COMPANY NEWS: Phillips to acquire Tosco in multibillion-dollar deal

Feb. 12, 2001
The most recent wave of mergers and acquisitions shows that the oil and gas industry continues to reshape itself.

The most recent wave of mergers and acquisitions shows that the oil and gas industry continues to reshape itself.

That reshaping arguably will be most dramatic in the US downstream. There, a speculated consolidation among refiners-spurred by more-stringent federal rules on fuels specifications shutting down smaller, less efficient plants-has already gotten under way with a big splash.

Phillips Petroleum Co.'s surprise proposal early last week to acquire Tosco Corp. for $7.49 billion in stock and debt had industry analysts buzzing over the deal's rationale. In terms of capacity, the combined company would become the second largest refiner in the US, just behind ExxonMobil Corp., and the third largest US retail marketer, with well over 12,000 outlets in 46 states.

Meanwhile, Houston-based El Paso Energy Corp., renamed El Paso Corp., has completed its $24 billion merger with Coastal Corp., Houston, to create the fourth largest US energy company, with a total value of more than $50 billion, officials said.

The service-supply sector has seen its fair share of M&A action as well:

  • First Reserve Corp. and Odyssey Investment Partners LLC agreed to acquire Halliburton Co.'s Dresser Equipment Group (DEG) in a transaction worth $1.55 billion in cash and assumed liabilities.
  • Drilling contractors Patterson Energy Inc., Snyder, Tex., and UTI Energy Corp., Houston, agreed to merge. Patterson provides US land-based drilling services. UTI provides contract drilling and pressure pumping services. The merged company will be called Patterson-UTI Energy Inc.
  • Takeover talks between Keppel Corp. division Keppel Fels and the Dutch offshore repair and conversion shipyard company Verolme Botlek BV have failed after months of discussions.

Phillips-Tosco deal

Under Phillips's acquisition agreement, the company will issue 0.8 common share for each Tosco share and assume nearly $2 billion of Tosco's debt. This agreement values Tosco at $46.50/share, which is a 34% premium over its Feb. 2 closing price on the New York Stock Exchange, sources said.

Based in Old Greenwich, Conn., Tosco has grown through acquisitions from a single-refinery company in 1992 to become the largest US independent refiner and marketer.

Phillips officials earlier had sought a joint venture with another refiner to run the company's refining and marketing (R&M) operations, while the Bartlesville, Okla.-based firm concentrated on its more profitable upstream operations. However, negotiations between Phillips and Conoco Inc. in 1996 on a possible JV fell through. Phillips also broke off a preliminary deal with Ultramar Diamond Shamrock Corp. in 1999.

"Phillips certainly was giving signs that it was trying to get out of the refining business instead of getting in," said Robert Hermes, president of Purvin & Gurtz Inc., a Houston consulting firm. "Apparently, Phillips couldn't get the price it wanted for its operations, so it decided to stay in the downstream market."

Deal praise, concerns

Phillips's move to acquire Tosco took many industry analysts by surprise, especially following the integrated major's persistent attempts to form a JV for its R&M operations.

"I would have been less surprised if Tosco was buying Phillips's refining operation," said Ray Ory, vice-president and manager of the Houston office of Baker & O'Brien Inc., an advisory firm for the refining industry.

Financial analyst UBS Warburg was thrown slightly by Phillips's announcement, saying that its decision clearly illustrated a "material change in strategy" for the company. "Given the trend in the industry to extract capital from the lower-return R&M and chemicals operations and redirect it to the higher return [exploration and production] operations, [this] move by Phillips has come as a surprise."

Tosco has nine refineries with 1.3 million b/d of capacity, making it the third largest US refiner in terms of capacity, behind ExxonMobil and BP. Phillips is ranked 17th among US refiners, with three plants totaling 355,000 b/d of capacity (OGJ, Dec. 18, 2000, p. 60).

