IT started with a lack of clarity. And it may end up with more confusion. The government’s aim to effect mega-mergers between State-owned oil and gas behemoths started on the backfoot, and now seems to be caught up on the wrong foot. In this year’s Budget speech, Arun Jaitley, the Finance Minister, said, “We see opportunities to strengthen our CPSEs (Central Public Sector Enterprises) through consolidation, mergers and acquisitions…. Possibilities of such restructuring are visible in the oil and gas sector. We propose to create an integrated public sector ‘oil major’ which will be able to match the performance of international and domestic private sector oil and gas companies.”
Obviously, Jaitley’s idea was based on the emergence of global behemoths such as ExxonMobil, Royal Dutch Shell and BP (British Petroleum), as well other giants like Saudi Arabia’s Aramco and Russia’s Gazprom. The day after the Budget, a Reuters piece said that the combined market capitalisation of five Indian oil majors—ONGC, Oil India, Indian Oil, Hindustan Petroleum and Bharat Petroleum—was just over $100 billion, which was far less than ExxonMobil and Shell, but comparable to BP (just over $115 billion) and higher than Russia Rosneft ($70 billion).
Immediately after the Finance Minister’s speech, Petroleum Minister, Dharmendra Pradhan, issued an important clarification. “It will not be one company. It will not be wise to put all eggs in one basket. There will be multiple companies… but all these will be integrated.” He clarified that each of these 3-4 large entities, instead of the existing six (including GAIL) major ones, will be present across the entire value chain—from exploration, refining to retail. Weeks later, he added that the restructuring will result in vertical mergers.
Months later, there were indications about the proposed mergers. Media reports indicated that initially ONGC, an exploration company, will acquire Hindustan Petroleum, a refiner-retailer. The next step will be to combine Oil India, another explorer and Bharat Petroleum, a predominantly marketing firm. At the moment, Indian Oil, India’s largest commercial company, may be left alone or acquire a few smaller oil State-owned companies. GAIL too may remain independent. Thus, there may be four integrated giants, rather than the current six.
However, experts contend that this exercise may turn out to be a futile one. The mechanism of the proposals may not yield too many benefits to either the acquirer or the acquired. To analyse it, let’s look at the five reasons mentioned by Jaitley in his Budget speech to justify the creation of a ‘single’ integrated company. These included integrated value chain, higher risk capacity, economies of scale, higher investments, and more value for shareholders.
Up and down the value chain
IN theory, it is an excellent idea to bring together the upstream (exploration) and downstream (refining and retail). In this combination, the former will have a ready buyer for its products, and the latter can control the cost, quality and delivery time of its inputs. Given the volatile crude prices, such a marriage will protect the exploration activities during times of low prices, and the refining operations when prices zoom. Low prices will boost refining margins, and the opposite will result in bonanza for the oil explorers.
These were the logics that drove a wave of madness in the oil and gas M&A arena in the 1970s and 1980s. As an article in the Economist said, “Some of the best known examples of vertical integration have been in the oil industry. In the 1970s and 1980s, many companies that were primarily engaged in exploration and extraction of crude petroleum decided to acquire downstream refineries and distribution networks. Companies such as Shell and BP came to control every step involved in bringing a drop of oil from its North Sea or Alaskan origins to a vehicle’s fuel tank.” Within a decade, the concept was junked.
The concept of vertical mergers in the oil and gas sector became “less compelling” towards the end of the 20th century. According to a McKinsey report in those years, “Whereas historically firms have vertically integrated in order to control access to scarce physical resources, modern firms are internally and externally disaggregated, participating in a variety of alliances and joint ventures and outsourcing even those activities normally regarded as core.”
In the recent times, Shell has restricted its exposure in refining to a few key areas. It sold off some of its refining assets, and merged several with another refining firm. The fact that integrated operations can falter, and lower profits was evident from ExxonMobil’s financial performance in 2015. According to a report, “ExxonMobil generated a total of $259 billion of revenues and $16 billion of net profit in 2015. ExxonMobil overall revenues and net profit declined significantly in 2015 as compared to the previous years because of a sharp decline in crude oil prices in 2015.” As a comparison, the company’s revenues and profits in 2011 were $467 billion and $41 billion, respectively.
Risk is attached to huge costs
ONE can always claim that the larger the balance sheet of a company, the higher is its ability to bet on somewhat risky investments. Its risk appetite grows with its bloated financials. However, there are two crucial things to remember in the upstream and downstream businesses. The first is that the risks attached are not just related to the business; it includes political, geopolitical, diplomatic and other risks. Hence, merely access to cash or a big balance sheet isn’t enough. A recent example was when Iran awarded a gas field discovered by ONGC Videsh to Russia’s Gazprom because of its eco-diplomatic battle with India.
