No Clear Winner Yet In Battle of Super Majors

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It has been roughly three years since BP agreed to take over US Amoco, officially kicking off what would become the "era of the super major." Exxon's subsequent acquisition of Mobil not only confirmed this trend, but also set in motion a bitter rivalry between the oil industry's three largest companies. With each implementing its own unique strategy, BP, Exxon, and Royal Dutch/Shell have waged a competitive battle for investors' attention -- and dollars -- since late 1998. Only now are the results of this contest finally emerging, as all three have had sufficient time to display their strengths and weaknesses. Although it has been a roller-coaster ride, BP has out-performed Exxon and Shell in equity markets since Aug. 10, 1998, the day before it announced its merger with Amoco. BP has fallen in and out of investors' good graces over the past three years, but has still managed to post a split-adjusted share price gain of about 35% since that date, compared to gains of about 21% for Exxon and Shell, and 7% for the S&P 500 Index. The market rewarded BP early for its "mover and shaker" approach, which -- besides the Amoco deal -- included an agreement to acquire US Arco for $27 billion in early 1999. BP shares rose by about 20% in the months after it announced the Amoco deal in 1998, while shares of Exxon -- which announced its acquisition of Mobil in November 1998 -- and Shell rose by 8% and 2%, respectively, in this period. Positive momentum continued for BP in 1999, as rebounding oil prices and further promises of cost-savings and strong growth from the Arco acquisition helped its stock gain roughly 30%. This compared to a 10% gain for Exxon stock, which suffered somewhat from a long review by antitrust regulators of its deal with Mobil. Shell began to see the benefits of its internal restructuring in 1999, with a share price gain of about 30%. But the tide turned for BP in 2000, as investors first questioned whether regulators would approve the Arco deal, and later became skeptical of the company's aggressive growth targets and its refusal to raise its dividend in line with competitors. While BP shares plunged nearly 20% in 2000, Exxon, which closed its acquisition of Mobil in late 1999, picked up ground with an 8% gain while Shell shares performed flat. So far in 2001, BP shares have risen by about 6% after the company convinced investors recently that its revised production targets are sound. Meanwhile, Shell's output targets have come under fire, resulting in a 3% share price drop, while Exxon shares have lost 7% based on concerns about its heavy exposure to global refining margins and a weak petrochemical sector. BP may have won some early rounds in terms of share price performance, but analysts say the fight is hardly over. Indeed, all three companies are only now beginning to come out of major restructuring periods. In the end, analysts say the winner will be the company that best navigates the fine line between profitability and growth. Keeping Score When Exxon Mobil leapfrogged ahead of Shell as the world's largest private oil company, many believed Shell would respond with a giant acquisition of its own, perhaps targeting Texaco or BG. Shell decided the time was not right for this, however. Under fire for having high operating costs and a decentralized management structure, it instead opted for a massive internal restructuring at the end of 1998 aimed at achieving billions of dollars in cost-savings and establishing a clear chain of command. With dangerously low oil prices threatening profits in 1998 and early 1999, cost cutting was a major premise behind the mega-mergers involving Exxon and BP, as well as the so-called "internal merger" that Shell initiated. In hindsight, all three companies have proven to be extremely efficient at reducing costs. Exxon is well on its way to cutting $7 billion from the combined annual cost structure of Exxon Mobil by the end of 2002. Likewise, BP is close to achieving its cost-savings target of $5.8 billion from its deals, which also include the acquisition of UK lubricants giant Burmah Castrol. Shell, for its part, will have cut annual costs by $5 billion by the end of this year, without the benefit of major acquisition. Exxon, however, has established itself as the leader in return on average capital employed (ROACE) -- a key measure of profitability for investors. According to UBS Warburg, Exxon has achieved an average (ROACE) of nearly 15% for the three-year period of 1998-2000, compared to about 13% for BP and Shell (see table). Analysts say strict capital discipline has helped Exxon achieve the highest earnings per barrel in the industry. Upstream Woes Despite their undeniable achievements in reducing costs, the three super majors have struggled with upstream growth. None has emerged as a top force in replacing oil and gas reserves or meeting production targets, as the companies' sheer size has worked against them. Analysts say that BP has fared best in reserve replacement over the past three years, despite lagging well behind industry standards. Between 1998-2000, BP averaged an oil and gas reserve replacement rate of 126%, compared to 116% for Exxon, and 102% for Shell, according to investment bank AG Edwards. The average reserve replacement rate for