental technology company) and its engineering staffs in Europe.
However, there are many chemical firms that are embarking on a radically different new strategy - divesting old line operations and buying into the emerging genetic-bio-chemical industries.
The middle 1980s witnessed the demise of the independent oil company sector as prices crashed. Prospects appeared very bleak. Then, miraculously, several technological advances in the late 1980s helped redefine attractive oil and gas deposits. In particular, relatively inexpensive 3D seismic services and horizontal drilling allowed independents to once again compete with the majors, even in difficult environments such as the ultra-deepwater provinces of the Gulf of Mexico.
Throughout the late 1980s and early 1990s, a resurgent independent sector strongly competed with the majors as finding and development costs declined rapidly. Finding and development costs continued to decline up until 1994, when they hit $4.18/bbl. It was only in 1995 that finding and development costs rose again to $5.26/bbl, when heavy demand for field services, particularly drilling, pushed prices for rigs up significantly.
In the meantime, the majors were pressed by increasingly poor returns on their capital, due to pressure from the resurgent independents and the national oil companies, who were aggressively expanding into the international arena. The "new" oil patch economics were proving to be a two-edge sword for the majors - a cost blessing and competitive curse.
In response to the growing pressure, the majors pursued programs to radically re-engineer their operations, cutting thousands of employees and focusing on their "core competencies." Also, they pursued joint venturing and strategic alliances that would allow them to cut cost further. These programs, however, did not solve all the problems facing the majors.
Most majors were still not able to replace their annual oil production at anything greater than 80%. This prodded top managers at several of the major producers, with willing cooperation of their investment bankers, to study the possibility of a major merger. Such mergers provide ample scope for cost-cutting and help solve the problem of depleting reserves. Exxon paid a rich $8/bbl for Mobil's in-ground reserves, but received 6.9 billion boe.
Advent of super majors
The advent of the super-major also provided another tool to battle the "new" economics of the oil patch, brought on by upstream technological advances. It allowed the super-majors in the new business-political climate to attempt to forge strategic alliances with low cost producer countries. Such alliances would provide the super-majors with an unbeatable low cost advantage over other majors and independents.
The consequence of alliances between producers and producer countries for the technical services and engineering contractors is also potentially great. One simply does not need expensive technical services and engineering contractor assistance to produce oil in the Middle East. However, this could place more sophisticated technology providers, such as Baker Hughes, Schlumberger, and Halliburton for example, at a disadvantage. Conversely, it would favor larger contractors and equipment companies, capable of providing simple things cheaply.
To sum up, the wave of consolidations will continue for some time in the hydrocarbon world. It will bring both great opportunities and mortal dangers to the players involved. Therefore, it is important for top management and strategists to think through the nature of upcoming consolidations and ramifications.