In addition, even the biggest of the oil companies have had to write down their investments, incur losses, or operate in hazardous conditions like civil war and terrorism, especially when they seek fields in politically-unstable nations. Indian firms, and more importantly the Indian governments, don’t seem to have adequate skills and competencies to handle such contingencies. Although ONGC invested in Sudan, and India inked deals with Iraq and Iran, a combined ONGC-Hindustan Petroleum doesn’t have the same expertise as Exxon or Shell.
Most private oil companies work well because they function like mini-governments and take independent decisions. In addition, they regularly use the might of their governments to solve and resolve issues. ExxonMobil is a perfect example of a company that acts on its own, but has the ability to twist the US government’s arms whenever it is necessary to do so. In the case of State-owned monoliths, the State backs them completely as is the case with Aramco. In India, even the merged entities will have neither of the two.
Scaling up the economies
Yet again, a merger between upstream and downstream is cost effective. If a firm can control its inputs, and manage to generate demand for its products, it is in an ideal situation. This can easily happen in an integrated company in any sector, let alone the oil and gas one. However, there are two crucial criteria for them to happen by the book. First, the integrated company needs to have the choice to decide the prices at which it will sell its products, both inputs for the downstream operations, and the final products to the consumers.
Second, the economies are driven by tactical decisions. For example, for the costs to be low, the refineries need to be close to the oil and gas fields, as also to the consumption regions. Neither of these is true in India, for any company. As per the Supreme Court ruling in the Ambani case, it will be the government that will decide the price of the oil and gas, and to whom they will be sold. The government fixes the quote, in some form, for the users in the different sector like power and fertilizers. The explorer simply cannot decide.
An arbitrary merger (or acquisition) between ONGC and Hindustan Petroleum is meaningless unless there is a detailed analysis of the locations of the former fields and latter’s refineries. If the refineries are located too far away, or because of political, rather than business, reasons, the economies of scale and synergies will not materialise. Instead, a better option will be to take a stock of all the exploration areas and refineries and then work out the jigsaw puzzle. Ask ONGC to take over any refinery, whether owned by Hindustan Petroleum, Bharat Petroleum or Indian Oil, if it makes economic sense.
Investing for the future
INVESTMENTS, as mentioned earlier, depend on risk-taking abilities, especially for spending money on overseas ventures, and autonomy. The State-owned oil companies possess neither. Vertically-integrated oil majors make sense if these too are handed over to the managements. This will imply professionalisation at the top, and a hands-off approach by the government. This doesn’t look to materialise in the near future; even the concept of integration is being imposed on the oil companies by the policy makers.
Benefits to the shareholders
Over the past 12 months, there were differences in the behaviour of oil exploration stocks, like ONGC and Oil India, and oil marketing ones, like Hindustan Petroleum and Bharat Petroleum. The former went up from a low base, reached a peak, and then crashed, although they were higher than the lows. The latter kept on increasing throughout the 12 months. For example, Bharat Petroleum was just over Rs. 500 in July 2016. It went up to almost Rs. 750; only in the past few weeks it came down as it shed about Rs. 100 to close at Rs. 630 on June 23.
Therefore, it will be difficult to predict how the shareholders will perceive the stocks of the combined entities, which are vertically integrated. The prices can move up or down depending on the synergies, as understood by the experts, and not by the government or the oil companies. Similarly, for the values to unlock, one will need greater analysis to decide if 1+1 in these cases is 2 or 11, or somewhere in-between. Neither can be taken for granted.
For shareholders to drive up the stocks and benefit from the higher valuations will require a number of other steps. One, the managements will need to be de-politicised, and professionals will have to be hired, especially at the top posts. There has to be independence in the selection of these individuals, and they will need to be compensated handsomely. Obviously, they will step in if they are given the freedom to make key decisions, without having to refer them to the oil ministry and its bureaucracy. Otherwise, we will have the same situation as is the case with the CPSEs currently listed on the bourses.
If a holistic view is shed aside, and the government goes ahead with the task of creating larger companies, such moves are bound to fail. More importantly, the government has to ask itself a crucial question: is the creation of the integrated oil companies merely an excuse to earn huge sums for the exchequer? This is evident from one of the options being discussed for the ONGC-Hindustan Petroleum alliance. The government wants ONGC to acquire the refiner, and wishes to sell all, or most, of its stake in the latter. Thus, the government will earn huge amounts, and ONGC will not benefit a tad. A case of rob Peter to pay Paul!