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Mergers and Acquisitions in the Energy Sector

Analyse the internal and external influences on corporate objectives and strategy.

Mergers and acquisitions are the combination of two or more companies into a new company with the difference being the way in which the combination takes place (Roberts, Wallace & Moles, 2010). For a merger, negotiations take place prior to the combination as it is considered that it will be beneficial to both companies. Acquisition entails one company buying the assets of another company to achieve managerial influence and is not necessarily by mutual agreement (Jagersma, 2005). An acquisition can be friendly or hostile. In a friendly acquisition, the company being acquired is willing to be acquired. Although every merger has a specific reason behind it, the principle underlying the business decision is to create additional value normally referred to as ‘synergy ‘. The synergy value can be in terms of increased revenues, lowering expenses or lowering the cost of capital. The biggest source of synergy value is lower expenses derived from the elimination of redundant services (Evans, 2000). Usually, the contentious factor during take-overs is the valuation of the companies. The seller will always value the company at the highest price possible while the buyer tends to set the lowest price possible (Evans, 2000). However, there are legitimate methods of valuing companies which include comparative ratios, replacement cost and discounted cash flows.

The fall in the oil prices in 2014 severely caused holistic negative impacts on the sector and other sector dependent organizations. These included equipment manufacturers, oil-related service corporations, NOCs (National Oil Companies) and governments. Rapid mechanisms to reduce costs and capital expenditure to maintain cash flow were, therefore, necessary. However cutting on expenditure was inadequate since predictions indicated oversupply would be prolonged. This called for major structural changes within the sector.

The industry players in a bid to strike a balance between short-term viability and long-term objectives sought to implement various strategies to keep them afloat and sustainable. Among the transformational strategies is the merging and acquisition of companies in the industry. A study by Kearney (2016), leading global management consulting firm, revealed that most companies could not sustain the situation of oil prices and that smaller companies with lean balance sheets aimed at propping themselves while larger and more financially stable companies sought to “off-load non-competitive and non-core assets”. The study suggests that merger and acquisition opportunities were, therefore, several.

Though the energy sector predicted a ballooning of M&A activities in 2015, the industry, responding to the volatile prices in oil did not experience the wave. Universally, only 40 deals occurred in the first quarter of the year. Upon oil price stabilization in April, there was experienced increased activity before stalling later in the year. The second quarter saw the Shell-BP merger and the acquisition of Williams Companies by Energy Transfer Equity happen (Kearney 2016).

Internal and External Factors

Despite most companies being valued lowly and the low oil prices offering a good platform for mergers and acquisitions; deal making has remained fairly unresponsive. The slow response is highly attributed to unstable oil prices which make potential buyers doubtful of executing those deals. Most prefer hoarding cash and making the best out of the prevailing operations.

A number of M&A deals have, however, in response to both internal and external factors or as a strategic measure, happened since the oil price slump in 2014. They include the Shell-BP and Schlumberger Limited and Cameron International Corporation mergers; and the acquisition of Williams Companies by Energy Transfer Equity (Kearney 2016).

Mergers and acquisitions are influenced by various factors in the internal and external environment.  Globalization is an external factor which is a major influence in companies’ strategic direction (Roberts, Wallace & Moles, 2010). Mergers can be used to increase the market share in a globally competitive environment. This works best when the two companies considering merging were previously operating and commanding market shares in different geographic regions. The merger will harmonize operations over the combined region thereby having an increased foothold in the world for the entity. This positioning is meant to take advantage of future opportunities. The positioning due to globalization can also be due to combine competitive advantages of the companies. Case in point is the merger between Schlumberger Limited and Cameron International Corporation announced in April 2016. Schlumberger is the world’s largest oilfield services company with superior well and reservoir technology while Cameron has specialized in surface equipment, flow control and processing technology (Kearney 2016). The combination of the two can be the key to technology-driven growth of the company.