Tosco acquired many of its refineries at bargain-basement prices. Analysts said Phillips seems to be acquiring Tosco at the top of the current refining cycle, after a rare year of fairly good annual returns for that industry. "That's certainly a good deal for Tosco shareholders," Ory said.

"Given the substantial improvement in US refining margins in 2000," UBS Warburg stated, "we are interested in the underlying assumptions used by Phillips in assessing the Tosco deal.

"As we do not see 2000 as the start of a multiyear high refining margin cycle, we assume Phillips has assumed a return to midcycle margins at some point in the future."

Meanwhile, mounting losses forced several oil companies to cut their European refinery throughputs by 20%, with others advancing scheduled maintenance work during the downturn, industry sources reported. Singapore, Asia's swing refining center, also reported margins in the red.

Only US refineries remain profitable. But Gulf Coast refiners running US light crudes recently reported margins have deteriorated significantly, sources said.

"February is usually the trough in refining profitability. What kept margins at a higher level to this point was demand for heating oil, but those inventories are rising again," Ory said.

However, Tom O'Malley, Tosco's chairman and CEO, foresees an extraordinarily strong cycle for the refining industry over the next 4-5 years.

The US market for refined petroleum products is growing at a glacial pace, "about 2%/year, optimistically," said Hermes.

But no new refining capacity can be built, and some existing capacity could be lost as a result of existing and pending government regulations pertaining to the environment and other issues.

"So if you're in this business for the long term, you have to buy existing capacity, hoping that it will be more profitable in the future than it has in the past. And at this point, there are fewer and fewer Tosco-like companies to be bought," said Ory.

More immediately, Phillips officials figure to cash in on the greater efficiency of the combined companies, through estimated pretax cost savings from synergies of $250 million/year.

Operations

Once the deal is closed, which is expected to occur at the end of the third quarter, O'Malley will become vice-chairman of Phillips's board and CEO of the combined refining, marketing, and transportation (RMT) operations.

Phillips's RMT operations will be based in Tempe, Ariz., where Tosco Marketing Co. is now headquartered. That puts it a long arm's length from Phillips' Bartlesville headquarters, where only a small amount of the combined downstream operations, including research and development, will be located.

There is little overlap between Phillips's and Tosco's refining and marketing systems. "Phillips is basically oriented to the [US] Midcontinent, while Tosco is coastal," Ory said.

Phillips's Sweeny, Tex., refinery, with 205,000 b/d throughput capacity, is its largest. It has another 130,000 b/d refinery at Borger in the Texas Panhandle. Its third and smallest refinery, at 25,000 b/d, is in the Salt Lake City area.

Tosco's biggest refinery, at 295,000 b/d, is at Roxanna, Ill. Other plants include: one each at Linden, NJ, Trainer, Pa., and Belle Chasse, La.; two connected plants at Los Angeles; two connected pants at San Francisco; and one at Ferndale, Wash.

The companies' combined retail outlets include 6,300 from Tosco under the '76 and Circle K brands, and 5,900 under the Phillips 66 brand. Tosco is the largest operator of company-controlled convenience stores in the US.

The combination will give Phillips more than a 15% share in the California, Oregon, Washington, and Arizona markets for refined products.

When BP acquired ARCO last year, public concerns over BP's large Alaskan oil holdings and its major position in the West Coast refining and retail sales market caused federal officials to force a sale of the ARCO Alaska properties. Phillips bought those properties for about $7 billion and nearly doubled its total reserves.

But certain analysts don't expect similar problems with the Phillips-Tosco deal, because neither company has BP's dominance in either the Alaska upstream or the West Coast downstream markets. Only Tosco's Washington refinery processes Alaskan crude, said Ory.

Other analysts perceive regulatory scrutiny on the West Coast as Phillips's primary hurdle before closing its deal with Tosco. "Although Phillips does not expect to effect any disposals following the completion of the transaction," UBS Warburg said, "it is conceivable that the [US Federal Trade Commission] may require some West Coast refining disposals."

