BP-Amoco Deal Signals a New Era in Energy

British Petroleum’s proposed acquisition of Amoco, announced last week, is a signpost to the world economy, the oil industry and even new fuel technology.

It signals that there will be other mergers as oil businesses consolidate to cut costs and increase returns on capital. It may surprise many people to learn that the oil industry, once thought to rule the world, is now less profitable than most other businesses. But these days many oil companies need to increase returns on shareholders’ capital to keep pension and mutual fund investors interested.

Longer-term, the BP-Amoco deal looks ahead 10 to 15 years to cars powered by different formulations of petroleum, including natural gas.

But first it says the world economy will be slow for another year, maybe two. Oil prices are just over $13 a barrel now compared with more than $20 a barrel a year ago because struggling economies in Asia are using less.

Current prices, with gasoline selling in many areas at less than $1 a gallon, are considerably less than oil companies anticipated. Sales and earnings are down in the industry, and the outlook is for more of the same because Asia is unlikely to make a sharp recovery in 1999.

London-based BP, at roughly $59 billion in annual sales, reached out to acquire Chicago-based Amoco, with roughly $25 billion in sales, reckoning that putting the companies together could save $2 billion in costs in the next two years and restore declining earnings.

But a $48-billion merger is for more than short-term reasons. The BP-Amoco union recognizes that big money and breadth of operations are needed to participate in new energy developments, whether in unsettled lands of the former Soviet Union or the Middle East or in Venezuela, Canada and Australia, where usable oil is being developed from heavy-tar deposits.

Yet even as they become larger, companies have to become leaner because oil surpluses--and low prices--are likely to be around for a long time. Use of oil and gas grows every year, but in the last decade so have new reserves of crude oil and equivalents.

Therefore, “companies have to get their cost structures in line,” says Daniel Yergin, head of Cambridge Energy Research Associates, a consulting firm.

Speculation was rife last week that Mobil, Chevron and Texaco--firms comparable to BP in size--would now acquire other companies or merge with one another.

Analysts predicted that large but less-than-giant firms such as Atlantic Richfield and Philips Petroleum would have to find some way to get bigger. And smaller companies such as Unocal and Occidental Petroleum would have to find merger partners.

“Size and scale matter when you’re bidding on big projects,” notes analyst Arthur Tower of Howard, Weil, Labouisse, Friedrichs, a New Orleans investment firm specializing in energy.

However, don’t expect bonanza prices for takeovers. BP’s offer of a 15% premium for Amoco’s stock is generous but not extravagant.

The fact is, lack of profitability more than anticipation of windfalls is driving this consolidation, says Douglas Terreson, Houston-based oil analyst for Morgan Stanley.

Terreson compares oil company returns on invested capital with those earned by firms in health care, consumer goods, industrial machinery and computer technology and finds that energy comes in dead last. The large and long-term investments oil companies must make affect returns, as do poor returns on refining and gasoline retailing.

“If low returns were to continue,” Terreson says, “institutional investors would simply say, ‘I’ll shift my portfolio, invest in paper companies or drug companies.’ ”

That’s why the BP-Amoco deal is widely seen as signaling a new wave of consolidation, in one sense taking the industry back to domination by big companies. In the oil industry’s first 100 years, after its founding by John D. Rockefeller and others in the 1860s, large firms spanning production, refining and distribution of oil products ruled the business around the world.

A rival pinned the name “Seven Sisters” on the leading companies--Exxon, Royal Dutch Shell, Mobil, Texaco, Chevron, BP and Gulf--for their cooperative ventures in the Middle East and elsewhere.

But times change. Gulf disappeared into Chevron in the early 1980s after being attacked for not earning enough on shareholders’ capital--an omen for the current time.

And even though six of the seven are still in business, the industry is different from the Seven Sisters era.

Companies don’t strive to own and control every operation anymore. BP and Mobil combined their refining and marketing operations in Europe two years ago. Shell and Texaco combined U.S. refining and gasoline retailing this year.

Companies that used to own oil reserves in countries around the world now develop those reserves under contract. Relations between countries and companies have changed dramatically. The Kuwait government, for example, owns 9% of BP’s stock.

And brainpower has become as important an asset as oil reserves. In that respect, BP, led by Chief Executive John Browne (a thoughtful guy who told the Harvard Business Review that “learning is at the heart of a company’s ability . . . to generate value for shareholders”), has proved adroit.

Decades ago BP gained a favored position in the U.S. market by buying Standard Oil of Ohio, which had discovered oil in Alaska. Six years ago it restructured its operations, and today it’s second only to Exxon in return on capital. Now it is bidding to reinforce its U.S. position by acquiring Amoco, the company formerly known as Standard Oil of Indiana.

“The choice of Amoco is significant,” says Joseph Tovey, a New York-based investment banker specializing in energy, “because it is one of the largest holders of natural gas.”

Why is natural gas significant? Because Browne has shown a real interest in environmental issues, not out of idle sentiment but because he realizes that the petroleum industry is coming to a turning point. He and others look ahead a decade or so to the time when fuel cells, based on natural gas, will power many of our automobiles.

Surely that’s not a farfetched prediction. We already see the first electric cars and hybrid electric-and-gasoline-powered cars on our roads. UC Davis has developed laboratory model fuel cells, and Ballard Power Systems, a Vancouver, Canada-based company backed by Daimler-Benz and Ford, is working on prototypes. That something different from today’s gasoline will power cars in 2010 is a certainty.

Times change and smart companies think ahead--that’s why BP proposed last week to acquire Amoco.

*

James Flanigan’s e-mail address is jim.flanigan@latimes.com.