For Oil and Gas Companies, Size Really Does Seem to Matter

Dealmaking activity remains in full force in the oil and gas sector. Notable deals are being cemented in many segments of the industry, including refining and exploration and production. Some of the largest deals have been among the exploration and production companies, E&Ps as industry experts refer to them. Cost-reduction pressures and the need for size – deal drivers in many consolidating industries – are strong motivations for E&Ps to seek out deals. The industry consolidation that began in the late 1990s and led to the creation of giants ExxonMobil Corp., BP Amoco PLC, and TotalFinaElf SA, continues today, experts note. Chevron Corp. and Texaco Inc. await approvals on their $36 billion transaction and scores of other deals are being announced, including Westport Resources Corp.’s acquisition of Belco Oil & Gas Corp. for $930 million, Williams Cos.’ absorption of Barrett Resources Co. for $2.4 billion, and Amerada Hess Corp.’s $3.2 billion acquisition of Triton Energy Ltd. Industry followers say that the decline in gas prices in 1998 and 1999 was a key factor that forced E&Ps into a rapid cost-cutting and consolidation mode. OPEC had increased its output at the same time that Asian economies were heading into recession, and oil prices fell, notes Ed Porter, research manager at the American Petroleum Institute in Washington, D.C. “Drilling activity went through the floor both in the U.S. and internationally. Of the immediate short-term factors, the drop in prices was clearly the single event that triggered consolidation. It at least affected the timing of the mergers, if not the events themselves,” he says. Oil and gas companies have been using m&a as a tool to contain costs, notes Paul Weissgarber, vice president and leader of the process industries practice at A.T. Kearney Inc. In recent years, firms have been achieving cost savings through the increasing scale they gain with acquisitions, he says. Another reason why the biggest companies began to combine is that exploration and production has been moving to more remote and challenging locations, says Phillip Ellis, head of the global oil and gas practice at Boston Consulting Group. The cost and skills required to develop projects in those areas has grown, and the major companies have been growing in response, he adds. Now that North America, the North Sea area, and other more familiar territories have been heavily explored and developed, E&Ps are heading into more remote places, where it is easier to find oil and gas, and companies must be able to deal with uncertainty and with foreign environments, says Eric Nelsen, vice president and head of the global oil and gas practice at Mercer Management Consulting. “Those skills don’t necessarily require a company to be big, but often when foreign governments are deciding on which company to work with, they like to have the comfort that comes with working with a firm that they feel will be able to stick it out for the long term, in case the first wells go dry or something else happens,” he says. The prospect of exploration and production opportunities opening up in the Middle East in the future is prompting companies to prepare to compete for projects there, says Porter. If the sanctions against Iraq were to be lifted, he says, there would be enormous exploration potential in the country. Other Middle Eastern countries that might invite companies to participate in development projects include Iran, Kuwait, and United Arab Emirates, he adds. “We are seeing some potential on the western side of the Gulf, with the Saudis opening up the development of their natural gas system,” he says. The companies that are actively involved in those development projects, or that have expressed interest in participating, tend to be the very largest companies. Whether they have real economic advantages because of their size or whether they are just perceived that way by the governments of those countries, they will have a competitve edge in bidding on the projects, he notes. On the other hand, Ellis says he is finding that most of the national oil companies are interested in cultivating relationships with smaller firms. They still want to maintain their relationships with large companies, he adds, but they also want to expand their portfolio of partnerships. Medium-sized companies that want to remain independent and be international players will have to find the right partner, he states. “They will not be able to stay independent unless they are fully valued on their fundamentals, which most of them are not, and unless they have a peculiar strategy that only they appear to be able to execute. In our view, one of the most important strategies that these middle-size companies can have is to find a national oil company that they can do business with,” he says. While North America has been largely explored and developed, much of the current m&a activity in the industry has centered on U.S. firms acquiring Canadian companies in an effort to establish a foothold in that country. In recent months, Conoco Inc. has acquired Gulf Canada Resources Ltd. for $6.3 billion, Hunt Oil Co. snagged Chieftain International Inc. for $600 million, Anadarko Petroleum Corp. solidified a $1 billion deal with Berkley Petroleum Corp., and Calpine Corp. has picked up Encal Energy Ltd. for $1.2 billion. One of the main attractions of the area is that Canada has been far less explored than the U.S., says Henry Groppe, a principal at Groppe, Long & Littell, a Houston-based oil and gas analysis and forecasting firm. Because the country has been less explored, many startup companies have sprung up in the region in recent years, and Canada now has many small and medium-sized companies that are focused and specialized. The smaller companies also generally develop more prospects than they have resources to support, so they present interesting targets for U.S. companies, he says. Additionally, says Nelsen, oil and gas production costs in Canada are lower than those in the U.S. because of the exchange rate between Canada and the U.S. That makes it cheaper for American firms to acquire their Canadian counterparts than to explore and developed reserves at home. “There are good values in Canada. That’s where the action is in North America. If you are a company that wants to have a presence here, you need to move into Canada,” he says. As E&Ps aim to grow in size and reduce costs, it appears as though their strategy may be paying off. “If you just run the numbers, the larger oil groups are achieving greater recognition from the stock market than the smaller ones. One of the reasons for this is that the majors have been able to squeeze a lot of costs out due to the scale advantages of the acquisitions they’ve made,” Ellis remarks. In general, the bigger firms are producing higher shareholder returns than the more modest-size companies, he adds. They are also generating higher “expectation premiums.” “The stock market appears to be valuing the major oil groups above their fundamentals. That expectation premium is ranging between 10% and 20%, which is in contrast to some of the more modest-size players, many of which have expectation deficits,” he adds. Weissgarber agrees. While a primary driver of recent oil and gas deals has been cost reduction, many merged companies are finding that they are outperforming smaller players in shareholder return. Their cost-effectiveness allows them to improve productivity and margins.