integrated firms was 136% during this period. Shell has proven to be the most efficient upstream operator with the lowest finding and development costs. Shell recorded average finding and development costs between 1998-2000 of $3.20 per barrel of oil equivalent, compared to $4.16/boe for Exxon, and $4.79/boe for BP. Many analysts also believe Shell has the most impressive array of upstream projects. Shell is "widely acknowledged to have one of the best asset portfolios in the industry, in terms of global reach and alignment for growth," according to UBS Warburg. One analyst cited the company's "leading positions in deepwater acreage and natural gas." Ambitious goals for oil and gas growth are proving much tougher to achieve than expected. Despite its superior asset portfolio, Shell recently became the latest super major to lower its volume goals for the year, after an earlier downward adjustment from BP. Shell announced its production growth target of 5% per year will be reviewed before its September strategy presentation. After output growth of 3% in the first quarter and just 1% in the second, Shell Chairman Phil Watts conceded the target would be a "challenge" this year. In February BP, reduced its medium-term volume growth target from 7% a year to a range of 5.5%-7%. While some of the shortfalls can be traced to spending that was axed in response to low oil prices, the majors' exposure to buyback or production-sharing contracts is a prime source of the problem. Both types of contract reduce the entitlement to oil volumes as oil prices rise. But for many analysts the issue is not whether these targets can be hit, but why they have assumed such huge status. Some argue that volume is being pursued at the expense of value and that majors are hanging on to low margin assets simply because they help them meet volume targets. "All the majors have published very aggressive corporate production targets that are effectively preventing asset sales in mature provinces from taking place," investment bank HSBC said in a recent report, citing BP. That company is keeping its core, mature UK North Sea interests to meet output targets, but the bank estimates the investment required will harm BP's returns. "People say volume is equal to growth," says Credit Lyonnais analyst Jurjen Lunshof. "That's what the market says. But it's nonsense. It's not volume for volume's sake you should look at, it's volume for margin's sake." From this perspective, Exxon may be the most prudent of the three. It has never committed itself to such high medium-term targets, even though it is involved in many of the same projects as BP and Shell. Instead, Exxon has promised moderate short-term oil and gas output growth of 2%-3% while publicly questioning its rivals' lofty targets. Downstream Domination In the downstream businesses, Exxon has clearly demonstrated its superiority. The company's system of integrating refining operations with petrochemicals operations to enhance overall downstream profitability has been emulated by both BP and Shell in recent years. BP and Shell have sold off substantial chemicals assets that are not associated with their refining operations since 1998. BP and Shell have also sold substantial refining assets, exiting from some weak markets but expanding in some strong markets, like Germany. Exxon has done little tinkering with its downstream assets other than divestitures required by antitrust regulators in the US and Europe. Analysts say Shell finds itself behind in terms of downstream profitability because of a weak business in the US, where it has operated primarily through two woeful joint ventures with Texaco and Saudi Aramco. In the first half of 2001, Shell earned just $283 million from US refining operations, compared to $2 billion for BP, and $1.25 billion for Exxon. Shell is currently negotiating to buy out Texaco's stakes in the Equilon and Motiva joint ventures, a move it hopes will improve future results in the US downstream (IPF Jul.,p5). Financially, Exxon, Shell, and BP all have extremely strong balance sheets. But Exxon and Shell have a clear advantage over BP because they are in a better position to aggressively pursue share repurchases and acquisitions. Shell and Exxon have debt-to-equity ratios of less than 13% and hold cash reserves of $9.5 billion and $9.3 billion, respectively. BP has a debt-to-equity ratio of 25% and holds cash reserves of just $1.1 billion. During the first half of 2001, Exxon repurchased $3 billion of its shares, while Shell repurchased $2.7 billion of its shares. Meanwhile, BP repurchased just $780 million of its shares. Deutsche Bank reckons that Shell's balance sheet can fund double the buyback rate than BP in the near-term. Sizing Up the Super Majors (Three-Year Average 1998-2000)* Exxon Mobil Royal Dutch/Shell BP Return on Average Capital Employed 14.8% 12.7% 13.1% Worldwide Finding and Development Costs (per boe) $4.16 $3.20 $4.79 Worldwide Oil and Gas Reserve Replacement Ratio** 116% 102% 126% (As of Dec. 31, 2000) Worldwide Oil and Gas Reserves (millions of boe) 20,872 19,132 14,963 Worldwide Oil and Gas Reserve Life (# of years) 13.0 14.4 12.9 % of Worldwide Net Proved Developed Oil and Gas Reserves 66% 46% 56% *Return on average capital employed figures come from UBS Warburg. All other figures come from AG Edwards.

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