Valero plan reflects U.S. M&A trends

Barbara Saunders
Staff Writer

Selected Gas/Electric Megamergers [ bytes]

In a move that underscores merger and acquisition trends in two sectors of the U.S. petroleum industry at once, Valero Energy Corp. is seeking a merger partner for its natural gas and liquids division so it can expand its refining division as a separate entity.

If a deal comes to pass, it could be the energy merger scene's equivalent of a BTU "convergence" transaction, where oil, gas, and electric power all factor into the picture simultaneously.

What's involved

Valero's assets include a 171,500 b/d refinery at Corpus Christi, where the company has spent about $1 billion on upgrades in recent years to convert low-cost, high-sulfur residual oil into reformulated gasoline and other premium products.

In the gas sector, Valero's assets include a 7,500 mile network of gas gathering and transmission lines within Texas that interconnect with most interstate pipelines out of the state.

San Antonio-based Valero also owns eight natural gas processing plants that produce liquids used as feedstocks for refineries and petrochemical plants.

In addition, Valero is a large natural gas marketer and ranks among the top 20 marketers of deregulated wholesale power in the U.S.

The company hopes to spin off its refining division and continue operating it under the Valero name, keeping this portion of business headquartered in San Antonio.

The future identity of the gas business is a question mark. Valero's idea is to find a merger partner that will pay top dollar for its gas assets in a cash-free, tax-free, stock-to-stock trade.

Gas-electric deal?

Analysts foresee a marriage of Valero's gas business with an electric utility high on the list of likely matches, as the two industries converge at a rapid pace.

Shawn Brennan of Merrill Lynch & Co. predicted, "An electric company will probably buy them. They seem to be paying the highest prices."

This is because many electric utilities are in a scramble for natural gas assets, from delivery systems to nationwide marketing operations.

Joining forces with a company strong in both areas is the fastest way to build market share in the burgeoning one-stop energy shop business (OGJ, Sept. 16, p. 16).

But analysts don't rule out a gas-to-gas pairing, in a climate where one strong company can still survive, but two can thrive. "There are going to be a lot of people out kicking the tires and looking at Valero," said James Jordan, of Williams McKay Jordan & Co., Houston. "It could be some of Valero's peers, (such as ) gas pipelines and liquids companies, and it could be some of the power companies."

Valero has hedged its bets. Of about 40 prospectus packages dispatched by the company, roughly half were sent to other gas concerns and the other half to utilities known to be in the market for a natural gas partner, company officials acknowledged.

On the refining side, Valero is attempting to parlay the value of its gas assets into the financial clout necessary to acquire more downstream capacity. "Someday, Valero would like to be a multi-refinery company," said Stephen Butz of Jeffries & Co., Houston. "First, they need to sell the gas side. They aren't able to expand their gas business, because the stock is undervalued, since it trades in line with refining and marketing stocks."

Jordan noted, "What they're really doing is making more visible value on the gas and gas liquids side, which tend to trade at a much higher multiple" than refining and marketing stocks.

If Valero's gas assets fetch the average valuation common in that sector today, Jordan continued, "the gas company might be valued at around $1.5 billion gross assets, less (about $500 million) debt, which means that a merger could isolate about $1 billion net asset value. I think it's the company's hope that this will force the value of the refining side higher. It all hinges on them being able to get $1 billion. I don't have any reason to believe this isn't realistic."

If Valero succeeds in its quest, it would join a select group of financially strong U.S. independents out shopping for more downstream assets. Tosco Corp. recently joined that roster by proposing to pay $1.4 billion for Unocal Corp.'s refining and marketing operation, (OGJ, Nov. 25, p. 32).

Ultramar Corp. and Diamond Shamrock also agreed to merge in late September, in a deal with combined equity value of more than $2.3 billion (OGJ, Sept. 30, p. 34).

According to a Jeffries & Co. Inc. report, the "sum of the parts will be greater than the whole for Valero." It notes that Valero benefits from its competitive position in the marketplace, by virtue of a refinery that converts low-value resid into high-value products. "As an independent company, the refining and marketing operation will benefit from a stronger, better capitalized company with very little debt and an enhanced ability to grow."

Timing is everything

As in refining, consolidation of the gas and electric sectors has been under way for a number of years, but the pace has picked up considerably in 1996. On the gas/electric side, companies are realigning in some new ways to take advantage of opportunities unfolding from the deregulation of electricity.

"We believe it is important for us to move forward while there is still a wide choice of potential strategic partners," said William E. Greehey, who came back from retirement to resume his post as Valero's chief executive officer and steer the company's reorganization.

Prior to 1996, most merger activity involved gas concerns acquiring other gas concerns, and electric utilities acquiring other electrics. This year, cross-sector combinations between gas and electric concerns began to multiply. And the value of these deals skyrocketed, with six involving gas interests worth more than $1 billion (see table).

Topping the list, in terms of sheer numbers, are multibillion-dollar combinations between electric utilities and gas utilities with either overlapping or complementary service areas.

Recent examples include the proposed mergers between Houston Lighting & Power Co.'s parent firm and NorAm Energy Corp.; Texas Utilities Co. and Enserch Corp.; and Pacific Enterprises and Enova Corp. These mergers have a defensive element, since both partners are in the same core business, as retail distributors of either power or gas.

But strategic mergers also have started that blend different core businesses-pipelines and electric utilities -jockeying for position in both wholesale and retail markets on a larger scale than ever before.

Enron Corp. started the trend in a $3 billion-plus merger with Portland General Corp., a mid-size utility that offers a customer base and transmission access at the California-Oregon border, where wholesale power markets are growing faster than many other parts of the country (OGJ, July 29, Newsletter).

Late last month, North Carolina-based Duke Power Co. and Houston-based PanEnergy Corp. agreed to join forces in a deal worth about $7.7 billion. The deal marks the largest gas-electric combination yet between firms with no overlapping territories (OGJ, Dec. 2, p. 44).

Most industry experts believe that these are just the beginning of a new wave of megamergers.

A report by Prudential Securities Inc. lists nine pipelines likely to be acquired by or seek strategic mergers with electric utilities. But defensively oriented mergers may continue to unfold in greater numbers. Prudential lists 20 more electric utilities that could be in the market for a gas utility and 16 gas utilities that may go out looking for an electric partner.

Whether Valero joins the ranks of gas/electric combinations or pairs with another gas partner, remains to be seen.

But one company official sized up the name of the game today: "We've been trying to grow the gas business for several years. To be really competitive, you have to be part of another entity."