Petroleum companies should include M&A options in strategy portfolio

May 18, 1998
Global M&A Transactions Largest Mergers and Aquisitions Announced in 1998 It's hard to pick up the paper these days and not read about another merger: SBC Communications and Ameritech, Chrysler and Daimler-Benz, Citibank and Travelers. Lately, most headline-grabbing megamergers have been outside of petroleum. Yet it's worth considering whether the petroleum industry could be poised for a new wave of mergers and acquisitions (M&A).
Scott Nyquist, Chris Friedemann
McKinsey & Co. Houston
It's hard to pick up the paper these days and not read about another merger: SBC Communications and Ameritech, Chrysler and Daimler-Benz, Citibank and Travelers.

Lately, most headline-grabbing megamergers have been outside of petroleum. Yet it's worth considering whether the petroleum industry could be poised for a new wave of mergers and acquisitions (M&A).

For many players, it may not make sense to play the M&A game. Deals don't always create the value expected. Bigger is not always better. And growth can come through internal actions that do not require a transaction. While winners in the petroleum end game might participate in deals or opt to sit on the sidelines, all players would be well served to assess how M&A could reshape the industry and examine their strategies for competing within it.

Changing industry dynamics and pressures to create value are forcing executives of global companies in all industries to consider M&A a strategic tool. Many of the forces driving M&A in other industries also apply to petroleum. Within all petroleum sectors, numerous options exist to reposition through M&A and unlock value through enhanced scope and scale. Best-practice observations suggest the winners will get ahead of the wave by incorporating M&A into their strategic thinking and avoiding the minefields that often derail merger integration.

Global forces driving M&A

M&A activity, including spinoffs (see related story, p. 37), is at an all-time high in many industries as players move to capture leadership positions in a dynamic global economy.

The global playing field has changed dramatically since the 1970s. New arenas such as China and the former Soviet Union have opened to foreign investment. Regional specialists have improved their products and services to become formidable global competitors. New entrants continually attack the legacy-asset positions of incumbents by leveraging widely available technology and capital sources.

In response to these forces, global players have repositioned themselves in many ways. Over the last 2 decades, nearly all restructured internally by selling non-core businesses, divesting unprofitable assets, and downsizing their human resource base. Some formerly integrated companies "de-merged" to better position their constituent businesses for stand-alone success. AT&T's spin-off of Lucent and NCR and GM's divestment of EDS and Hughes were grounded in an assumption that the value of integration is low in certain industries and that increasing focus is crucial to long-term success.

And recently, across many industries, players have begun to join forces in deals of unprecedented magnitude to grow and better compete on the global playing field. Some seek to grow by gaining scale in a specific industry segment, as Bank of America and NationsBank are attempting in super-regional banking. Others seek to grow by extending the scope of their operations by merging synergistic assets, capabilities, relationships, and brands, such as both Disney-Capital Cities/ABC and Citibank-Travelers.

Dynamics within the boardroom also are influencing the urge to merge. Pressured by powerful institutional shareholders to enhance share prices, boards of directors are encouraging executives to consider all levers to expand the top line, remove costs, and drive the stock price higher. With much internal restructuring value already unlocked, boards and executives increasingly turn to external options such as M&A to deliver the next increments of value.

The shift toward option-based executive compensation has also fueled M&A activity. In the past, merger advocacy implied that executives risked losing lucrative salary packages in the post-merger restructuring. Today, advocacy implies vesting millions in stock options if the deal closes and shareholders reward the move.

Today's deals are also structured differently from those in the last M&A wave during the 1980s. Friendly stock-swap mergers have replaced hostile cash-based takeovers that required significant stock premiums to execute (and diligence to recoup). With the changes of ownership occurring on more friendly terms, the premiums required to execute the transactions have fallen, and the number of deals has increased.

Petroleum hit by similar forces

The petroleum industry is affected by many of the same forces that are driving M&A activity in other industries.

Deregulation, privatization, and the opening of formerly closed markets have increased the size of the playing field, but the required capital (and risks) and human resources test even the largest players. The basic industry structure remains challenging due to high fragmentation, emerging nimble competitors, increasing power within the oil field service sector, and growing sophistication of customers and resource holders. Overcapacity in many sectors and weak demand in Asia are keeping a lid on prices. And since 1986, most companies have continuously squeezed their asset portfolios and cost structures to unlock latent internal value.

