Tremors From Cheap Oil

Plunging prices spur the world's biggest merger and reshape petro politics

Exxon Chairman Lee R. Raymond says he longs for the days of $20-a-barrel oil. So does every other oil executive. But what makes Raymond and his company different is how well they tolerate today's $11-a-barrel price. The lowest inflation-adjusted oil prices of the past half-century have other oil companies running for cover, and once-standoffish oil-producing nations are suddenly desperate for strong partners. Yet, Exxon Corp.--perhaps the most efficient of the majors--is ideally placed to cash in.

And on Dec. 1, it made its first move, announcing the biggest takeover in corporate history: a $75 billion stock deal to purchase Mobil Corp. and forge the world's largest oil company. As the chief executive of $181 billion Exxon Mobil Corp.--a behemoth fully a third larger than No. 2 Royal Dutch/Shell Group--Raymond will be able to seize global opportunities that are unavailable to weaker competitors.

STRUGGLING OPEC. What opportunities? Exxon Mobil--and other companies that can compete with its efficiencies and technical skills--will be the leaders in a new era for the energy business. The old order, dominated by the notion of scarce oil and by the political machinations of OPEC, is crumbling. No longer capable of keeping prices high by deliberately withholding supplies, OPEC members are now struggling to survive on a diet of cheap oil.

By contrast, producers such as Exxon are thriving--in part because of OPEC's tactics. Denied access to the most easily recovered oil reserves, Exxon, Mobil, and others have honed their skills in harvesting hard-to-reach oil and gas at improbably low costs from remote Asian steppes, deep waters off the coast of Africa, and far above the Arctic Circle. These discoveries--as well as weak demand in Asia--have helped produce an oil glut that is wolfsbane for the cartel: The bigger the glut, it seems, the less able OPEC is to reach agreement on production limits. Following a recent unproductive meeting in late November, the price of West Texas Intermediate, the benchmark U.S. grade, hit $11.13 per barrel on Dec. 1.

The first big opportunity that Exxon Mobil may try to explore is a partnership with Saudi Arabia. It has a quarter of the world's oil reserves, and the cheapest to tap. But the Saudis have seen revenues plunge because of declining prices that they have been reduced to borrowing money from tiny Abu Dhabi.

Now, the kingdom is ready to deal. On Sept. 25--two decades after Saudi Arabia nationalized its oil industry--Crown Prince Abdullah ibn Abdul-Aziz held a one-hour "tea party" with top executives of seven major U.S. oil companies to discuss possible cooperation. Other Mideast producers are also considering such partnerships. And who is better positioned than the company that will be the biggest by far? Says Fahnestock & Co. analyst Fadel Gheit: "You're talking about a company that can alter the economic landscape of a country."

Not everyone can capitalize on this impending shift in power in the world of oil. The global meltdown of many key emerging markets earlier this year was accelerated by deflation in the commodities markets, and in particular in oil. Major losers then--Russia and many other ex-Soviet states, Indonesia, Malaysia, and to a lesser extent Mexico--will suffer even more under the new order. Even if consumption rises dramatically over time, most analysts believe prices should remain in check because of advanced technology and because OPEC nations need to sell as much as they can to maintain their incomes.

Russia could be among the biggest victims. According to Moscow's CentreInvest brokerage, it costs $6 to $8 a barrel on average to produce and pipe Russian oil, several times Mideast costs. Together, oil and gas account for almost half of Russia's export earnings. And with its government is close to default on $150 billion in hard-currency debt, the continuing drop in prices is the last thing Russia needs.

Other producing nations that count heavily on oil revenue are having to make adjustments as well. Mexico, for instance, has reserves that are relatively cheap to recover, but its state-owned oil company, Pemex, is under pressure. "Pemex isn't generating the cash flow to make the investments that they need," says Rafael Quijano, managing partner of Latin American Petroleum Intelligence Services in Washington.

HIGH TECH. Low oil prices are excellent news, of course, for big energy consumers. A sustained $10-per-barrel drop in the price of oil cuts about 0.7 points from the annual U.S. inflation rate over five years and adds about 0.3 points to the U.S. economy's growth, according to an analysis for BUSINESS WEEK last year by Standard & Poor's DRI. That, in fact, is about what has happened over the past year.

