Yesterday's Wall Street Journal raised the specter of another large wave of consolidation in the oil and gas industry, triggered by this week's announced merger between Norway's Statoil and Norsk Hydro. Unsurprisingly, the Journal focused on the industrial logic of such tie-ups, along with the mismatch between stagnating oil prices and rising earnings expectations. However, at the scale of the top companies, these rationales start to ring hollow, when we examine their potential drawbacks, which increase in scale in proportion to the size of the merged companies. On balance, further mergers among the top tier of companies seem unlikely to deliver lasting value to shareholders, while doubling down bets that are overdue for diversification.
The first drawback is a paradox of sorts. Many of the biggest mergers have been driven by the need for the major oil companies to continue growing reserves, to replace those consumed in production and to grow, overall. Finding oil on Wall St., rather than with the drill-bit has been a good way to shift reserves from weaker to stronger players--paralleled by the inevitable recycling of the least desirable acquired properties to smaller, lower-cost operators--but it generates its own limits. Having rolled up a long succession of companies, including Sohio, Amoco and Arco, BP's annual oil and gas production now stands just under 1.5 billion barrels of oil equivalent (BOE.) That means that in order to keep its reserves replenished, it must find the equivalent of a Thunder Horse field--or buy a company the size of the former Unocal every year. Revisions and extensions on existing reserves cannot handle that load forever. The bigger you are, the harder this gets. The Journal provided a nice illustration of this phenomenon by suggesting that Hess, valued at $14 billion, wasn't big enough to interest the Super-majors.
Another counter-argument is harder to quantify, relating to how big mergers are typically executed in the oil patch. The corporate headquarters usually doesn't change much, because axing the acquired company's headquarters staff and top management provides easy synergies. But the legacy folks attached to the acquired assets are still out there, and they will reflect their origins for years. Corporate cultures don't mix like martinis; they mix like yogurt with the fruit on the bottom. Could this phenomenon have contributed to the problems at BP's (formerly Amoco's) Texas City refinery? It's hard to say, but if you keep gobbling up new companies before you've fully digested your previous meals, it could matter a lot.
If second-tier companies feel the need to merge, in order to compete with the Supers, I can't argue with that. But I would suggest that for the largest players, the time has come to cast their sights in a direction that doesn't require running faster and faster on the reserves treadmill, and where the inevitable culture clashes would infuse truly divergent, stimulating viewpoints. That means branching out into energy segments that are either less mature, or that don't have this same reserve-replacement characteristic. When you consider the big external challenges of energy security and climate change, two logical choices emerge: investing in alternative energy, including biofuels and unconventional hydrocarbons, or electricity, which seems likely to start eroding oil's transportation market share within ten years.
There are good reasons in classical economics and current business practices for managers to conclude that there are significant returns to scale in this industry. At the same time, however, this is subject to diminishing returns at some point, perhaps around the current size of the Super-majors. When you're as big as Shell or ConocoPhillips, is there really any project you can't take on, any technology or region you can't afford to participate in? But when a CEO has built a personal reputation--and the firm's market capitalization--on successful mergers, how can he tell shareholders it's time to learn a new trick? That seems like the essence of good leadership.
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