How to survive the merger battle

David Knott
London
[email protected]

The petroleum majors have all completed massive cost reduction and rationalization programs and are enjoying record returns.

This is the view of the Pan-European Oil Team at UBS Ltd., London, which reports that these programs have slowed and that the industry in general is at the tail end of a restructuring phase.

So, what's next? When industry returns begin to fall, as they inevitably will, according to UBS, the only way to boost profits will be by merging two cost bases into one.

"Critical mass and global reach are vital for the industry, however," said the team, "and with the industry entering a new phase of increased access to enormous projects in areas such as the former Soviet Union and Middle East, financial strength will be more important than ever before."

Refining and marketing is the industry's most labor-intensive sector. U.S. companies are consolidating, while European companies are likely to follow: "The BP/Mobil joint venture is the first example of this, while Royal Dutch/Shell is pursuing a policy of consolidating small-scale players."

Critical mass

UBS reckons that only five European players have the critical mass and geographic scope to compete globally with U.S. majors.

These are British Petroleum Co. plc, Royal Dutch/Shell, Elf Aquitaine SA, Italy's Ente Nazionale Idrocarburi (ENI), and Total SA.

"Any concentration in the industry would make survival even harder for small-scale regional players," said UBS, "and would force a significant change in approach in Europe.

"The industry will continue to concentrate over time, but European action will be a defensive reaction as opposed to first mover initiatives."

Among potential mergers that UBS highlights: BP and Mobil Corp., which have great similarities in performance; and Enterprise Oil plc, London, and Saga Petroleum AS, Oslo, to create the world's largest pure E&P company.

"Merger of Enterprise and Saga is a remote possibility at present," said UBS, "given that Norsk Hydro and Statoil hold more than 20% of Saga, and Norwegian culture is not ready for such a ground-breaking deal.

"Looking further ahead, we can see consolidation as being the only survival route for the plethora of companies in central and eastern Europe, with OMV playing a prime role in the process."

Survival strategy

If big players are merger-hungry, what will happen to the little guys? I asked Jeremy Eldon, global head of oil and gas research at UBS.

"The loss of the independents would not be a negative," said Eldon, "from a shareholders' perspective. So they will have to find niches if they are to survive.

"In the future, companies that are winners will either have a world-class performance or exploit a niche market. The strategy that doesn't work in this situation is for a small company to spread itself out."

Eldon says that the refining and marketing sector is where the benefits of scale are most important. Hence refiners and marketers are under more pressure than other sectors from shareholders.

"In exploration and production, it is hard to find niches," said Eldon, "since the sector has a global spread and the product is a commodity. But E&P returns are good, so companies here are under least pressure from shareholders."