However the geopolitics play out, and wherever prices go, it clearly pays for producers to have the best technology and lowest costs. Notes Robert P. Peebler, CEO of seismic software developer Landmark Graphics Corp.: "If you're the most productive company, you can take advantage of the low prices, because you're going to have the cash flows to acquire properties. And when you have high prices, you can be more profitable."

On the other hand, if you're still operating under the assumption that the earth's petroleum--or at least the cheap stuff--is about to run out, you're not going to thrive in the new oil era. Technology is making it possible to find, produce, and refine oil so efficiently that its supply, at least for practical purposes, is basically unlimited. So oil executives need to be as obsessive about cutting costs as anyone else. "You cannot count on the market to bail you out of bad decisions," Raymond said in a Dec. 2 interview.

Hence the merger wave. Says Leo P. Drollas, deputy director of the Center for Global Energy Studies in London: "The industry is looking ahead and seeing low oil prices as far as they can see. The mergers are a defensive action." Internal cost-cutting is no longer enough, Mobil Chairman and CEO Lucio A. Noto said at a Dec. 1 news conference: "The easy things are behind us. The easy finds. The easy cost savings. They're done....We tend to do the smart thing when times are tough. And times are tough now."

By joining forces, Exxon and Mobil aim to cut $2.8 billion a year in costs--much of it by eliminating 9,000 jobs, or around 7% of their combined worldwide total of 123,000. Though they'll keep both brand names, they will merge the marketing organizations that support them. "It is good management applied to a bigger asset base," says Rod Peacock, managing director for global energy investment banking at J.P. Morgan Securities Ltd. in London, who advised Exxon on the deal.

The merger of Exxon and Mobil will not only create the world's largest oil company, but it also will create one of the world's largest companies of any kind. The combined revenue of Exxon and Mobil for the first nine months of 1998 was $119 billion, vs. $115 billion for No. 1 General Motors Corp. Low oil prices plus divestitures may knock Exxon Mobil down to second place. (Note to numbers watchers: Some sources report higher revenue numbers for Exxon and Mobil, mainly because they include fuel excise taxes that are passed straight to governments.)

Does size matter? Yes. The biggest companies--Exxon, Royal Dutch/Shell, and British Petroleum--routinely have a higher return on capital than their smaller kin, says Douglas T. Terreson, a Morgan Stanley Dean Witter analyst. Big companies can defray fixed costs over a wider revenue base. And they can tackle the biggest international projects--without partners, if need be. They can afford not only to explore and sink wells, but to build refineries, petrochemical plants, pipelines--the whole assemblage that host countries desire. Indeed, Mobil may have seen the wisdom of a merger after losing a bid to develop natural gas fields in Turkmenistan because it couldn't match Shell's offer to build a pipeline for $1 billion.

Until this year, there had not been a major oil merger since the 1984 combination of Chevron Corp. and Gulf Corp. Then in August, British Petroleum announced a $64 billion deal to buy Amoco Corp. And now Exxon is buying Mobil. Says Terreson: "BP-Amoco was a shock to the system, and Exxon Mobil was a seismic shift. There are going to be several more to follow."

That's a good bet. On the same day as the Exxon Mobil deal, France's Total agreed to buy Belgium's PetroFina for $13 billion. Texaco Inc. and Chevron, worried about being left behind, might make natural partners. In a speech to analysts on Dec. 2, Texaco CEO Peter Bijur said: "We will not rush into anything. We don't feel the urge to merge."

Conoco Inc., recently spun off from DuPont Co. in the biggest initial public offering ever, could disappear into some other company's embrace soon--this time, probably another oil company. Asked at a news conference how much farther the consolidation might go, Total CEO Thierry Desmarest answered: "The game will go on until the antitrust authorities call it off."

The Exxon-Mobil deal certainly rings antitrust bells. It unites the two biggest companies of the Standard Oil Trust, which was broken up by the courts in 1911. But most experts expect the deal to go through--perhaps after the companies divest refineries and gas stations in markets where they have large market shares. In Washington, D.C., for instance, together they sell 35% of all gasoline, says National Petroleum News.

Low prices are shaking the world oil industry from top to bottom. The pain is widespread. And old titans may disappear. But as Exxon's deal for Mobil shows, for some players, crisis equals opportunity.