The convergence of the gas, electricity, and petroleum industries is changing the shape of today's energy market. Add the recent megamergers among integrated petroleum companies, and you've got the ingredients for vast potential changes in the not-so-distant future.
We've examined what the future state of the converged energy industry could be, given these major structural changes. What will be the obstacles to creating value? What are the stakes of inaction? What are the strategic implications? Exploring these questions, we have highlighted factors that will likely drive the next wave of convergence, and identified "signposts" that will indicate future industry direction.
Convergence and its enablers
In the early 1990s, the term "convergence" came into vogue and today is broadly used to characterize many of the changes and events we are seeing in today's petroleum, natural gas, and electric power industries. We think of convergence in terms of "value chain integration" and describe it as the partial or full integration of the natural gas, electric power, and-to a lesser extent-petroleum industries, at one or more points along the value chain.
Contrary to what we often hear, convergence will be more than the simple common ownership of gas, electric, and petroleum businesses by a single entity, or a mere sharing of back office or operational support functions. Rather, convergence-driven integration has and will allow new and "reinvented" players to embrace energy market opportunities in a synergistic way. It has also led to the emergence of wholesale trading and retail marketing businesses that seek to bundle or arbitrage multiple energy commodities. Simply put, convergence is the business response to the natural value chain collisions that are occurring in these industries.
Several key forces have allowed the natural gas, electricity, and petroleum industries to converge. Forces such as gas and electricity industry deregulation, the continuing development of natural gas as the fuel of choice for power generation, and advances in power generation technology have all eliminated potential barriers between the industries.
Deregulation of the gas and electric industries is the most important of these trends. While the initial round of deregulation measures was put in place in the mid-1980s, of more recent importance was US Federal Energy Regulatory Commission Order 888, which in 1996 opened electric transmission access to non-utilities. This order superseded inconsistent state regulations and firmly established the basis for national wholesale competition for electricity. In Europe, Britain and Scandinavia have led the way in liberalizing gas and electricity markets, with the rest of Europe quickly following. Phased-in electricity liberalization began earlier this year, and gas is due to follow next year.
On both continents, the net effect is that gas and electricity continue to be traded more and more freely, and sophisticated spot and futures markets have developed quickly. In the US, Congress is considering legislation to reform the Public Utility Holding Company Act of 1935 (PUHCA). Its passage would allow a freer market for utility mergers and accelerate consolidation of gas and electric players. Meanwhile, state-by-state retail deregulation is, in some cases, forcing the divestiture or transfer of significant generation assets.
For several reasons, natural gas has become the fuel of choice for new power generation. Improvements in exploration, development, and production technology have made natural gas less expensive to find and produce, resulting in significant increases in economically viable natural gas reserves. A friend of environmentalists, natural gas burns cleaner than coal and oil-based fuels. And, due to its ease of transportation and efficient conversion into electricity, gas is increasingly viewed as "interchangeable" with electricity in some end-user applications.
As gas has become less expensive, highly efficient combined-cycle gas turbines (i.e., modular plants with low per-kilowatt capital costs) have been developed to improve the economics of power generation. The result has been a deluge of nontraditional entrants into the generation business. Integrated petroleum companies are also leveraging existing cogeneration assets and experience, a logical complement to expanding gas reserves and trading expertise.
Strategic rationale for convergence
There are a number of explanations for the combination of natural gas, electric, and petroleum players. The most prominent are the new-found abilities either to exploit enhanced market opportunities driven by customer demands and market forces or to leverage overlaps in capabilities, driven by the need for similar skills in certain business segments. Fig. 1 illustrates the primary segments along the electric power, natural gas, and petroleum business systems where integration opportunities lie. Clearly, convergence between electric power and natural gas is more complete than with the petroleum industry because of the two industries' interdependence.
Enhanced market opportunities
Natural gas and electric power players are seeking to capture bigger and broader opportunities more efficiently and effectively to improve their competitive positions-while also trying to survive as consolidation plays out. Specifically, a convergence-related acquisition or merger could allow companies to:
- Exploit customer-market overlap opportunities in the wholesale and retail markets.
- Improve cross-commodity and cross-market arbitrage trading opportunities.
- Expand beyond traditional service territories by building a wider geographical footprint.
- Build foundations for new growth platforms through additional businesses, commodities, and services.
