Does India really need a giant oil PSU?
The idea of merging state-owned oil companies germinated during the AB Vajpayee years and surfaced during Mani Shankar Iyer’s tenure as the UPA petroleum minister.
The idea of merging state-owned oil companies germinated during the AB Vajpayee years and surfaced during Mani Shankar Iyer’s tenure as the UPA petroleum minister. An advisory committee on Synergy in Energy, chaired by V Krishnamurthy in 2005, strongly recommended against such a merger. After the NDA came to power in 2014, petroleum minister Dharmendra Pradhan floated the idea of a giant company in July 2016. Surprisingly, it did not feature on the national agenda as significantly as it has after the presentation of Budget 2017.
The finance minister wants a giant integrated oil company to compete with the likes of Exxon, BP, Shell, Chevron, Total, etc, “to bear higher risks, to avail of economy of scales, to take higher investment decisions and create more stakeholder value”. The petroleum minister wants instead multiple mega-oil companies. The accompanying table gives some idea of the size of India’s six large state-owned oil companies to challenge the feasibility of such a plan. Market capitalisation of all six is approximately equal to BP, half of Chevron and one-third of Exxon and twice that of Reliance.
The following analysis of India’s oil sector, based on eight criteria, shows that the demand for the merger policy is not well-founded.
Managing risk: Undoubtedly, to take higher risks, one needs a minimum amount of capital. All the six major Indian oil companies have more than this minimum amount of required capital. Let me give the example of a little-known Irish company, Tullow. There are several companies like Tullow in oil industry. With market capitalisation of just $2.6 billion, it has managed to have exploration acreages in 19 countries and succeeded in finding oil in Ghana, Uganda and Kenya in recent years. In each country, by forming consortia with small and large oil companies, Tullow managed to reduce the risk.
While exploring either in virgin or well-established territory, oil companies, even the largest ones, always try to reduce risk by taking partners to form a consortium. It is not necessary that India needs a giant oil company to bear higher risks. ONGC’s overseas subsidiary ONGC Videsh Ltd has been able to do this already by joining other oil companies and is active in 17 countries.
Success of discovering oil depends not on the size of a company. It is largely dependent on the company’s ability to attract world-class geologists and managers, and its access to the latest technology.
Economies of scale: As discussed above, in the case of upstream operations, there is no economy of scale to discover oil and gas, or to develop them. It is not the size which results in discovering oil reserves, but the technical ability to identify sweet spots, to drill in difficult environment and develop discovered reserves efficiently. Large and complex discoveries require large investment and the size of a company has no impact. However, there are economies of scale to be achieved in refinery investment. Tea-kettle and small refineries have higher per barrel cost while large refineries have a lower per barrel cost of operations and thus higher profits. However, after an optimum size, there may be some amount of negative returns. Thus, one has to optimise the size against complexity. The three downstream, state-owned companies—IOC, BPCL and HPCL—have already achieved such economies of scale. Thus, merging them will not result in any economy of scale.
Ability to invest in large projects: It is certainly true that unless a company is of the “minimum required” size in terms of asset, profit and market value, it cannot invest in projects requiring huge amount of capital. In the oil industry, even small projects, especially in the upstream sector, need millions of dollars, and mid-sized ones, billions. Offshore oil and gas projects require tens of billions of dollars. However, by forming consortia as oil companies around the world do often, large capital can be raised to support even projects requiring $10 billion or more. When a new oil discovery has attractive economics, banks are willing to lend huge amounts of money based on project finance. Also, equity money can be raised, just as companies like Tullow have done.
Some have attributed the failure of ONGC to buy into oil properties abroad—competing against Chinese or oil companies from other jurisdictions—to its “small” size. These failures are not because of it being small. They have more to do with bidding strategies, evaluation of attractiveness, and the practically unlimited capital available to Chinese companies.
At present, the largest oil project (requiring more than $50 billion) in the world is the development of Kashagan field in Kazakhstan. ONGC tried to buy Conoco’s share in Kashagan. But it failed not because of its size. The Chinese government succeeded in convincing the Kazakh government to partner with the Chinese National Petroleum Corporation. What is needed is not integration, but strategic thinking.
Creating shareholder value: In recent years, oil companies have realised that it is better to be small rather than big to create better shareholder value. Marathon Oil (2011), ConocoPhillips (2012) and Marathon (2013) have spilt up functions into two upstream and downstream. Is this a herd mentality which we often see in the oil industry, or a sincere effort by the management to create better value for their shareholders? Time will tell. It is possible that in the future some of these companies may merge back again.
From 2012 to 2016, the average shareholder return of the two companies formed after the breakup of ConocoPhillips was 40% whereas, for the same period, it was 12% for Chevron and 18% for Exxon. This example refutes the argument merger is better for the shareholders. There are many studies which have showed that more often than not, in other industries as well, mergers have often failed to generate value for shareholders.