Oil & Gas: Mega Merger

Small may still be beautiful, but ‘larger the better’ is a more apt motto for modern business organisations. Size matters; particularly in the oil and gas industry where capital investments tend to be huge, and the risks, even higher. In contemporary times, technology giants are increasingly displacing traditional companies from the Fortune 500 lists. But oil is right at the top of the heap. And yet, the recent move by the Indian government to merge state-owned oil and gas companies to create a unified behemoth has triggered responses that range from surprise to disbelief to skepticism. Of course, there were some who have welcomed the move as a timely, wise and strategic decision.

While delivering his fourth budget speech on 1 February, finance minister Arun Jaitley declared: “The government plans to form a major oil company by merging some of the existing firms in the oil and gas sector to take on international and domestic players... Possibilities of such restructuring are visible in the oil & gas sector now and we propose to create an integrated public sector oil major that will be able to match the performance of international and domestic private sector oil and gas companies. (It will give them the) capacity to bear higher risks, avail economies of scale, take higher investment decisions and create more value for the stakeholders. India has 18 state-owned oil and gas companies at present. The top six include large exploration and production players namely Oil and Natural Gas Corporation (ONGC), Oil India, and refining and marketing companies namely Indian Oil Corporation (IOC), Bharat Petroleum Corporation (BPCL) and Hindustan Petroleum Corporation (HPCL), besides the gas giant GAIL.

The Unified Giant
Exactly how big will be a unified giant and how will it stack up against global oil majors? The eight largest state-owned enterprises in the sector are Indian Oil, ONGC, BPCL, HPCL, GAIL, Oil India, Gujarat State Petroleum Corporation (GSPC) and Mangalore Refinery and Petrochemicals (MRPL). The revenue from other entities will not substantively change the numbers. If these entities are merged, the total revenue of the unified giant will be about $140 billion. It would become the 11th largest oil and gas company in the world, though still far behind behemoths like Saudi Arabia-based Aramco ($460 billion) and China-based Sinopec ($440 billion). Some think that the unified entity will have greater room to negotiate and maneuver and will reap benefits from economies of scale.

Says Nikunj Dhanuka, Managing Director and CEO of IG Petrochemicals, “The petroleum sector in particular was in the forefront of action, with the stage being set for the Indian state-owned petroleum companies to be merged into one big national petroleum company with economies of scale and the ability to leverage an integrated portfolio of offerings in the international competitive marketplace. This will set the stage for building a national petroleum resource entity, capable of leveraging some of the best deals and cost advantages given the negotiating power that it would have. In doing so, the country should have its own version of PETRONAS or Royal Dutch Shell or BP, which is capable of being competitive in the international space as well as meeting with the ever-growing demand of the domestic market in the next one year, with a totally integrated end-to-end portfolio of products.”

This enthusiasm was, however, missing among other senior professionals, industry experts and consultants that BW Businessworld contacted. One of the very few to respond on record was B. Ashok, chairman of Indian Oil, the largest company in India in terms of revenues. He says, “The oil and gas companies in the public sector are robust and have their own unique strengths. In my opinion, the mergers could be done in phases, after a careful and professional mix and match process.” According to him, the public sector enterprises operating in the oil sector have multiple stakeholders, and the aspirations and expectations of each of these stakeholder groups have to be taken into consideration while going forward with a plan.“The immediate challenge will be to overcome the cultural differences among the enterprises and to create a buy-in among various stakeholders with a conviction that any merger would be a win-win proposition. Also, there can be different models of achieving integration and we should carefully evaluate the pros and cons of each of these models and arrive at a consensus that benefits all, and at the same time addresses India’s current and future energy needs,” he adds.

Even as the Budget speech of Jaitley has led to many comments, there is still no clarity on what exactly will be done next. Several people in the government, industry, investors and the analyst community, with whom BW Businessworld spoke, said that it may be yet another non-starter as was the case twice in the past when similar proposals were mooted by two previous governments. While the government is claiming that it would be able to complete the process, starting from the concept paper to the ground work, in the current fiscal year, a leading global consultant with a key portfolio of oil sector practice confirms that it will take much longer. One day after Jaitley delivered his Budget speech, oil minister Dharmendra Pradhan said in a media interview that the government was looking at the option of creating multiple integrated state oil companies, not just one large firm. “It’s not going to be a merger of all oil public sector undertakings into one,” said Pradhan, adding that “It’s an in-principle decision taken by the government to develop a few integrated state oil companies, which will have better risk management capacity and the clout to compete in international markets.”