Many petroleum sectors have already undergone an initial wave of M&A activity.

Among the independent exploration/production and refining/ marketing companies, M&A activity has been strong. Recent headline transactions include: Burlington Resources Inc. with Louisiana Land & Exploration Co., Mesa Inc. with Parker & Parsley Petroleum Co. (Pioneer Resources Corp.), Sonat Exploration Co. with Zilkha Energy Co., Flores & Rucks Inc. with United Meridian Corp. (Ocean Energy Inc.), and Ultramar Inc. with Diamond Shamrock Inc. These "mergers of equals" are strategic responses designed to grow in a mature business, improve the scale of operations, and share complementary skills.

Several of the majors are selectively turning to M&A for growth. Texaco Inc.'s acquisition of Monterey Resources Inc. strengthens its position in California heavy oil. ARCO's acquisition of Union Texas Petroleum Holdings extends its international resource holdings.

Several smaller integrated players, including Unocal Corp., Ashland Oil Inc., and Pennzoil Co., have de-merged to isolate their upstream and downstream operations and focus on segments where they can outpace the competition. In some cases, the de-merged entities have "gone-it-alone." In others, they subsequently merged with others to improve their competitive positions in selected segments. Ashland, for example, combined its downstream operations with those of USX-Marathon Group to gain scale in U.S. Midwest refining and marketing. Pennzoil intends to merge its lubricants business with Quaker State Corp. to augment its position in motor oil marketing and car care.

The national oil companies (NOCs) have also been active on the M&A scene. Argentina's YPF was privatized and then bought independent Maxus Energy Corp. in 1995. Saudi Aramco has been acquiring downstream assets in Europe and Asia and, through its Star Enterprise venture, will be part of the new Equilon (Shell Oil Co.-Texaco) JV in the U.S. Venezuela's Petroleos de Venezuela SA (Pdvsa) is extending its hold on U.S. refining and marketing capacity through its earlier Citgo Petroleum Corp. acquisition, Uno-Ven (Unocal Lemont) deal, and recent 50% purchase of Amerada Hess Corp.'s St. Croix refinery. In the former Soviet Union, Yukos and Sibneft merged early in 1998 and are now selling a 5% stake to France's Elf Aquitaine.

In the service sector, Sonat Inc. and Transocean Offshore Inc. merged their deepwater drilling businesses to gain scale in this high-growth, capital-intensive segment. Halliburton Co.'s intended merger with Dresser Industries Inc. and acquisition of Landmark Graphics Corp. expanded the scope of its services and enhanced its ability to create integrated service packages. To keep pace with its larger rivals, Baker Hughes Inc. recently agreed to acquire Western Atlas Inc. in a $5.5 billion stock deal (see related story, p. 30).

Although it is difficult to pinpoint the amount of value creation possible in the petroleum industry through M&A, published figures on anticipated JV savings help to bound the opportunity. Recent regional downstream joint ventures (Shell Oil with Texaco in the U.S., Mobil Corp. with BP Oil Inc. in Europe) are projected to save about $1/b/d of refining distillation capacity. Regional upstream ventures (Shell Oil with Amoco Corp., Shell Oil with Mobil) have announced annual savings averaging $0.85/boe of production.

A "back-of-the-envelope" extrapolation of these average savings to the worldwide assets of the 15 largest U.S.-based petroleum companies implies a hypothetical value creation potential of nearly $8 billion/year ($4 billion for only U.S. assets) or roughly 20% of the 1997 pre-tax operating income for these same players. If extended to other smaller or non-U.S. companies, the industry value creation could be substantially higher.

Options to reposition

While the forces driving potential M&A activity in the petroleum industry are universal, the rationale and types of opportunities vary from sector to sector.

Each industry sector-majors, midsized integrated, independents, NOCs, and service companies-has numerous options to create value and reposition strategically through M&A.


For a major, the first-order M&A decision is whether to remain a broad-based, vertically integrated company or to de-integrate and focus the constituent businesses on pure upstream, downstream, and chemicals opportunities.

As the petroleum industry has evolved over the last quarter century, the value of vertical integration has diminished. While certain projects have an aspect of traditional vertical integration (e.g., Venezuelan heavy oil production, upgrading, and refining), most global opportunities today are either stand-alone or are integrated along the natural gas chain and require nontraditional commercial capabilities (for most players) in power generation and natural gas/electric marketing.

