Mergers and the Oil Eldorado
This article was first published in Middle East Economic Survey February 1st 1999.
The merger frenzy to which the oil industry is succumbing today should not be attributed to the recent price collapse. Prices fall and rise in the short period; mergers are designed to last for a much longer while.
Companies seek to merge, so desperately that some are willing to sacrifice their independence, for more fundamental motives than a transient price upset. These motives belong to a story that goes back to the early 1980s. A story which has a single hero: the shareholder.
In a remarkable revolution shareholders bestowed on themselves the divine right to growth. Read dividends and share prices growth. And this right supersedes those of all other stakeholders – labour, customers, and the countries where companies operate.
But shareholders are absentee landlords. They cannot achieve this growth objective without the help of insiders. They readily found them in management and brilliantly succeeded in mobilising them by offering share options. From then on management adopted the motto _deliver shareholder value’ that is growth plus the firm promise of future growth.
The management of oil companies faced, however, a big hurdle from the outset. Their’s was a low growth if not stagnant industry. The growth in profits could not be easily achieved through increases in gross oil revenues. Attention had to turn therefore to net revenues and return on assets.
Some companies began to retrench and downsize, selling non-core assets, buying back their own shares, and of course shedding labour everywhere including R&D departments. Although there were some mergers in the early days (Gulf- Chevron, BP-Sohio, Texaco-Getty) others preferred to reduce their size rather than expand.
As there are limits to reductions in employment, companies focussed next on the savings potential of new technology. They did remarkably well on this new front particularly in exploration and off-shore development. So well indeed that cost reductions can no longer be achieved at the same rate.
Lower taxation enhances net revenues. Oil companies thus lobbied governments to reduce or abolish upstream production taxes and royalties. Their greatest success on this fiscal front was in the UK.
Having exploited the cost-savings potential of labour redundancies and technology and done their utmost on taxes, oil companies are now trying to deliver growth promises through alliances, mergers or acquisitions. The new philosophy is that size does matter.
Downsizing achieved cost reductions by lowering the ratio of labour to assets, and increased rates of return by shedding non-performing activities. Mergers which, on the contrary, involve increases in size seek both lower labour ratios and higher returns by adding together complementary assets, and getting rid of duplicate facilities. Let us get bigger so that we can continue to cut.
The expected benefits of mergers relate to economies of scale, labour redundancies and the mysterious workings of synergies. For these to obtain one needs to find a partner that is both suitable and willing. Alas, the many that are eagerly willing today are not always suitable.
The secret hope is that mergers will increase profits by increasing concentration in both input and output markets. This is perhaps what synergy means. Companies of course will never refer to the small elements of market power that mergers may give. Twisting the meaning of concepts they say ‘We need mergers to enable us to compete’.
Are mergers the last step in the quest of growth in profits? The most successful will realise benefits in two or three years’ time, and with luck generate then after a steady stream. But shareholders demand growth not constant incomes.
One avenue, the companies hope, remains for profit growth. Its name is access to the rich oil reserves of the Middle East and Latin America. It is there that the oil paradise lies. Past nationalisations have closed its doors. And the companies’ most cherished desire today is to return to Paradise Lost.
Gatekeepers are more likely to open its doors when they have been weakened by impoverishment, political pressures from the West, and ideological brainwashing. For this reason, some may think that low oil prices today are a blessing in disguise.
Once inside paradise companies will naturally want to produce without constraints. It is not difficult to imagine the possible impact on oil prices and the political consequences of low revenues for exporting countries. The forced entry of paradise with the idea that maximum production is bliss may hold a vengeance against companies. Their profits are not immune to low oil prices and their investments to the assault of reborn nationalism.
There is no Eldorado in oil without a production policy. Companies fascinated by the haunting image of this Eldorado should begin to think about the necessary marriage between access to huge and cheap reserves and production restraints. Are they prepared, for example, to shut down a barrel of high cost oil for every new barrel of low cost oil they may produce in the Eldorado? Or will they blindly bring the roof down on fragile governments of oil countries and ultimately on themselves?
Think of the Venezuelan elections: oil nationalism is not yet dead. Think of the parlous state of the oil market: maximizing production brings about a price collapse. What should matter is profits and revenues, and more often than not it is price which sustains them, not maximum production and greater market shares. A simple notion which everybody seems to have forgotten at great peril to all concerned.