Companies exist to maximize the wealth of their shareholders. Therefore, if a chance to increase the shareholder value comes in the form of a merger then it will most probably be considered. In the case of Schlumberger and Cameron, the merger increased the value of Cameron’s shareholders by 56% (WSJ). Reduction of expenses eventually increases the profitability of companies. In this merger, streamlining of operations can reduce expenses a great deal thereby reducing the impact of stubbornly low oil prices.

Mergers and acquisitions are also affected by the regulatory environment in which the companies operate in. There are regulations which must be fulfilled for a merger or acquisition to be approved. These regulations are meant to protect the interest of stakeholders who may include shareholders, customers or the government. A merger deal between Energy Transfer Equity and Williams Companies has been terminated this year after lawyers could not advise on the tax treatment of the deal. The regulatory environment may be conducive or prohibitive to mergers and acquisitions. Prohibitive regulations are put in place in instances where the merger can result in an unhealthy competition in the market. This occurs mostly when the two biggest market players have the intention to merge. Such a merger can result in a ‘monopoly–like’ company (Roberts, Wallace & Moles, 2010). This can pose artificial barriers to entry into the market by new firms.

Difficult and challenging economic environments such as the fall in the oil prices may call for companies to re-evaluate their business models in a bid to transform their organizations. One of the strategies that they adopt is by either merging with or acquiring other companies (Jensen & Ruback, 1986).

Since the inorganic growth of companies has become insufficient in countering the prevailing low growth rates, firms often turn to developing vibrant M&A strategies to complement them consequently achieving the company’s set goals. Prior due diligence on the apt target companies is done. Such companies with strategic and desired regions and complimentary services or goods are put on the radar of availability. The companies are therefore quick to act whenever such companies become available for a merger or acquisition (McLaughlin & Mehran, 1995).

Diversification in a company’s portfolio can be addressed both as a factor influencing mergers or a strategy for the merger (Roberts, Wallace & Moles, 2010). There are cases for and against diversification but with the oil industry facing one of the worst downturns which have the possibility of lasting longer than expected, it makes perfect sense. In the world of mergers and acquisitions, diversification will be in acquiring or merging with complementary companies as opposed to competitors. To Schlumberger Limited, Cameron International is a complementary company. Cameron International is in the operation of several businesses which are outside the core oilfield services dominated by Schlumberger, Halliburton and Baker Hughes. Cameron has specialized in the provision of world class flow technologies. Therefore, by the acquisition of Cameron, Schlumberger is expanding its territories into areas with lesser competition. The services offered by Cameron are also not easily replicable thereby offering sustainable growth in the foreseeable future.

Capitalizing on the financial statistics of the merging companies and the fact that both firms are on the same sector and trading on similar products, synergy effects can easily be achieved (Gaughan, 2002 and  Mahoney & McCormick, 1988).

Firstly, the companies grow bigger in scale. Slow organic growth of individual companies could be achieved through merging and acquisition other firms. The combined resources, personnel, and finances mean that the companies are in a better position to use the existing and establish new and larger markets and networks (Sherman, 2010). Increase in research and development may often result in achieving speedy growth and thriving market presence (Gaughan, 2002). Schlumberger’s operating cash flows were way much bigger than Cameron’s. Revenue and operating cash flow, therefore, increased after merging.

Secondly, combined companies establish operating synergies as the merged companies enjoy economies of scale better than at individual levels (Bruner, 2004). Acquisition of raw materials is simplified as it is done in larger quantities than at an individual scale thus guaranteeing them larger cost rebates (Tidd & Bessant, 2008). Furthermore, transport costs are decreased since the raw materials and finished products are transported in large volumes thus reducing the transport cost per unit (Verde, 2008 and Jensen 1986). Overall production charge per unit will be greatly reduced (Gaughan, 2002). It is easier for merged companies to initiate new product lines and enter into new markets in an already existing distribution system. Higher return on investments, amplified volumes of products as well as projected sustainable futures as positted by Damodaran (2005) can arise from combined operations of the merging companies. The combination of Schlumberger which is the world’s largest oilfield services company with superior well and reservoir technology and Cameron whose specialty is in surface equipment, flow control and processing technology, could lead to a technology-driven growth of the company. Cameron and Schlumberger look ahead to achieve synergies in cost through reduction in costs of operations, management of the supply chain and improvements in manufacturing systems. This, however, is expected to be the result for the initial year while the revenue synergies are expected in the second year.