Capability overlap opportunities
It is difficult for one company to develop all the skills at the levels needed to be successful in each part of the business system. Accordingly, convergence players are striving to capitalize on the synergies of similar and complementary skills, capabilities, and assets along various segments of the electric and gas (and petroleum) value chains:
- Retail. The marketing skills and capabilities required to sell gas are similar to those needed for electricity. Similar also are skills needed to bundle and deliver offerings around energy management or other residential needs, such as cable television, home security, and phone service.
- Wholesale marketing. Core skills such as trading, risk management, industrial and large commercial marketing, and back-office processes are similar. In addition, BTU relationships and arbitrage opportunities exist across commodities.
- Transmission and distribution. Although gas and electric networks are physically different, a stable of skills, provided services, processes, and back-office operations are similar. Additional opportunities exist, such as operating or acquiring other utility services (water, cable, telecommunications).
- Generation and midstream gas assets. Similar capabilities exist in areas such as plant optimization, maintenance, and reliability.
- Corporate centers. As mergers continue, significant savings are possible through reduction in redundant staffing and in bringing combined enterprises up to best-practice standards.
While the convergence game plays out, top management's challenge is to make the right strategic moves to position their organizations to capture these market and capability opportunities. Of equal importance, however, is the ability to execute as strategic moves are made. "Former utilities" have been transforming into "energy companies" by creating more-competitive mindsets within their companies. However, these new energy companies should not underestimate the enormous challenges of changing processes, technology, culture, and human performance as they proceed to create their futures.
Convergence marketplace events
Convergence among electric and natural gas companies is occurring at a rapid pace.
Over the past 2 years alone, 14 of the top 30 largest gas and electric players have made major convergence-related acquisitions or other defining moves.
Fig. 2 illustrates several notable transactions that have occurred within the past few years. Yet we believe the industry is still in the early stages of consolidation. If PUHCA reform passes, the pace may even surpass the relentless consolidation of the US banking industry.
Integrated petroleum companies
The ability of integrated petroleum companies to effectively integrate their value chain with gas or electric power opportunities is less apparent today than what we see directly between the electric and gas companies. However, their potential to impact the convergence market space is significant and indisputable.
Several traditional integrated petroleum companies are moving down the value chain into generation, trading, and to some extent retail gas and electricity. Fig. 3 depicts the current position of some major petroleum companies.
There are strong indications that majors such as Royal Dutch/Shell and Texaco Inc. are ready to step up their involvement in the power generation market and compete at the retail level for distribution of natural gas and electric power. Texaco currently operates about 2,500 Mw of power capacity and has more than 5,000 Mw of power capacity under construction; it also trades about $3 billion/year in its gas and electricity trading operations. Shell is aggressively pursuing a "fuel-to-power" strategy to expand its role downstream; it has acquired 50% of independent power producer Intergen, controls US gas pipeline Tejas and leading gas marketer Coral Energy, and currently sells gas directly to residential customers in Georgia.
Given this current level of activity, and the need for big oil management to refocus their attention once oil-oil consolidations run their course, when might we see a major oil company buying a large gas and electric utility? It may come as a shock to many industry participants and observers when, instead of buying the next mid-tier oil player, one of the three oil supermajors makes a major downstream gas-electric acquisition.
Although there are some plausible reasons why companies should not take the plunge, the case for major petroleum companies entering the electric power or energy retail business is a powerful one. Fig. 4 highlights reasons supporting both sides of the issue.
We believe there are a number of "signposts" that would portend a more-aggressive move by the major petroleum companies into the convergence market space. These include:
- Relatively low oil prices (i.e., the next sustained period of prices below $20/bbl), continued poor refining margins, and stable gas prices continuing through current wave of consolidation.
- Increasing gas reserves as a percent of total reserves, spurring big oil to look for convergence-related growth opportunities.
- Increasing entry into and investment in commercial generation and broader entry into gas and electric retail pilots.
- Continued privatization and deregulation of global utilities markets, especially passage of PUHCA in the US and the EU Directives for Gas and Electricity in Europe-each would catalyze an acceleration of merger activity.
- An increased pace of actual mergers, acquisitions, and alliances with electric utilities.
Some financial analysts believe electricity is not the answer for oil giants and may not be as close as we hypothesize. We believe this view will change as power generation, trading, and retail become truly competitive markets across the globe.
The future rushes up
As the energy world moves forward to a "convergence end game" over the next several years, we believe the following scenario describes the future global industry:
Energy will come to mean gas and electricity as much as it has oil in the past. Because there was no competition for 80 years, gas and electricity have been taken for granted. Now, these industries will move into the limelight.
