No New Wave of Mergers on the Way
Oil prices could still bounce back to $100 a barrel, though that seems an unlikely prospect right now. One thing we can be sure of is that the market will always be unstable; another is that demand is the only factor that matters when defining strategy

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On May 15, 1911, the United States Supreme Court found Standard Oil guilty of violating the Sherman Antitrust Act, which had been passed in 1890 but had never been enforced. John D. Rockefeller’s company was split into thirty-eight units, including Exxon, Mobil, Chevron and Amoco. Ever since, the oil industry has struggled to reconcile size, which reduces costs but confers market dominance, with fragmentation, which creates uncertainty but favors competition and reduces prices. Eighty-seven years later, in 1998, oil fell to $10 a barrel. This triggered a wave of mergers, and the two biggest remnants of Standard Oil, Exxon and Mobil, fused to create what is still the biggest private-sector oil company. Today, two decades later still, prices and profits have been low for more than two years. Supply continues to exceed demand, and we might expect this uncertainty to result in more megamergers.

The Future of M&A lies outside the United States

Mergers and acquisitions have risen in 2017, but these have been marriages of convenience between small to midsized companies, and there is no immediate sign of any major deals like those of yore. In the U.S., the biggest and most profitable market, midyear M&A volumes stood at USD 43 billion, up 35 percent on the USD 35 billion for the whole of 2016. The spotlight is still on big companies operating outside the country, which show little sign of entering into deals like those of twenty years ago. This is mainly because the context is very different and the prospects less gloomy. In late 1998 and early 1999, The Economist published a detailed review of the energy sector, claiming that the oil industry was out of date, a tangle of rusty pipes that risked being swept away by the new kind of organization typified by Jeffrey Skilling’s Enron. Enron was the new star in the U.S. financial firmament, though its luster was already tarnished. Created in 1985 by merging two gas pipeline companies, Enron grew up during a period of electricity market liberalization and became a major innovator before the dot-com bubble burst.  It exemplified the new business model that traditional oil companies could never aspire to, despite the urgings of strategy consultants, because they were too closely tied to physical assets like oilfields, refineries, and petrol pumps. The fact that no one really understood what Enron did was neither here nor there— but then everything became blindingly clear in December 2001, when it became the biggest bankruptcy case in the history of capitalism. During the confusion of the late 1990s, banks made lots of money from large-scale investment in Enron’s high-tech trading. They looked askance at the old oil industry, constantly criticizing its supposed lack of foresight and innovation. The Asian recession of 1998 had reduced demand for oil, and Iraqi output was coming back onstream after the first Gulf war, thanks to the oil-for-food program.  This created excess supply, and prices fell to $8 a barrel, the lowest figure in real terms since the 1930s. One famous Economist cover in March 1999 suggested that the world was drowning in oil, as the price fell below $5. Profits slumped, and even the most optimistic forecasts showed prices staying below $30 a barrel for the next twenty years. Huge numbers of people lost their jobs and could be excused for thinking that traditional oil companies had had their day, now that gasoline was cheap, abundant, and sold online. They must have envied their more enterprising or fortunate friends who had gone to work for big-name traders like Enron, or for companies like Edison Mission, Dynegy and Entergy, firms that have since shut down or now serve limited areas of the United States. Life was not easy for the people running these companies. Profits were low, and analysts were urging them to cut costs and innovate, as some gas and electricity suppliers were doing in the face of competition from energy traders.

The oil industry adapts to a new era

The first company to respond was BP. In August 1998, it acquired its U.S. rival Amoco, another relic of the dismantled Rockefeller empire. This came as a surprise, partly from a financial viewpoint but also because it marked a British incursion into American territory and an industry of strategic importance to the country’s energy supply. BP has not always had an easy ride since then, especially when it was forced to pay huge fines following the Deepwater Horizon oil spill in 2010. This opened the floodgates for a series of mergers: most importantly between Exxon and Mobil, then Total and Fina, then Chevron and Texaco. After that, there were none of similar size until 2015, when Shell acquired BG Group (BG) after eyeing it for over a decade. However, this was more an acquisition of complementary operations, mainly in the gas sector, which gained it political support in Great Britain and allayed the concerns of the antitrust authorities. The takeover was also eased by BG’s growing difficulty in making the transition from British monopoly to major international company. The 2014 collapse in crude prices squeezed the huge profits of companies that had once charged more than $100 a barrel. The long-term fortunes of the three biggest, Shell, BP and ExxonMobil, matched those of the industry as a whole, accounting for 70 percent of total earnings by the big six private companies, which also included Eni, Total and Chevron. Their combined earnings fell from a peak of almost $100 billion to just $11 billion in 2016, a record low in real terms. This put huge pressure on their costs, with the losers being the service providers managing major projects for them. One of the biggest changes over the past twenty years has been the oil companies’ gradual outsourcing of production, which began after the first price crash in 1986. Partly thanks to the rise of the finance sector, they have become leaner, concentrating on their traditional core business of geological exploration and paying other companies to build their production infrastructure. They still have quite a lot of refining capacity, but this is the weakest link in the integrated supply chain, with relatively high costs and low profits. This is a legacy of the past: no oil company has built any new refineries in its existing markets, and some have been shut down.

Big Oil becomes more agile

Oil companies have become more flexible since 2014, with less infrastructure and lower costs - though this is partly down to reduced business volumes and outsourced market risk. The biggest loser has been the service sector. Not surprisingly, this is where the biggest oil industry merger of 2016 took place: the $32 billion fusion between General Electric’s oil and gas operations and Houston-based Baker Hughes. The latter company had tried to merge with Halliburton in 2014 as oil prices began to collapse, but this move was thwarted when U.S. and European antitrust authorities objected that there was too much overlap between the two companies’ services. This was not a problem for the 2016 merger since GE specialized in compressors and Baker in wells. In August 2017, Total acquired the oil operations of the $40 billion Danish conglomerate Maersk, which specialized mainly in seafreight and shipbuilding, for $7.5 billion in shares and debt. Total had been expanding fast for several years. Maersk needed to rationalize: it was in difficulty thanks to low demand for freight services and declining charter income. Total used the acquisition to increase its output, with an ambitious target of 3 million barrels of inhouse production a day, and thereby achieve economies of scale. The wave of mergers that followed the last oil-price crash in 1998 is unlikely to recur because today it is clear that prices could quickly bounce back toward $100, distant prospect though this might seem at the moment. In 2013, when global demand was less than six million barrels a day, no one could have dreamed that oil would cost $50 a barrel within three years. Market instability is the only certainty, which makes life difficult in an industry that invests billions of dollars in projects with payback periods of up to fifty years. The only real factor in defining strategy, whether for mergers or anything else, is the demand for oil.  And demand is growing, whatever short-term financial ups and downs the industry may experience.