The second-order decision for the majors is whether to get bigger or broader.

The "bigger-is-better" majors could use M&A to gain scale in one or more industry segments. Mergers between like-sized majors could deliver scale in several segments simultaneously and enable the entity to capture synergies in three areas:

  • Reduce operating and administrative costs by consolidating asset positions and rationalizing the corporate center.
  • Enhance growth rates by leveraging complementary assets/capabilities and mutually beneficial relationships with external parties.
  • Improve negotiating power (and contractual terms) with key suppliers, customers, and resource holders.
Alternatively, these bigger-is-better majors could use M&A to gain scale in a single segment by "absorbing" the assets of smaller regional players (e.g., Texaco's Monterey acquisition in California heavy oil). While a series of single-segment deals could ultimately have the same effect as one "mega-major" transaction, the integration challenges and acquisition premiums could be significant.

The "broader-is-better" majors could move to increase their scope of operations through M&A in complementary businesses. Some might choose to integrate along the natural gas chain by acquiring a power developer or electric utility. Others might acquire an integrated oil field service company to become a "one-stop-shop" for all E&P services. Others might extend their positions within particular segments, such as financial services or deepwater E&P (by acquiring a deepwater driller and floating production system fabricator).

The "what ifs" around the majors are limitless, yet certainly interesting to ponder. What if ARCO and Mobil both de-integrated and merged their international upstream operations with Unocal to build an Asian natural gas franchise? What if Chevron Corp. put its domestic downstream assets with those of ARCO and Mobil to challenge the Shell-Texaco venture? What if Exxon Corp. merged with a large gas and electric utility to offer wellhead-to-burner-tip energy services around the world? The rules of the game, and the power balance in petroleum, would certainly change.

Midsized integrated firms

M&A could significantly reshape the midsized integrated petroleum sector (comprising companies such as Marathon and Phillips Petroleum Co.).

In other industries, midsized players historically come under performance and M&A pressure as they face advantaged competitors in each line of business and in each region. Frequently, they get squeezed between larger and scope-driven megafirms and nimble specialists that more readily capture the best opportunities, partners, and talent.

In automobiles, Jaguar and Chrysler were eventually forced to merge into Ford and Daimler-Benz. In pharmaceuticals, Ciba-Geigy and Sandoz merged to become Novartis in order to take on larger entities like Merck. In airlines, USAir and TWA struggle to remain competitive as larger carriers like American outsize them and "nimbles" like Southwest outpace them.

Within petroleum, many of the midsized players face the same pressures. As a group, they have underperformed (on a return-to-shareholder basis) both the majors and the smaller petroleum specialists over the last 7 years. While majors returned nearly 16% and selected specialists over 20%, the midsized firms returned just 8% to their shareholders.

Industry trends do not suggest that the competitive pressures on the mid-sized companies will abate. Mature-market joint ventures among the majors in both the upstream and downstream further enhance their scale-driven advantages. In emerging markets, the midsized firms frequently lack the "brand cachet," scope of capabilities, and relationships required to seize the most attractive opportunities as well as the "deep pockets" needed to fund a diversified, capital-intensive project portfolio.

Moving forward, M&A activity among the midsized players could increase. Some might follow the paths of Unocal, Ashland, and Pennzoil and de-integrate. Some might merge within the sector to gain scale and breadth comparable with the smaller majors. Others might divest of businesses in which they lack distinctiveness and increasingly focus on a smaller number of segments in which they have an advantage. Still others might "merge into" the majors in friendly stock deals.


Although hit hard by the oil price collapse of 1986, the independent sector benefited from the resulting industry restructuring.

As the majors restructured their portfolios through asset sales, the independents stood ready for nearly a decade to gobble up the people and assets deemed non-core by the larger firms. Independent R&M companies like Tosco Corp. and E&P firms like Apache Corp. grew through acquisition of these "non-core" assets. However, as the majors' divestiture pipeline slowed in the mid-1990s and the U.S. industry further matured, many independents struggled to maintain their historic growth rates.