As expected, most of the oil and gas units that are supposed to be participating in this reformatory move, reserved their comments when asked to share their views for this story.

Historic Recurrence
History appears to be repeating itself. The country has seen it at least twice in the last two decades, when two previous governments explored similar options. The last attempt was about 12 years ago. It was Mani Shankar Aiyar, the then petroleum minister in the first Manmohan Singh government, who formed a committee to look into such an option in 2004. The committee, under former steel secretary V. Krishnamurthy, was constituted to recommend an appropriate structure for state-owned oil and gas companies. The mandate was to look at the possibility of creating a larger entity with a very strong balance sheet to raise huge capital from international markets for acquiring energy reserves and assets abroad.

The committee, which included former petroleum secretaries, Vijay Kelkar and G. V. Ramakrishna, former chairman of ONGC B. C. Bora, the former chief of Bharat Petroleum U. Sundararajan and the former finance secretary G. K. Arora, however did not favour the merger plan. Says former minister Aiyar, “I was in favour of the proposal then as circumstances were different. The scenario has changed completely since then and I don’t think it makes any sense now”.

A similar proposal was made in 1994-95. The petroleum ministry in the P. V. Narasimha Rao government, which is credited for economic liberalisation of India, also looked into an oil PSU merger option. Captain Satish Sharma, the then petroleum minister, too formed a reforms committee led by then oil and gas secretary Kelkar, and Bharat Petroleum’s Sundararajan.

Both committees had similar views. They were critical about an overall merger and rejected the idea of forming an oil monolith, saying it will not only create market monopoly but also affect the efficiency created by individual companies. Instead the committees suggested strengthening the structure of the state-owned oil companies through policy measures and improvements in management to focus on their core competencies.

While their views against merger of oil companies were also based on many other economic and political factors, including bad mergers and acquisitions in the global oil industry, another major objection was the strong resistance from heads of the oil companies.

According to a leading industry consultant who worked closely with the Krishnamurthy committee, the last merger plan was dropped because the heads of individual oil PSUs trashed it as non strategic. And, it was the people factor, including the job cuts and difficulties in managing hierarchies in the event of a mega merger, which fumed the resistance.

Undoubtedly, the current proposal demonstrates the government’s well-intended vision of creating a globally competitive energy behemoth. But considering the changing global industry scenario, where India is emerging as one of the most attractive retail markets for its private players as well as foreign oil giants, a decision in haste could turn the move counter productive.

Plus, what could potentially block the entire project is the political dilemma on critical issues such as job cuts, hierarchies, and interest of minority shareholders, among others.

Although more clarity on the model and objectives are yet to emerge from the government, the proposal in its current form hasn’t gone down well with the critical stakeholders from the industry.

Industry insiders and sector experts, including analysts and consultants, appear seriously skeptical of the overall concept. They say that what would rather make sense is a structural reformation by integrating upstream and downstream players separately. Any other model will certainly prove to be a serious policy blunder, they say.

“The issue to merge would necessarily need to be debated and addressed in the context of India’s diverse energy needs and global energy outlook. Securing desired levels of energy security, integrated investment planning, cost efficiency, deeper integration with global energy markets and human capital are critical aspects that need to be addressed upfront,” says Ajay Arora, partner and national leader (Oil & Gas), EY India.

According to Arora, India can evaluate the merits of consolidation on segment-wise basis such as upstream, downstream and separately for gas. Such consolidation gives the benefit of balance sheet size and focus, resulting in lower costs of capital and ability to execute large domestic and global projects. Hence, giving the Indian oil PSUs the size and scale to compete with global oil and gas majors. The benefits of such an integration/merger are imminent. However, the merger needs to be planned meticulously in view of deal complexities, timelines and related human capital issues.

M&A Upsets
As a matter of fact, the key rationale behind mergers and acquisitions in any sector is achieving operational synergies and optimising cost efficiency in a competitive industry environment. This would essentially mean resource optimisation, pruning extra capacities and overheads, including jobs, eliminating duplications and increasing efficiencies with the aim to boost profitability.

But in a country like India, where jobs remain a sentimental issue both in the political and social perspective, public sector organisations can’t even imagine such a sudden move. In addition, Indian public sector companies have heavy hierarchical clouts as well as a strong union culture, which will make integration and job cuts almost impossible to get through.

Besides, the committees tasked with exploring the feasibility and success of such an experiment also didn’t find enough empirical evidence that mergers and acquisition strategies were successful in majority cases.