Cross-commodity products offered by large companies will become standard. For example, Dominion Resources reflects this strategic thinking with its recent acquisition of Consolidated Natural Gas Co. Now Dominion's business extends from the wellhead to the consumer. Customers are offered both electricity and gas, as well as a stable of energy-related products and services. Importantly, Dominion can make economically based decisions every day about whether to store, sell, or produce electricity with its gas.
National (and soon international) retail brand positioning and stewardship will become critical. Already, companies are developing new names and building national and global image campaigns around them. Texas Utilities took its stock trading symbol, TXU, as its new corporate identity. Houston Industries Inc. shed its local utility holding company name and was reborn as Reliant Energy. We've also seen Constellation Energy and the emergence of a host of other new identities.
Conventional wisdom suggests that these incumbent utility "brands" can successfully position themselves to hold onto most of their home market share even after customer choice is allowed, as AT&T has in telecommunications. Seemingly, this has been confirmed by observations in California, the first state to deregulate its electricity market (although there is contrary evidence in the UK electricity market). However, once stranded-cost provisions in many US states expire and "killer" retailers move in from other industries, the perceived safety net could tear overnight.
Players with deep retail experience will truly be skilled at leveraging brands and bundled offerings. Those and world-class customer-relationship management skills have the potential to dramatically erode the comfortable market share of today's incumbents. Rapidly expanding e-commerce will be a key enabler in this arena because of its broad and relatively inexpensive ability to reach potential consumers.
Local incumbents may indeed look like the more-recent AT&T-struggling and losing market share but moving aggressively to position to win. Incumbents and new entrants alike will need to make critical choices about where and how to compete in this game over the next few years. Will competition be broad, across the value chains? Is the optimal position as a focused player, such as a distribution company-only consolidator?
Consolidation will accelerate and broaden to global scope as utilities rapidly buy each other, and major oil companies buy large electric-gas players. At first, the buying and selling will primarily be within national borders-such as the US banking industry analogy-but activity will soon expand across the globe. Although US utilities' recent investments in Europe, Latin America, and Australia have provided less-than-stellar returns (some players are even reversing course by selling out), we believe the lessons of these misadventures will teach other companies what to avoid, not eliminate their desire to forge ahead.
Foreign firms' entry into the US will likely accelerate as the US continues to deregulate. We have recently seen US investment by two UK players: Scottish Power acquired PacifiCorp, and National Grid acquired New England Electric System.
Further, it is only a matter of time before an oil company such as Shell makes a major electric-gas acquisition. We will also see more from global players such as AES, as they move beyond generation into distribution and trading on a worldwide basis. We will see competition increasing in Asia and other parts of the world as countries seek to make their energy markets more efficient. The day is not far into the future when a Japanese consumer will be able to choose his electric-gas supplier (on a bundled bill) from a list that includes major US and European players, as well as "Nippon Energy" and a host of other (e-commerce-enabled) suppliers.
Increasingly, the convergence game is being played out on a global playing field, and companies cannot hide for long. Early movers, by acting now, are betting they will be better-positioned in the long run because of the knowledge, skills, and assets they gain with the pursuit and capture of each new opportunity. These companies are focused on both internal growth and acquisitions. As long as global deregulation proceeds, key players will continue to use their significant cash to grow and consolidate the industry.
These players can create their "convergence future" only if they develop strategic options and provide a key differentiator-superior execution against management challenges.
The Authors
Glenn Rockefeller is an associate partner in the Strategic Services Energy practice of Andersen Consulting. His work is focused in the areas of strategy development, operations improvement, and organization design. Prior to joining Andersen, he was an engagement manager for McKinsey & Co. Inc., working exclusively in the energy and electric power industries. Prior to McKinsey, Rockefeller was the director of business planning for the US industrial gases operations of The BOC Group. He has an MS in energy policy and a Masters in governmental administration, both from the University of Pennsylvania, and a Bachelors in engineering from the Stevens Institute of Technology.
Rich Patrick is a Houston-based associate partner in the Strategic Services Resources practice of Andersen Consulting. Before joining Andersen Consulting, he was a senior engagement manager at McKinsey & Co. Inc. Patrick has a broad range of consulting and industry experience in the utility, oil and gas, and chemicals industries. His work has included trading and risk management-related projects; evaluating and implementing mergers, acquisitions, and alliances; reengineering critical business processes; managing large-scale change programs; and leading associated organization design, benchmarking, and valuation work. Patrick has a BS in chemical engineering from the Georgia Institute of Technology and an MBA in finance from the University of Chicago Graduate School of Business.