Thirdly, the companies stand to benefit from the financial synergies that may stem from merger and acquisition deals. This is because the combination of the two imperfect correlated cash flows of the merging companies may reduce individual default risks arising from the coinsurance effect created (Huyghebaert & Luypaert, 2013). In addition to reducing the cost of debt, combined firms benefit from larger debt tax rebates on interests due to the growth of their borrowing capacity. Consequently, the cost of capital decreases. In the merger between Schlumberger and Cameron, the value of Cameron’s shareholders increased by 56%. Profitability increased as a result of reduced expenses and streamlined operations.

Other benefits that may arise from M&A activities include reducing competition, achieving domination in the market and achieving pure diversification. It has also been established that companies stand to benefit from tax regimes in merger deals especially when larger companies acquire firms with net operating losses to reduce taxable income (Berger & Ofek, 1995).

Mergers and acquisitions even though well thought out can be faced with several challenges during acquisition or can go bad after finalizing (Gaughan, 2002 an Winburne et al). Royal Dutch Shell acquisition of BP Group is one such story. Hardly a year after the acquisition, negative cash flows in a very tight market has seen Royal Dutch contemplate shedding off assets of more than half the value of the acquisition. Through the acquisition deal, Shell was acquiring assets in Brazil in terms of oil fields. The prevailing political climate posed multiple risks. The inability of lawyers to advise on the tax treatment of the deal between Energy Transfer Equity and Williams Companies has resulted in the termination of the deal.

Harmonization of the post-merger entities can prove to be slow and tedious as individuals in the separate organizations attempt to integrate within the new firm to dispense of their responsibilities (Cartwright& Schoenberg, 2006 and Colman et al, 2011). The already established culture and organizational structures prove difficult to break and can result in the failure of M&As. Major challenges of M&As therefore, revolve around human resource. 

Loss of key expertise in the form of resignations of employees from the organization due to job insecurity is one of the key concerns of the newly formed companies. Often, employees are not aware of M&A activities until they happen (Gaughan, 2002). This communication breakdown leads to distrust and fears among the employees with regard to their future and roles in the new dispensation. The uncertainties may lead to voluntary migration of employees from the company leading to a shortage especially in expert staff (Waight, 2004).

The loss of key top-level employees also leads to a diminished dedication and lower efficiency in the remaining staff. The new work atmosphere and culture disorient them and tend to lose their commitment towards the company. It, therefore, rests with the company’s management to devise new mechanisms to boost their sense of belonging and trust in the company. This is often done through clear definition of roles and responsibilities, identification of rewards and awards of appraisals.

Companies thrive in existing and almost innate cultures that show common values, goals and beliefs expressed in leadership, management and strategy formulation in their day to day activities (Mayer & Altenborg, 2008). It is almost difficult to combine existing cultures of merging companies in the new organization (Peng, 2006). Change is inevitable. Shifts in these cultures can have negative impacts on the newly organization since people resist change (Camara & Renjen, 2004).

As mergers and acquisitions happen, communication to the staff is key. There should be clear cut enumerations of responsibilities, expectations, development plans and managerial changes that are expected in the new dispensation. This should be able to improve integration and quicker adaptation to the new set up (Chapman, 2004).

Conclusion

The much anticipated merging and acquisition of companies’ activity in the wake of oil prices drop in 2014 did not happen on the scale it was expected. This was majorly because prospective buyers were hesitant to buy out or combine with other firms with fear of a prolonged price crisis. They opted to wait, maximize their revenues and capitalize on reducing operating costs.