Global data on mergers and acquisition across sectors show more than 70 per cent of them did not bring expected results or rather failed to give higher returns for shareholders in those organisations. And, the major causes of failure were directly related to unsuccessful integration process and people issues.

“Integrating India’s oil and gas PSUs across different operating areas in the value chain, mainly the upstream (exploration and production) and downstream (refining and marketing), will only upset the applecart,” says a leading sector expert with a global consultancy firm, who doesn’t want to be identified.

According to two industry analysts, some of the merger cases in the Indian public sector undertakings have proved big failures as the concerned decisions were taken in haste and without much clarity on the integration processes.

For instance, the Air India-Indian Airlines merger has by now become a classic case of the worst merger decision of the UPA government. Air India’s performance has worsened, and losses have widened, compared to efficiency and growth of its private sector rivals over the period. Jitender Bhargava, a former executive director of Air India who has written a damning book named “The Descent of Air India” said in a newspaper interview, “Whether it was the aircraft acquisition, merger (with Indian Airlines) or many other big expenditure decisions which harmed Air India financially were taken without proper thought or detailed discussions within the airline. A handful of Air India officials did lend support for questionable reasons. What also surprised me was though we had (banker) N. Vaghul on the board as an independent director, he did not red flag any of the decisions which had a huge financial bearing and led to eventual crippling of Air India.”

Another example is Coal India, which was created as a single entity that virtually controlled all the coal reserves of India. Though the company performance has improved recently, it has consistently been a poor performer and responsible for recurring and crippling shortages of coal in the country. So the question is what if a corrupt minister and the ruling party in the future use a unified oil giant as a milch cow? It has happened in the past and there is no saying it will not happen again in future.

For example, two of ONGC’s decisions in the past have led to considerable controversies. In 2008-09, the company had forked out close to $2 billion to buy out Imperial Energy, which was exploring primarily in Russia. It has been eight years since the investmet, and ONGC is yet to find much success in discovering oil or gas. Many allegations were leveled against the then UPA government for gold plating. More recently, ONGC decided to take over the KG basin gas blocks controlled by GSPC for about $1.2 billion. And this time, Congress leaders accused the NDA government of indulging in an alleged “scam” to save debt-ridden and loss-making GSPC. That’s not it, about 15 years ago, ONGC had acquired the stake controlled by the Aditya Birla Group in refining company MRPL. It is baffling why a crude-oil major took over a refining company instead of state-owned refining giants like Indian Oil. It is the possibility of arbitrary decisions like this that makes analysts even more skeptical.

Perhaps that is why, a key decision maker like finance secretary Ashok Lavasa was guarded while talking to BW Businessworld on the issue of creating a merged entity. He says, “Different businesses at different points in time, in different contexts, will have a different argument. Whenever the details are worked out, we will have to keep all these aspects in view, and do what is in the best interest of the sector, the best interest of the shareholders, and the best interest of the consumers...This is something which is in the works. It would be little premature for me to spell out the details. But different aspects have to be kept in view before a final view is taken on this.”

Global Scenario
At the same time, it is a fact that mergers and acquisitions have been the norm in the global oil industry, and most of the global oil giants, including Exxon Mobil, ConocoPhillips, Royal Dutch Shell, BP, Grazprom, Rosneft, Sinopec, China Petroleum are all results of mergers. Also, most of these oil giants, except a few big ones in the US and Europe, are currently state owned.

However, no country in the world except Venezuela has just one national oil company controlling the entire industry and market. Although China and Russia moved towards creating a consolidated oil and gas giant in the 1990s, they gradually backtracked and both countries have at least half a dozen large oil and gas companies.

Even as the Venezuela experiment of a single state-owned entity was launched by the late Hugo Chavez who wanted to create a ‘socialist paradise’, the experiment has been a costly failure as the state monopoly has actually started seeing a drop in production.

It is also interesting to note that the reason why countries have not created a single entity is efficiency. Empirical evidence shows that one behemoth as a monopoly always becomes inefficient over a period of time and leads to poor productivity. Even within the state sector, competition between companies is universally considered to be better, say industry experts.

The NDA government’s rationale behind the proposal to combine some or all of the state-owned oil and gas companies into one major entity i that it would give them the wherewithal to bid for major exploration and production assets in India and overseas.

It is also interesting to note that the latest proposal of consolidation and merger of the oil PSUs came just two years after another expert committee’s recommendations for greater accountability and autonomy for India’s national oil firms.

