The announcement last month that ConocoPhillips plans to break up into two separately traded companies took Wall Street by surprise, raising uncomfortable questions as to Big Oil’s raison d’etre. If COP proves that it can indeed unlock value from separating its exploration and production unit from its refining and marketing units, then other companies, namely BP and ExxonMobil, could soon find themselves under pressure from their shareholders to follow suit, forever changing the energy landscape.
Up until now, it was widely accepted that being bigger was the key to being a better oil company. That view was taken to its logical extreme in the late 1990s when the “Super Major” oil company was born. In the United States, Conoco merged with Phillips, Chevron merged with Texaco and Exxon merged with Mobil. In Europe, BP snapped up U.S. oil companies Amoco and Arco while France’s Total acquired Belgium’s Petrofina and fellow French oil company Elf Aquitaine. Only Royal Dutch Shell avoided the merger mania.
The reason for the mergers was clear — oil prices had collapsed. In the late 1990s, oil traded down as low as $10 a barrel due to a myriad of events — some situational, like the Asian economic crisis of 1998, and some structural, like the decreasing link between oil consumption and economic growth in Western nations. In addition, the number of oil fields that were open to commercial development had diminished, while royalties from existing fields were on the wane as oil-producing countries demanded a larger piece of the revenue pie.
The mergers were seen as a success for most of the majors as they were able to rationalize their business models and streamline operations. Being bigger gave them more pricing power when dealing with oil service contractors and greater leverage when negotiating with foreign governments. But the benefits of being bigger seemed confined to separate business units: While a refining unit got more efficient through the merger, it wasn’t because the company had a strong exploration and production unit, and vice versa.
That’s because the exploration side and the refining side of the oil business have little to do with one another. Contrary to popular belief, Big Oil has almost no control over the price of oil these days. That power squarely rests with oil-rich nations that hold most of the world’s oil reserves and the Wall Street banks and hedge funds that speculate and make markets in the oil trading game. So even though ExxonMobil pumps oil, it can’t guarantee that its refining unit will be able to profitably process a barrel into gasoline or heating oil.
Pure-play revival
Investors who wanted exposure to the oil and gas sector noticed this disconnect. As they put more money in the smaller, pure-play companies that focused on one industry vertical, Big Oil began to trade at a discount. In fact, since the merger mania of 2000, Big Oil has traded at an average discount of between 11% and 12% compared to their smaller pure play competitors, according to a recent study by Citi Investment Research and Analysis.
That discount translates into billions of dollars in lost value in companies this big. Take the case of Marathon Oil. The small integrated oil and gas firm announced in January that it was splitting up into two companies – one that concentrated on exploration and production and one that concentrated on refining and marketing, similar to the COP split. The day before the announcement, Marathon had a market value of around $28.9 billion. Today, the two independent companies, Marathon Oil Corporation and Marathon Petroleum Corporation, have a combined market value that is 30% higher at $37.4 billion, which means the split potentially unlocked $8.5 billion in value.
If COP were to ultimately gain 30% in its split, it would add a whopping $33 billion in value, based on its market valuation on the day before the deal was announced. But unlike with Marathon, COP has seen its share price fall since its announcement — down around 3% on lackluster earnings.
Of course, Marathon and COP were trading at different places when they announced their decisions to split up, with Marathon (MRO) trading at around a 20% discount to other integrated oil companies, while COP was trading more or less on par with its peers. It seems like the market revalued Marathon to trade in line with its peers and then credited it an additional 10% in value to make up for the average discount between integrated oil companies and pure-play companies. If that logic holds and COP pops 10%, it could still stand to unlock $18 billion in value – not too shabby.
The remaining oil majors — ExxonMobil (XOM), Total, Chevron (CVX), Shell (RDSA) and BP (BP) — as well has the smaller integrated oil companies, like Hess, will undoubtedly be watching COP (COP) intently as it begins its dismemberment. Analysts have already started to fiddle with the numbers. Most have pointed at BP as being ripe for a break up. The oil major currently trades at a fraction of its net asset value, thanks mostly to the black eye it took from the massive oil spill in the Gulf of Mexico last year. Deutsche Bank estimates that if BP were to spin off its refining and marketing unit, it could unlock $15 to $20 billion in value if it were to trade in line with its peers.
But the analysts at Deutsche Bank say it’s “foolhardy” to believe that the company would make any major strategic split given the billions of dollars in potential losses it still faces in connection to last year’s oil spill. It could take years for that mess to be sorted out, keeping BP together by force. Then again, BP is already taking steps to reduce its refining presence without a split by selling off some of its largest refineries to help pay for damages in connection with the spill.
BP is not alone in selling off its refineries. For example, Shell has cut 40% of its refining capacity in the last 12 years through asset sales. A split in Shell’s case therefore might not yield the same value as it would for COP.
Furthermore, oil companies are conservative, so convincing them to make a radical split, even if it could potentially unlock billions of dollars in value, won’t be easy. Take ExxonMobil. Just a 10% increase in value through a split would be worth $43 billion to shareholders, which is equivalent to the GDP of Tunisia. But ExxonMobil is known as the most conservative member of Big Oil, making any split hard to imagine.
“Although ExxonMobil would the ideal candidate since a split could unlock the most value, it is the least likely to do so, as management is convinced that the integrated model will serve it in the future as it has in the past,” says Fadel Gheit, the energy analyst at Oppenheimer.
But even ExxonMobil isn’t immune to shareholder pressure. COP is slated to complete its split in the first quarter of next year, giving the company’s shares some time to turn to the upside.
If the ConocoPhillips story is a success for shareholders, there will be calls to break up Big Oil just in time for the annual meetings in the spring. So by this time next year, it is possible that Big Oil will go the way of Rockefeller’s once gargantuan Standard Oil — with the markets, not the government, forcing a break up this time.
