Wednesday, August 1, 2012

Big Oil’s ‘split’ting headache

The world’s largest publicly-listed oil majors did achieve operational efficiencies by riding the M&A wave that began post the Asian Crisis. But times have changed and with their merged state being questioned today, some are mulling over a new strategy to split upstream and downstream operations. Is this a wise move?

The reason was obvious. On a cold December evening in 2003, ExxonMobil’s (former) CEO, Lee Raymond, made public his decision to extend his occupation of the corner office until mid-2006. Why? Integration at the four year-old, $230 billion-worth merged entity called Exxon Mobil was still incomplete, rendering it unfit in terms of “operational efficiencies” to be handed over to the younger oilman Rex Tillerson. Raymond wanted to give Tillerson more face time with Wall Street. In a little over two years, Tillerson was handed over the reigns. Since then, onlookers have watched Exxon’s share chart rise with their mouths gaping. If Tillerson today seems as though he knows his way around rigs, it is because he has steered handsomely a big ship, for over half-a-decade. [Today, had Exxon been a nation, it would be counted as the fourth-largest oil producing country, with a daily production volume of 4,968,000 barrels of oil-equivalent per day (boepd), only behind Russia, Saudi Arabia and US (source: US Energy Information Administration).] For Tillerson, the “grow big” story has worked. He has toiled hard to make the company the most integrated player in the oil business today, through superior capital allocation plans and a relentless pursuit of technology and operational improvement. It has delivered the highest returns on capital relative to peers since the past five years. But Exxon’s tale only represents the pretty part of the merger mania. Conoco Phillips is on the other end of the see-saw.

There is a new fad in town. That of merged entities trying their hands at spin-offs to improve efficiencies and market value. Even experts and Wall Street bankers – who had previously championed the cause of the inorganic way forward – are today questioning whether these individual companies would have been better off as individual entities, and more valuable in terms of aggregated market capitalisation. Truth is oil companies, over the decades, have increasingly lost control over the price of oil, which fluctuates at the whims and fancies of oil producing nations and the derivatives market. This further means that for big oil, improving on operational efficiencies has become most critical. And to achieve that, the not-so-happy merged oil companies like ConocoPhillips are contemplating a split of their upstream and downstream operations into two independent public entities – one dealing with exploration and production (upstream) while the other with refining and marketing (downstream).

And such contemplation – to undo what the merger wave did a decade back – is coupled with action. Months after Marathon Oil (an oil and gas firm with revenues of $73.6 billion in FY2010) split into two independent entities in January 2011 (Marathon Oil – the upstream arm, and Marathon Petroleum – the downstream arm), ConocoPhillips (COP), the world’s third largest integrated energy company (on July 14, 2011) followed suit. Although it is too early to analyse the outcome of this move, fact is that the popular market reaction has not been too encouraging.

In the case of Marathon, a day before the announcement of the split, its m-cap stood at $31.3 billion. Today, it is down to $30.5 billion. Definitely not a positive sign. If a split unlocks value (as it happened in the case of Motorola Inc., ITT, Daimler Chrysler), it starts showing loudly in the investor crowd almost instantly. In case of Marathon, it didn’t. Our case of analysis to understand why a split for an integrated oil company is a tough pill to swallow (and better not undertaken for operational reasons), is COP. Since the announcement, it has shed value to the tune of $16 billion – down by 15%. Why is it that the investors are not optimistic about the split strategy to work for COP? Given that the company has already closed much of the valuation gap with its industry peers – exceeding it in some cases – any extraordinary appreciation in m-cap over the short term is highly unlikely. Also, there are factors that will make all gains from the split partially ineffective. The first and foremost being its recent walk on the inorganic path, which has increased the job for the taskforce supposed to work on the split. Acquisitions have dominated its growth strategy during the past 4-5 years. The company bought American natural gas assets (Burlington Resources), Russian oil supplies (20% stake in Lukoil), and stranded gas in Australia (Origin Energy). These “expensive” deals culminated in a $34 billion goodwill-impairment charge. With its ill-timed acquisitions and a $11 billion share repurchase plan failing to deliver returns, the investors understand that this split strategy is “only” a survival attempt.


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