Going forward, we could see continued M&A activity among the independents, especially in E&P. Many might merge simply to increase their U.S. reserves base and net income. Others might use M&A to fatten their balance sheets and launch into higher-risk, cash-intensive international ventures. Some could pursue regional consolidation strategies to acquire fragmented "mom and pop" producers, just as Browning Ferris and Republic Industries did in the respective landfill and used-car businesses. A limited number of advantaged regional specialists like Devon Energy Corp. and Meridian might strike stock-for-asset deals with larger players looking to reposition. The remainder might follow Monterey's path and exchange their resource holdings for stock in regionally advantaged majors and midsized players.

National oil companies

Given the size of their natural resource holdings and their quasi-government status, many of the larger NOCs have the potential to play a significant role in any industry consolidation.

While outright mergers could be difficult in this sector, the NOCs do have several M&A-related options to extend the scale and scope of their operations.

Some of the Middle East producers may seek to further integrate downstream by acquiring regional R&M assets from majors, independents, or formerly state-owned entities. A global partnership between an R&M specialist like Tosco and either Saudi Aramco or Kuwait Petroleum Corp. could provide a significant U.S. market outlet for these Middle East NOCs and allow the venture to tap undermanaged or undersupplied global R&M assets.

Some reserve-long, but capability-short, NOCs could pursue ventures with independent E&P firms that possess the requisite exploration, field development, and reservoir management skills. In return for skill transfer, the independents could be given privileged access to resource development opportunities in the NOC's home market.

Alternatively, some NOCs could sell stakes in themselves to larger players (as Yuksi has with Elf) to raise capital and tap world-class management and technical talent.

Some NOCs might more closely align on a regional basis. A consortium of YPF SA, Petroleo Brasileiro SA (Petrobras), and Pdvsa (potentially with Spain's Repsol SA) could shape the end game in energy development in South America. Similarly, a consortium of Indonesia's Pertamina and Malaysia's Petronas could drive the outcome in Southeast Asia.

Other NOCs might align to pursue market segments where they share complementary assets, capabilities, or relationships. As an example, Norway's Statoil and Petrobras have extensive deepwater offshore operations and could form a venture (potentially with a deepwater drilling company or offshore fabricator) to capture a leading position in global deepwater development.

Service companies

Within the oil field service and equipment (OFSE) sector, we have already seen high levels of M&A activity and more could be coming. Former single-line competitors might pool their assets and organizations to secure the dominant position in their industry segments, as Sonat and Transocean did in deepwater drilling. Additionally, players in related segments might combine to extend the breadth of their offerings as did Falcon Drilling Co. Inc. (onshore drilling) and Reading & Bates Corp. (offshore drilling).

The larger, integrated OFSEs might continue acquiring single-line firms to broaden the scope of their product and service lines. Speculation continues about a Halliburton move back into the geophysical segment. Schlumberger's lack of a top-side engineering and construction capability glares more brightly after Halliburton's merger with Dresser. Both of the big integrated firms lack meaningful positions in the drilling segment. And not all customers are yet convinced that Halliburton and Schlumberger have attained world-class levels in prospect generation, field development, or reservoir management. A deal with a petroleum consulting firm or independent E&P company could enhance these skills.

Given the importance of the technology, physical assets, and human talent resident within the largest integrated OFSEs, they are likely to be central to any M&A moves to change the game in petroleum. What if a consortium of three or four majors (or NOCs) partnered to buy Halliburton? And what if, in response, another consortium partnered to buy Schlumberger? With two mega-major consortiums in control of global resource development from sand face to refinery gate, the balance of power among NOCs, OFSEs, and producers would shift dramatically.

M&A best practices

Based on lessons learned from leading M&A practitioners, we believe the winners in the petroleum M&A end- game will be those that get ahead of the wave in three areas. Best practitioners will:
  • Fully incorporate M&A into their strategic thinking and response set.
  • Take actions to align potential candidates with their vision to ensure the desired deals "get done."
  • Plan for and execute the post-merger integration process with the same zeal as the actual transaction. Throughout, they will recognize and adjust to the many obstacles that often derail even the most compelling combinations.

M&A, strategic thinking

Successful practitioners fully integrate M&A into their strategic thinking and plans for growth. They understand where value in their industry is (and will be) created; assess how to complement their existing positions with synergistic assets, relationships, and capabilities; and readily anticipate the moves of their competitors.