Mergers and acquisition deals can either work for or against the combining firms. Among the benefits that such activity may have on the companies include growth and development, reduction in operating costs, maximization of revenues, diversification and maximized competitive advantage. Mutual benefits to be accrued from combining the companies often guide the M&A process with companies carrying out due diligence.

The major challenge and setback of combing companies is loss of employees, distrust among the employees left after migration and breaking of operational, managerial and financial cultures in the combining cultures. These can, however, be mitigated with prior research and analysis of the existing cultures and timely integration measures. Communication comes in as a key component in raising awareness to the employees about the reason and aftermath of the merging process. Confidence is therefore boosted.

References

Berger, P. & Ofek, E. (1995). “Diversification’s Effect on Firm Value”, Journal of Financial Economics, Vol. 37.

Bruner, R. (2004) “Where M&A Pays and Where It Strays: A Survey of the Research”, University of Virginia’s Darden School, Journal of Applied Corporate Finance

Camara, D. & Renjen, P. (2004). The Secrets of Successful Mergers: Dispatches from the Front Lines. The Journal of Business Strategy, Vol. 25, Issue 3.

Cartwright, S. & Schoenberg, R. (2006). Thirty Years of Mergers and Acquisitions Research: Recent Advances and Future Opportunities. British Journal of Management, Vol. 17, Issue1.

Chapman, N. (2004). Key Success Factors in Mergers and Acquisitions, Strategic HR Review. Vol. 4, Issue 1, 27.

Colman, H., Stensaker, I. & Tharaldsen, J. (2011) A Merger of Equals? The Integration of Statoil and Hydro’s Oil & Gas Activities. Fagbokforlaget. Bergen.

Damodaran, A.  (2011). “Equity Risk Premiums: Determinants, Estimation and Implications – The 2011 Edition”. Stern School of Business

Gaughan, A.(2011). Mergers, Acquisitions and Corporate Restructuring. Fifth Edition. John Wiley & Sons.

Huyghebaert, N. & Luypaert, M. (2013). Sources of Synergy Realization in Mergers and Acquisitions: Empirical Evidence from Non-Serial Acquirers in Europe. International Journal of Financial Research.

Jensen, C. (1986). “Agency Costs of Free Cash Flow, Corporate Finance and Takeovers”. American Economic Review, Vol. 76, No. 2.

Jensen, C. and Ruback R. (1983). “The Market for Corporate Control: The Scientific  Evidence”. Journal of Financial Economics, Vol. 11.

Kearney, A. (2016). Mergers and Acquisitions in Oil and Gas.

Luypaert, M. and Huyghebaert, N. (n.d.). Determinants of Growth Through Mergers and Acquisitions: Empirical Results from Belgium. SSRN Electronic Journal.

Mayer, C. & Altenborg, E. (2008). Incompatible Strategies in International Mergers: The Failed Merger between Telia and Telenor. Journal of International Business, Vol. 39, No. 3.

McLaughlin, R. & Mehran H. (1995). “Regulation and the Market for Corporate Control: Hostile Tender Offers for Electric and Gas Utilities”. Journal of Regulatory Economics, Vol. 8:181.

Peng, M. (2006). Global Strategy. South-Western, United States

Roberts, A., Wallace, W. and Moles, P. (2003). Mergers and acquisitions. Harlow: Pearson Education.

Sherman, A. (2010). Mergers and Acquisitions from A to Z. Third Edition. New York. American Management Association.

Tidd, J. & Bessant, J. (2008). Managing Innovation. Integrating Technological, Market and Organizational Change. Fourth Edition. West Sussex. John Wiley & Sons.

Verde, S. (2008). “Everybody Merges with Somebody—The Wave of M&A in the Energy Industry and the EU Merger Policy”. Energy Policy 36 1125–1133

Waight, C. (2004). HR Involvement in the Investigative Phase of a Merger & Acquisition. International Journal of Training and Development, Vol. 8, Issue 2.

Winburne, Blake H. & Archer, R. “The Top Five Traps in Energy M&A Transactions”, Inside M&A –July/ August; McDermot Will & Emery Newsletters.

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