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Consolidation is key for oil & gas sector

  With a merger between ONGC and HPCL becoming almost a certainty, the question is how this move will help the oil and gas industry, especially in the global scenario, and with China doing aggressively well. We explore in this article the reasoning and the possible way forward.  

Dr Suresh Srinivasan

The oil and gas sector in India is showing signs of sectoral consolidation. The government seems to be driving the public sector players into the consolidation mode. A cabinet committee has given its in principle approval for the sale of the government’s entire 51% shares in HPCL to ONGC, making the former a subsidiary of the latter. It is expected that ONGC will take over the management control of HPCL along with this equity sale. Potentially, the two companies may be merged.

The Indian Government currently holds a 68% stake in ONGC, with the rest being held by financial institutions, foreign investors and the public. It is also reported that a potential combination of Indian Oil Corporation (IOC) and Oil India Limited (OIL) is on the cards.

So what does the global experience say about vertical integration and consolidation in the oil and gas industry scenario?

Refining vs production

Consolidation in the oil and gas space is an interesting development. Public sector companies have long dominated the oil and gas space, both in the upstream as well as in the downstream parts of the value chain.

There has always been a debate as to whether vertical integration in the oil and gas industry actually adds shareholder value. When the oil price is high, upstream players stay subdued with low investments and their profits low, while margins of refiners expand. The opposite happens when the oil price starts moving up. Of course, productivity differential at the refining stage do play a role.

The rationale for value chain integration in the oil and gas industry is primarily driven by the levels of oil price. With the drop in global oil price over the last few years, upstream exploration and production companies have been bearing the brunt. However, that same scenario has helped the refining companies, as they receive crude oil inputs at lower costs, positively impacting margins.

Oil price & profitability

Crude oil hit the historic mark of $140 a barrel in July 2008, dropped to $43 in February 2009 but recovered back to $100 by April 2011. However, since May 2014, it has been falling steadily to hit a bottom of $37 in January 2016. Currently, the crude price is hovering at around $50 a barrel.

While oil price was high, many global companies like British Petroleum, Marathon, Murphy and Conoco Phillips deliberately took a call to partially wind down their refining business to stay more focused on exploration and production. Companies like ExxonMobil continued to stay fully vertically integrated.

Today, with oil price hovering at around $50 a barrel, many of those companies that have remained fully integrated, including Chevron, Shell and Total, have performed far better than their focused ‘pure play’ peers like Marathon and British Petroleum. Profits of global majors broken down between upstream and downstream sometimes reverse with steep oil price changes, and hence act as a hedge when they are vertically integrated. The ability to adjust production to serve most profitable markets over an integrated value chain is also an advantage.

Top oil & gas companies

There are two Chinese companies in the global top five oil and gas majors. China National Petroleum and PetroChina are in the third and fourth position, in terms of revenue; They follow global majors like Exxon Mobil and Shell.

The largest of the Chinese oil companies are government owned and are vertically integrated.

Oil & Gas: The China story

Although the logic of global oil majors is equally applicable in the Chinese context, the rationale for consolidation and vertical integration in China is a bit different. China, like India, imports more than 70% of its crude requirements and is extremely ‘crude’ hungry. China’s national oil companies have been persistently acquiring oil fields and assets across the globe to secure the country’s long term energy requirements. They achieve this by providing financial and technical assistance to oil rich countries.

For example, at least a third of power projects that came into existence in Northern Africa (Egypt, Libya, Algeria, Morocco, etc) were built by China. They added more than fifteen Gigawatts of power to the region. Similar Chinese investments have flown into countries like Angola, Ghana, Sudan and Uganda. Such investments are now paying off; close to one fourth of Chinese crude oil import are now effected through such countries. A very articulate long term energy security policy that seems to be well working!

This involves enormous investments from China and Chinese national oil companies, which serve as a front for the sovereign government’s overseas oil investments. To that extent, China’s national oil companies need to be large and financially strong and have the capability not only to strike viable global deals but also manage such magnitude of imported crude. Hence, the large fully integrated national oil companies are the best structure to secure China’s long term energy security.

The Indian context

In the context of the ONGC-HPCL transaction, as well as the proposed IOC-IOL merger, and potentially the larger consolidation of the Indian oil and gas industry, the central idea clearly is to have large companies, financially strong and possessing the capability to acquire energy assets outside the country. ONGC Videsh and OIL have earlier ventured to acquire assets abroad.

ONGC Videsh, for example, is operating in more than 15 countries. OIL again has invested in oil assets in countries like Russia, Mozambique, Nigeria and Gabon. These are quite small in comparison to the China’s overseas energy investments, and are also quite fragmented and lack scale.

Bringing in focus

More importantly, over the last decade, the vertical integration strategies of Indian oil majors have been quite haphazard. Bharat Petroleum (BPCL), primarily a downstream player, has been investing in upstream assets including potential investments in Mozambique and Brazil. Same is the case with HPCL, which set up a number of joint ventures and subsidiaries to venture into the upstream business.

Upstream companies like ONGC entered the downstream business with the acquisition of Mangalore Refineries and Petrochemicals (MRPL) and also had plans to enter the retail business. At some point, there were also cross holdings across ONGC, IOC and Gas Authority of India (GAIL). This lack of focus across the fragmented companies is precisely what the government is attempting to restructure. With more than 10 government-owned oil companies operating in India, consolidation could be the only way forward.

The consolidation

The ONGC-HPCL transaction may not be able to reap the full synergies of vertical integration at this point in time, as there are no clear cut indications as to whether a merger will happen. In the short run, the two entities may still exist as is! Again, merging the two large organizations, as and when it happens, will come with its own challenges and the ability to pull the synergies through would be a challenge.

However, the immediate visible benefit is that the government is expected to get revenue of around `30,000 crore from this sale, as ONGC is expected to pay cash to the government in this share purchase.

So, per se, we may not be able to see any immediate major synergies and benefits from the ONGC-HPCL deal, as it is just the shareholding that is moving from one government entity to the other (ONGC). However, this could be a primer for a larger consolidation drive that is in the offing!