For players in petroleum, identifying the options for M&A requires resolving several fundamental questions:

  • What is the value of integration both in existing businesses (e.g., E&P with R&M) and in potentially complementary ones (e.g., E&P with power generation or E&P with oil field services)?
  • Is our firm best positioned to achieve global dominance by getting bigger, by getting broader, or by getting more focused?
  • How big and broad can our company get through organic, internal actions, and how does this compare with our options to grow through M&A?
While responses to these questions may be different for each player based on unique starting positions and alternative views on the future competitive environment, best practitioners will employ detailed, fact-based approaches to comprehend the knowable while bounding the uncertain.

Whether they choose to merge, acquire, de-merge, or "go-it-alone," winners in the petroleum end-game will understand the opportunities and the challenges implicit in their decisions.

Ensure deal gets done

Successful practitioners take actions to align potential candidates with their vision to ensure that the deal gets done.

As "mergers of equals" on friendly terms have become more prevalent, the candidate screening process has evolved. Financial impact is no longer the exclusive driver of the candidate "short list" and has been joined by a broader set of screening criteria.

Best-practice companies readily calculate the typical "hard" synergies from asset consolidation, staff reduction, and increased purchasing power, yet they also try to ascribe real value to "softer" synergies like best-practice transfer and their ability to improve the operations of undermanaged assets. In addition, they screen against somewhat subjective criteria, including alignment with aspirations and strategy and the degree to which assets, relationships, capabilities, and organizations (including cultures and management teams) are complementary.

Further, best practitioners rigorously plan for the initial interactions with potential candidates. To lock up the best partners, they've got to position the right story to the right people on their short list. Given that they may get only "one shot," they want to make sure of their aim. In preparation, they reflect on a series of questions before proceeding:

  • Who at the candidate is most likely to respond favorably to the message (e.g., a CEO or an impartial external board member)?
  • What are their motivations (e.g., protect a brand, vest their options, tap an executive for succession)?
  • How should they begin discussions (e.g., informally on the eighth tee, through external advisers)?
Once discussions are under way, best practitioners focus on resolving contentious social issues like the "team at the top," organization design, and the restaffing process. Even in the friendliest of transactions, these emotional topics are the sources of heated debate and can scuttle promising deals.

Plan, execute integration

Successful practitioners plan for and execute the post-merger integration process with the same zeal as they pursued earlier stages of the transaction.

They anticipate the destabilizing forces introduced by a merger and take steps within the first 30 days after the announcement to clarify issues of why the deal was done, who's in charge, and what the role of key players will be in the new company.

Once the organization is stabilized, they execute against a detailed road- map that was developed before the deal was ever announced. They recognize that successful integration does not happen automatically and view the post-merger stage as an important phase for capturing synergies, dislodging entrenched practices, and reshaping cultures.

As such, it is given high visibility and forethought.

While best practitioners stay abreast of the highlights of the post-merger integration process, most executives McKinsey & Co. have observed quickly return to address the broader strategic opportunities available to the new company.

They observe the reactions of competitors, adjust their mental models of the end-game, and plan the next move required to unlock latent value in their industry.

To them, M&A is a continuing chess match and a valuable vehicle to achieve the aspirations for their company.

They might not be at the table when the match is over, but they play to ensure their successors have the pieces needed to win.


The authors thank their colleagues Andy Steinhubl, Jonathon Day, Tom Kellagher, Scott Andre, John Bookout, Ron Hulme, Bill Ebanks, Rich Patrick, and Raul Elorduy for contributing their views on the content of this article. Bill Matassoni, Diane Taylor, and Beth Peters provided valuable editorial suggestions.

The Authors

Scott Nyquist, a senior partner in Mc- Kinsey & Co.'s Houston office and a leader of its North American petroleum practice, has extensive experience serving energy clients in the U.S. and abroad. Scott has an MBA from the Harvard Business School and a BS in chemical engineering from the University of Michigan. Prior to joining McKinsey, Scott worked for Exxon Production Research on topics related to offshore platform design.
Chris Friedemann, a consultant in Mc- Kinsey & Co.'s Houston office, has served petroleum clients throughout the Americas and Asia. Chris has an MBA and BS in petroleum engineering from Stanford and was a senior reservoir engineer with Exxon before joining McKinsey.

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