Merging state-run oil firms: a disaster in the making

While unveiling India’s Budget this year, which has many positive features, Finance Minister Arun Jaitley committed a monumental blunder. He announced the government’s intention to merge public sector oil companies to form an integrated mega oil company to compete with multinationals like Exxon, Chevron, Shell, BP, Total etc. Stated goals for this mega merger were to “bear higher risks, avail economies of scale, take higher investment, and create more value for stakeholders”.

However, the minister failed to consider the consequences to India’s energy security or the impact of reduced competition on consumers and the economy. A quick look at the history and current state of the international oil industry should convince policymakers why a mega merger is a questionable idea—in fact a similar idea was rejected by an advisory committee on synergy chaired by Krishnamurthy in 2005.

In the late 1880s, John D Rockefeller succeeded in cornering the oil refining and production capacity to control the market. He created the giant, Standard Oil, in the US by buying out many of his competitors. In 1911, when the US government realised the harmful impact of his monopoly, it was broken into several companies.

Seventeen years after the break-up, the 30 surviving companies were worth five times more than the original company. In recent years, there have been demergers in the US oil industry showing similar positive results. Marathon, ConocoPhillips and Hess were broken into upstream (oil and gas production) and downstream (refi­ning and marketing) in 2011, 2012 and 2013.

From 2012 to 2016, the average shareholder return of the two companies formed after the break-up of ConocoPhillips was 40%, whereas for the same period it was 12% for Chevron and 18% for Exxon.

Based on this analysis, the NDA-ruled Centre may not be accurate in assuming a mega merger will create better shareholder value. Many studies of mergers in other industries have also not produced better value to shareholders. 

Suggesting that economies of scale provide an advantage rings hollow. The reason Indian oil companies lost the opportunity to buy into Rosneft had nothing to do with economies of scale. For example, a little known Inpex, a Japanese oil company, managed to get share in Kashagan, the largest oil discovery in the last 30 years with over $50 billion investment. If the Indian government used its political capital, Indian oil companies could have succeed in buying into Rosneft just as they did in the Sakhalin oil fields.

Oil companies are able to take higher risks by adapting clever bidding techniques, using world-class expertise, creating strategic partnerships, and with intensive research and development, not by investing large amounts of money. Even the largest oil company does not want to control 100% of any field.

Vertically integrated oil companies have relatively better earnings stability. For example, during the recent drop in oil prices, the total operating income in downstream operations of the five super majors dropped from $109 billion in 2010 to a loss of $5 bn in 2015. On the other hand, their downstream profit increased from $16.4 bn to $35.9 bn. While downstream profits did go up substantially, they could not compensate for the loss in upstream. Compared to the complexity of managing integrated operations, the benefit of earning stability cannot be justified.

A look at India’s current banking sector illustrates what the concentration of power in one company will do. By having a single shareholder (government) controlling a large share of the banking business, competition is minimal despite the presence of private sector banks. If PSU banks were controlled by different shareholder groups, the Indian banking sector would be far more competitive today.

Despite having world class expertise in the IT sector, India’s banking has lagged behind other countries in digitisation. This is apart from the considerable power yielded by employee unions of these banks and how they are able to threaten any new policy initiative even when it could help the economy and consumers.

We can learn from Mexico. For the last 80 years, state-owned Pemex controlled just about every aspect of the petroleum sector. Last year, private oil marketing companies were finally allowed to open petrol stations to compete with Pemex. The oil sector union was so strong, no policy (however good for the country) could be adopted without its consent. Because of the Pemex monopoly, consumers suffered. The law was changed to introduce competition.

Energy security
A mega merger of oil companies in India will result in conditions that will give rise to the problems we are facing already in the banking sector today and the one that Mexico has faced for 80 years. Competition is essential. However, the most potent and perhaps convincing argument concerns India’s energy security. When one single company controls the marketing and distribution operations, it has the power to hold the entire country for ransom, threaten to close all petrol stations, or stop the distribution of LPG to residences.

India has finally started to fill strategic petroleum reserves to ensure energy security. This is an expensive operation to ensure oil supplies during times of supply crisis, as happened during the Indo-Pak war in 1971 when Saudis threatened to cut off oil supplies.

So why would we now deliberately create an environment where an artificial shortage of petroleum products is a possible threat? Probability of such an event may look small, but it cannot be ruled out. Should such an event take place, the results would create civil unrest throughout India.

We need some strategic thinkers in the NDA government who will convince policymakers to drop this idea at the earliest. The government should instead work on creating more oil marketing companies by breaking up the giant Indian Oil to create a more competitive market for petroleum products.

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