Mergers, JVs help industry combat downturn

Anne Rhodes
Associate Managing Editor-News

Low oil prices and meager earnings have characterized the oil industry in 1998.

In order to cope with today's challenging operating environment, energy companies need to continue cutting costs and reorganizing in order to gain competitive advantage, said William Beisswanger, Ernst & Young LLP's national director of energy services, at the firm's annual energy conference in Houston early this month.

It has been "a very difficult year for the industry," said Beisswanger. Oil and gas prices are down, refining margins are low, and chemical prices are soft. Even major integrated oil companies are having a "relatively difficult time," he said.

Many companies have already taken steps toward reversing their declining profit margins. These measures include reducing capital spending, forming joint ventures, and merging with or acquiring other firms. "This trend will continue in all segments of the industry," predicted Beisswanger.

Downstream outlook

At the conference, J.L. Frank, president of Marathon-Ashland Petroleum LLC (MAP), shared some details of his firm's success with improving results by combining forces with a former competitor.

The combine of the downstream arms of Marathon Oil Co. and Ashland Petroleum Co. began operating on Jan. 1, 1998. During the first half, said Frank, MAP achieved an 8% return on capital employed, led its peer group in operating income per barrel of throughput, improved safety performance relative to the two predecessor organizations, and saved $80 million by improving efficiency.

"We manage a single efficient system," said Frank, "not seven discrete refineries. We believe ours is the most efficient system in the industry."

He added that his company expects to achieve savings of $250 million by the end of its fourth year of operation (2001).

Despite his rosy outlook for MAP, Franks says the U.S. refining industry still faces a number of challenges. These include continuing capacity creep and high environmental compliance costs.

"Increasing regulation will continue to pressure marginal plants," said Frank. For this reason, he expects the merger and acquisition (M&A) frenzy to continue in the near term.

But, at some point, "The attractiveness of (mergers) will begin to decline as people pick the low-hanging fruit," he predicted.

Upstream trends

A similarly prudent approach of cost savings and careful investment is needed for the upstream oil industry, said Rich Langdon, chief financial officer of EEX Corp., at the Ernst & Young conference.

"There are only two significant excesses left," said Langdon, with a bit of irony. "There is too much oil in the world, and too many players (are) chasing too few opportunities."

E&P firms can expect continued intense competition for investment opportunities. And additional chances for cost savings remain, he says. For these reasons, further consolidation is inevitable.

In order to cope in this climate, EEX plans to "create value in material projects and realize value through alliances," said Langdon.

For independent producers, says Langdon, the obstacles that lie ahead are technology, financing, and project execution. The smaller firms simply don't have the resources that the majors do in these areas.

But there are opportunities for independents to gain advantage, he says. These lie in the areas of organizational structure, staffing, and business strategy: "Independents need greater skill and more-focused investments."

Mergers

Soaring M&A activity is playing a key role in helping firms contend with the current slump. Eric Mullins, a vice-president of Goldman Sachs, analyzed M&A trends more closely.

"We are seeing unprecedented volume and unprecedented size (in M&A transactions)," said Mullins. And these deals are increasingly being financed through equity and stock deals, because companies can't get access to the necessary cash for debt-financed transactions.

In addition, he said, "Hostile activity is on the rise." In fact, it has reached about 80% of the level seen at its peak in the late 1980s.

"In particular, in energy, with prices being where they are, we're going to see more of that," said Mullins. This is because shareholders are becoming more active, and there is less stigma attached to being a hostile raider.

The planned merger of British Petroleum Co. plc and Amoco Corp.-thought by some to be the pinnacle of the M&A trend and by others to be the starting gun-has set a remarkable precedent in the stock market, says Mullins.

Changes in the firms' stock prices since the merger was announced indicate that the market believes their projected cost savings figure of $2 billion, he said. In addition, the market has already given the companies credit for the achievement on Day 1 of operation, even though it will take several years to realize the savings.

In the downstream industry, M&A activity is essentially a different form of capacity rationalization, said Mullins. Shutting down a refinery has become too expensive from an environmental standpoint; therefore, joint ventures can be a convenient solution.

The drivers for formation of these combinations are: operating cost reductions, capacity expenditure avoidance, process and logistics optimization, increased market share, and economies of scale.

In the refining industry, said Mullins, if a company operates long enough, the periods of upswing can provide enough profitability to help a company survive the down cycles. So the goal for refiners is "sustainability."

Mullins expects the M&A fever to continue, to one degree or another. He predicts that one of two things will happen.

If commodity prices remain soft, more firms will feel the need to make a transaction. If prices rebound a bit, however, sellers will find these transactions more attractive, and there will be "a very, very active merger market," he said.

Mullins predicted that industry's dark cloud will begin to lift in first half 1999: "The current market conditionsellipseare not going to be sustainable for a long time."

He predicts that supply and demand will start to come back into balance in first quarter 1999. A significant improvement in oil prices-to $16-17/bbl-will probably take a little longer, but "we will begin to see some improvement (in the first or second quarter)."

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