<THE DRIP PORTFOLIO>
Boil and Bubble
Oil in Trouble? Plus, centering ourselves.
by Jeff Fischer ([email protected])
Paris, France (Dec. 17, 1998) -- What is happening in the oil industry and why? Where do we stand right now, and where are we going? We'll address this today in the context of the Drip Port's goals, which include finding market-beating investments that have many advantages over the competition. (Plus, I guarantee at least three jokes in the text. Note, however, I didn't say good jokes!)
Recent Big-Time Activity
Last week, the European Union gave British Petroleum Co. antitrust approval for its $62 billion acquisition of Amoco, and on the first day of this month -- as everyone knows -- Exxon and Mobil announced a $78 billion plan to become one. Together, Exxon and Mobil will be the largest company (by sales) in the United States. Last year, revenue for the two companies totaled $186 billion, topping General Motors by $20 billion (or nearly half the net worth of Bill Gates, to put such large numbers in context).
These mammoth-size transactions follow the Royal Dutch/Shell Group marriage. In fact, these three new companies (if the latest deals go through) will easily be the three giants leading the oil industry: Royal Dutch/Shell, British Petroleum/Amoco and Exxon/Mobil. (Exxon/Mobil will reputedly be renamed "ExMob," despite the negative connotations. Or so we hear.)
Once formed, ExMob would have 28% market share, while Royal Dutch/Shell has 22%, and BP/Amoco would control over 10%. Texaco has about 5% market share, and more than 20 other oil companies split the remaining 35% into tiny pieces. These small companies probably won't remain alone for long, however: we'll see more and more mergers and acquisitions.
Past and Present
What's with all these acquisitions, anyway? It's so unusual. Something must be wrong with the oil industry!
Well, no.
In actuality, since the late 1970s, billion-dollar mergers have been shaping the oil industry into what it is today: a pool of companies that is decreasing by number, but holding steady in overall size, and actually growing. 1995 to 1997 were record years for oil companies. Last year, all-time record strong net income was earned at Chevron and other industry leaders. That was last year, not 20 years ago, or even 10 years ago. Last year. Keep that in mind as you now listen to countless reports about how moribund and hopeless the oil industry is. Merely one year ago you couldn't turn a corner without a stock broker trying to sell you an oil investment because the industry was "so predictably strong and wonderful. Who doesn't need oil?"
Anyway, this year's mergers do follow a plunge in oil prices to new all-time (inflation-adjusted) lows of around $11 per barrel, but large mergers were going to happen sooner or later anyway. The consolidation process merely accelerated due to two conditions that exist this year:
1) You know it: low oil prices create a difficult situation in the industry. Oil prices are expected to average $12.35 a barrel this year, down from $21 just two years ago. Think about that! The price of the commodity that these companies sell has been nearly drilled in half -- hey, similar to computer chips!
Next reason...
2) The more that large, industry-leading companies merge, the more that other companies must do the same to stay competitive. It's a chain reaction. For example, soon after the Exxon/Mobil announcement, one wasn't surprised to hear that Total SA of France and Petrofina SA of Belgium were in merger talks, too, with a value of $9 billion and expected annual savings of $1 billion. At least the two companies could work together to lead their small part of the world.
The point is, though, that the mergers taking place now are the next natural step following twenty years of snowballing (meaning, growing larger by acquisition) in the industry. The consolidation shouldn't surprise everyone and doesn't mean the industry outlook is nothing but dismal. Consolidation is more of the same. It just makes the most sense to do it when the industry is either booming or crawling.
In 1979, the largest acquisition in U.S. history was done by Shell Oil when it bought Belridge for $3.2 billion. In 1981, Conoco was acquired by DuPont for $7.8 billion. In 1984, Mobil bought Superior Oil for $5.7 billion. (Superior was the country's largest independent oil firm.) The list goes on, including Occidental and Cities Service, and Texaco and Getty Oil, and finally Chevron ate the largest oil enchilada of the times in 1985, buying Gulf Oil for $13 billion. (This oil enchilada was more oily than even Taco Bell's famously greasy offerings.)