This committee, again headed by Vijay Kelkar, was mandated with drafting a broader proposal to reduce India’s oil imports by 2020. In 2014, the committee said strengthening the oil PSUs with greater accountability and autonomy is the need of the hour. But it is not very clear if the latest move could be considered a continuation of the same with a greater impetus on the financial bandwidth and strong balance sheet.

Since India is keen to acquire oil assets in international regions for energy security, it certainly needs to have globally competitive oil entities to compete with foreign giants.

In addition, these public sector companies also compete with comparatively more efficient private players such as Reliance Industries, Cairn India and Essar Oil in the domestic market. If the mega merger takes place, the new integrated player would be able to compete with global players such as the BP and Rosneft and Shell among others.

According to a recent S&P Platts report, India with its ever rising oil demand is attracting a lot of multinational firms to set up shop here. Simultaneously, the government is also stepping up efforts to ensure that state-run oil companies are on equal footing to compete, not just with domestic private players but also with global oil firms.

In 2016, India’s oil products’ demand rose by a robust 8.8 per cent year-on-year to 192.80 million mt, or 4.14 million b/d, according to data from the Petroleum Planning and Analysis Cell.

Platts Analystics predicts that India’s oil demand growth will outpace China’s for the third year in a row in 2017. It estimates that Indian oil demand is expected to grow at about 7 per cent to 4.13 million b/d and China’s by only about 3 per cent to 11.5 million b/d.

The government’s decision to build emergency storage sites in underground caverns in the country to hedge against energy security risks also makes lot of sense.
In his Budget speech, finance minister also said that two new planned reserve facilities along with the existing three reserves will take up the country’s strategic reserve capacity to 15.33 million metric tonnes.

India currently meets more than 80 per cent of its energy requirements through imports. So the government has now set a goal of reducing this import dependence to 67 per cent by 2020.

How Prepared Is India?

As stated earlier, it isn’t the first time a mega merger plan in the country’s oil sector has come up for discussion. And as it happened in 2005, the discussion on proposed monolith structure for oil sector hasn’t found much favour within the industry even today. The advisory committees had earlier stated that any merger in the Indian context which would result in massive job cuts, might not be feasible.

“Not much seems to have changed since then. We believe that the implementation of such a merger remains a concern, specifically getting the minority shareholders on board,” says an industry consultant.

The analyst community is also equally worried about the impacts of such a merger.

A Fitch Ratings note, immediately after India’s Budget announcement on the proposed oil PSUs merger, said, “Although the proposed merger of state-owned oil companies could reduce inefficiencies across the sector and create an entity better placed to compete globally for resources, it would face significant execution challenges, particularly in terms of managing the integration of employees, addressing overcapacity in the merged entity, and winning the backing for the merger from private shareholders.”

“A merged entity would have opportunities to save on costs and improve operational efficiency as there would be less need for multiple retail outlets in a single area,” the Fitch note said, adding that it would also reduce transportation costs as the retailers can source from the nearest refinery, rather than the ones they own — as is currently the common practice. A merged entity would also be able to share expertise for exploration and acquisition of resources, it added.

“But, how will the state handle the likely decline in competition after a merger,” the Fitch note asked the most critical question.

“DEFINITIVE ROADMAP ON OIL PSUs’ MERGER VERY SOON”
Many countries across the world are breaking oil behemoths into smaller entities. We, on the other hand, are talking of creating a behemoth. What’s the rationale? Whenever you look at these businesses with a number of components that are handled by different utilities, there’s always a question of deriving the maximum advantage. Either with vertical integration or sometimes by dismantling an integrated entity. One has to look at the business cycle and the time when you can reap an advantage. All these things would be taken into consideration by the government before a final decision is taken.

What does it mean by one big entity or twothree entities having presence in the entire value chain?
This is something that is in the works. It would be little premature for me to spell out the details. But different aspects have to be kept in mind before a final view is taken on this.

Globally major corporations are being demerged into smaller entities. Are we walking another trajectory?
Look at the power sector. At one point in time, we went through a process of unbundling because it was felt that the production, the delivery, the retailing should not be bundled into one utility.

Different businesses at different points in time, in different contexts, will have a different argument. Whenever the details are worked out, we will have to keep all these aspects in view, and do what is in the best interest of the sector, the best interest of the shareholders, and the best interests of the consumers.

By when will we see a definitive roadmap?
I think very soon

By Suman K. Jha