However, some analysts are concerned that Phillips may become too reliant on refining as a result of the proposed acquisition. The combined refining capacity will be almost three times Phillips' current US oil production.

Other reactions

Reactions from some credit rating firms and other analysts were primarily positive following Phillips's announcement.

Chicago-based ratings service Fitch IBCA Duff & Phelps placed Phillips's unsecured debt and trust preferred security ratings on rating watch with positive implications. Presently, Fitch has assigned a rating of BBB to Phillips's senior unsecured debt and a BBB- rating to its trust preferred securities. Phillips's commercial paper rating, meanwhile, has been affirmed as F2.

Fitch placed Tosco on rating watch with positive implications as well.

Overall, Fitch views Phillips's Tosco acquisition as positive in terms of the company's operations and finances. The ratings service said, "Operationally, the combined compnay will have economies of scale that should benefit it in the form of cost savings and expanded marketing opportunities.

"Financially, the issuance of equity strengthens the balance sheetellipseTosco's downstream operations provide balance to Phillips's existing operations, which are leveraged to the upstream."

Dain Rauscher Wessels said of Phillips's announcement, "This transaction clearly represents a significant change of course, and we understand why some Phillips investors were taken aback." However, the analyst thought that Phillips CEO Mulva did a sufficient job in explaining the shift, saying, "Now, with the combined impact of ARCO Alaska and the Tosco acquisition, [Mulva] has transformed Phillips into a much stronger company, a fully integrated major with higher quality earnings and a stronger balance sheet, with little, if any, earnings dilution in the process."

The Phillips-Tosco marriage will have a considerable impact on the US lubricants business as well, according to Little Falls, NJ-based consulting firm Kline & Co. Inc.

"Everyone must recognize that with Tosco comes the announced acquisition of Sunoco [Inc.]'s branded lubricants business," said William R. Downey, Jr., vice-president of Kline's petroleum and energy practice. "[The] three regional players-Tosco's 76 lubricants company, Phillips, and Sunoco-will come together to form one national player," Downey said. If no spin-offs are launched, the newly formed company would become the fifth largest branded lubricant producer and marketer in the US, he says.

El Paso-Coastal

The US Federal Trade Commission cleared the way for El Paso's combination with Coastal after company executives agreed to divest interests in five pipeline systems and other assets.

Included in the pipeline divestitures are El Paso's Midwestern Gas Transmission system; Coastal's 16% stake in the Iroquois pipeline; and Coastal's 50% interests in the Empire State pipeline, the Stingray pipeline, and the United Texas Offshore System (UTOS).

El Paso will also divest Coastal's ownership of the Gulfstream natural gas pipeline project.

Proceeds from those sales are expected to total $243 million and will be used to pay debt and to fund future growth opportunities, officials said.

Also as part of the transaction, El Paso Energy Partners LP has sold its interests in several pipelines to other companies for undisclosed sums.

El Paso has sold its interests in the Green Canyon and Tarpon gathering systems to Williams, Tulsa.

Other offshore divestments include:

  • The 25.67% ownership each in the Nautilus pipeline system and Manta Ray Offshore gathering system.
  • The 33.92% interest in the Nemo gathering project, now under construction.

Proceeds from sale of those assets will be combined with $29 million cash from the parent company and reinvested into new businesses and assets, officials said.

William A. Wise, El Paso chairman and CEO, said of the merger, "The scale we now possess opens an even wider range of extraordinary opportunities. Our combination of assets, intellectual capital, and financial resources creates the largest and most broadly based natural gas company in the world.

Reorganization

The combined company has been organized into four reporting segments. One segment, the El Paso Pipeline Group, will manage its 58,000 miles of interstate pipelines. The group's five interstate pipeline companies-ANR Pipeline Co., Colorado Interstate Gas Co., El Paso Natural Gas Co., Southern Natural Gas Co., and Tennessee Gas Pipeline Co.-will continue to operate as separate pipelines with separate tariffs, officials said.