But wait. One thing.
The acquisitions of today are of a different ilk than in the past. Business was booming in the 1980s and everyone thought oil would soar to $40 a barrel, or more; so acquisitions were done with debt (oooops!), a move that later haunted companies as oil prices fell. By contrast, in this decade acquisitions are about cost-savings and remaining competitive, and they're financed by stock rather than debt, but they're still not surprising. If the industry was booming, these acquisitions would still occur, but for a different reason -- as they did in the past.
How much longer can consolidation take place? Answer: we're still in the early phases. Being absolutely enormous, the oil industry isn't nearly as consolidated or concentrated as the beverage industry, or computer chips, or even the soup industry, where only one or two companies dominate. The oil industry is getting closer to that, however, and, governments willing, it will continue down this route. By the year 2010, we'll probably have 1/5th the number of oil companies that we have now.
Like boy scouts round a nighttime campfire -- sharing tall stories and happy to be "brothers" in a big, dark world -- oil companies are going to grab hands and experience the darkening night together.
The Destiny of Oil Companies
And what darkening night is that?
A full 75% of the world's known oil reserves are controlled by OPEC -- OPEC, a group of grown men who can't agree on the color of the sky, let alone on how to manage the world's oil supply. When OPEC agrees to curb production, if just 80% of its members comply it is considered excellent. Why? Because most OPEC members don't want to slow production and lose near-term profits. Sure, lower supplies would soon raise prices, but Economics 101 isn't a mandatory class when you're born a billionaire; and anyway, OPEC members don't have time to wait for rising prices, they want to maintain sales now; and they don't want to lose market share to other OPEC members who ignore curbs.
While OPEC bickers and sets iffy curbs, the crisis in the Asia-Pacific region decreased world demand for oil significantly at a time when production was at record highs following a three-year boom. This left oil companies between a rock and a hard place. Imagine if Intel built four new chip fabrication factories months before a large slowdown in demand: yes, big trouble. Oil companies are sitting on production and refining capacity that the world doesn't currently need, and OPEC is pumping oil into inventory reserves that are already record high. To make matters worse, oil prices are quoted around the world in U.S. dollars, meaning that as Asian currencies deflate in value, oil prices actually rise, making oil even less affordable in troubled economies.
How Temporary is Temporary?
Yet, all of these issues sound temporary, don't they? Every Fool knows that the price of and the demand for commodities fluctuates. 1997 was record strong. 1998 is weak. Next year... Who knows? The doom and gloom that we hear this year is premature, however. Oil's importance won't likely diminish for three to four decades, and very good times will be had again. The leading companies -- because of what they're doing now -- will be in a strong position to profit. Enough so that 1997's record performance probably won't stand for too long. Great years will come.
The Drip Port is concerned with the next 20 years, though -- with the overall long-term trend. We can reasonably analyze Campbell Soup, Johnson & Johnson, and even Intel and Mellon Bank enough to know that their markets should be considerably larger in 20 years, and the companies considerably more profitable -- if they're successful. But can we do this with oil? Can we find the few oil investments that are most likely to beat the market over 20 years, whatever the industry does?
My initial reaction is: Maybe.
Oil is a commodity like computer chips are a commodity. There are more moving parts with oil, but semiconductor chips likely face as much chance of being replaced by new resources as does oil in the next two decades. So -- while leading today's market -- which oil companies are also preparing for the new energy sources of the future? We'd rather invest in management that sees itself as an energy leader, not just an oil leader. Which companies are those? That's something to consider on the Drip Companies message board. Also, read our Investment Criteria to see if you believe that an oil company or future energy leader can fit the mold. I believe that we can find the oil company most likely to beat industry peers, but what about beating other industry investments, and the S&P? We'll see!
Tightening the Sails While Still Sailing
We'll have more tomorrow on our ongoing study (taking stock, as it were, before speeding forward). Tomorrow is Touchstone Friday, too, so we'll review the news of the week and do housekeeping, including taking care of our January investment.
Fool on!
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