Financial Times: Spanner in the works over BP and Shell merger

Published: July 25 2007 22:44 | Last updated: July 25 2007 22:44

Tony Hayward, BP’s new chief executive, will have saddened investment bankers everywhere this week with his rejection of speculation about a possible merger with Royal Dutch Shell.

As well as denying rumours that the companies were in talks, he suggested a merger would be the wrong answer to BP’s problems. BP needed to fix its operations, not its strategy, he said.

In saying so, he contradicted what is now a widely held view among bankers, consultants and analysts who follow the industry: that consolidation is in fact the only answer to the challenges facing the oil “majors”. They predict a fresh wave of mergers to match the spate at the end of the 1990s that brought BP together with Amoco, Total with Elf, Exxon with Mobil, and Chevron with Texaco.

In spite of this, Mr Hayward’s scepticism should be taken seriously. However hard bankers may be selling the case for mega-mergers, the corporate leaders have good reason to be cautious.

The case for consolidation is that the international oil companies are facing the most difficult outlook in their history. Much of the world’s resources are closed to them, whether by choice, as in the case of Saudi Arabia’s oil, or by political tensions, as in Iran. In countries where they can operate, from Russia to Venezuela, the terms have deteriorated.

Everywhere, the technical difficulties and the cost of finding and extracting resources have increased and companies are coming up against newly assertive and well-resourced competition from companies in emerging markets.

In that environment, advocates of consolidation argue, the only way for oil majors to deliver value to their shareholders is to get together. A note from Morgan Stanley, for example, described a BP/Shell merger as a “very logical” move.

The argument has three main strands. First, at a time of slow growth in production and hence revenues, oil companies need to cut costs through rationalisation to improve their earnings.

Second, only the biggest companies will be able to win the battle for resources. Alex Turkeltaub of Frontier Strategy Group, a consultancy, says: “Large as the private international oil companies are today, they lack the strength to pressure governments and ‘national’ oil companies successfully, and another mega-merger could enhance their ability to compete in this new world.”

Third, and most profoundly, some experts argue that given the physical constraint of the amount of oil and gas that is accessible, there is too much money in the industry. The majors need to consolidate to reflect their more limited horizons.

However, there are also powerful arguments against this view. As Mr Hayward said this week, BP’s operational problems stem in part from having failed to integrate Amoco properly after the merger in 1998. Doing another big deal would create another massive problem of integration.

The merger wave of the late 1990s was driven by companies with high stock market ratings acquiring those with lower ratings; today potential bidders do not enjoy those market premiums.

Nor is it clear that merged companies would necessarily get better terms from resource-rich governments: BP and Shell individually might be able to negotiate more total access than a behemoth BP Shell.

A merger between two global companies would probably force large-scale disposals to satisfy competition authorities and disturb the relations between companies and governments all over the world, throwing uncertainty into a multitude of relationships and tax arrangements. It would also be very likely to cause a political outcry.

Above all, perhaps, the companies do not seem ready to accept that they are in decline. “When two companies merged in the 1990s, when oil prices were low, they were basically shutting down one of their exploration departments,” says Jon Rigby of UBS.

“But now prices are high, and I am not sure there is the appetite to shut exploration down at this stage in the cycle.”

If oil prices fall, and the cash flows into the oil companies begin to dry up, everything could look very different.

Companies that slip up, particularly if they are the smaller players such as BG Group or Marathon, could become vulnerable.

But as long as oil supply is tight and prices are high, the majors seem likely to be able to keep making the case that they are big enough to stand up by themselves.

Copyright The Financial Times Limited 2007