ANR and Tennessee Gas Pipeline will comprise the Eastern Pipeline group, headquartered in Houston. El Paso Natural Gas and Colorado Interstate Gas will make up the Western Pipeline group, to be based in Colorado Springs. Southern Natural Gas will continue to be based in Birmingham, Ala.

The merchant energy segment will manage El Paso's wholesale customer business and its extensive portfolio of natural gas, power, and energy assets worldwide. Officials said that segment has demonstrated 250% growth on a pro forma basis over the last 3 years.

The production business segment holds reserves totaling 6 tcf of natural gas and controls more than 3 million net acres. Last year, that combined unit added 1.9 tcf of gas reserves on a pro forma basis at a reserve replacement cost of $1.07/Mcfe, officials said.

The El Paso Field Services segment holds interests in 24,000 miles of intrastate pipeline and gathering systems; 35 processing and treating plants; and eight offshore platforms.

In addition, the newly formed El Paso Global Networks Co. will focus on developing a bandwidth merchant platform for the commercially underdeveloped broadband industry, officials said.

David A. Arledge, former chairman and CEO of Coastal, will join El Paso's board of directors as vice-chairman. Arledge will retire as a company executive but will remain with the combined company in an advisory role, officials said.

Together, the combined El Paso and Coastal US workforce stands at roughly 16,500. Late last month, the company said that it would cut 1,650 employees. These cuts would occur "across all business units and at all levels of the company," El Paso said.

Since the announcement of the merger with Coastal at beginning of last year, some El Paso employees have left voluntarily and another 1,635 have taken the option to retire early.

Halliburton divestiture

Halliburton will retain a 5% equity interest in DEG after closing on its sale to equity investment firms First Reserve and Odyssey Investment. Subject to adjustments, Halliburton expects to recognize a pretax gain of about $500 million and an after-tax gain of about $300 million upon closing.

Halliburton revealed last year that it intended to divest the group in order to more closely focus its core businesses (OGJ Online, Apr. 30, 2000). It acquired the group in 1998 as part of its merger with Dresser Industries Inc.

The Dresser Group is an energy services firm that includes five main divisions: Dresser Valve, Dresser DMD-Roots, Dresser Instrument, Dresser Wayne, and Dresser Waukesha. Revenues are more than $1.4 billion.

Morgan Stanley Dean Witter & Co. acted as financial advisor to Halliburton.

Patterson-UTI

Under Patterson's proposed acquisition deal, UTI Energy stockholders will receive Patterson common stock on a one-for-one basis. At the close of the market on Feb. 2, the companies had a combined market valuation of $2.6 billion, based upon their share prices.

The merger is subject to approval by the shareholders and government antitrust review provisions.

Mark Siegel, UTI chairman, will be chairman of Patterson-UTI. Cloyce Talbott, Patterson chairman and CEO, will be CEO of Patterson-UTI.

Talbott said, "Patterson-UTI will have more than 300 land-based drilling rigs strategically located in some of the most prolific oil and gas producing regions in North America."

Siegel said, "Both UTI and Patterson have built shareholder value through strategic acquisitions, and we believe the merger will provide the combined companies with a stronger platform for further growth."

Keppel breaks talks

Keppel confirmed in November that Keppel Fels-one of the largest builders of rigs in the world-was in talks with Wilton Fejinoord Holdings on the possible takeover of the Rotterdam yard.

The acquisition would have given Keppel a foothold in the European ship repair and offshore market.

The announcement came a week after Keppel Fels' sister firm, Keppel Hitachi Zosen, shelved plans to develop a yard on the Indonesian island of Batam.

Keppel has two yards in Singapore, Amfels in Texas, and the Caspian Shipyard Co. joint venture in Azerbaijan. It recently signed a JV with Brazilian PEM Setal Group to sublease a Brazilian yard.