Russian Merger Raises Pressure on Independent Producers

Abstract: Independent producers in Canada and the United States face a large and new rival as a result of a blockbuster merger in the Russian oilpatch, a deal that may alter the face of the North American energy industry.

Analysis: The wilds of Siberia are a long way from North America, but this week's blockbuster oilpatch merger in Russia sent a cold wind blowing through corporate headquarters in Calgary, Tulsa, and Houston.

On first glance, the willingness of Yukos Oil to pay $13 billion in cash and stock for Sibneft has little to do with large independents such as Apache, Burlington Resources, EnCana, and other well-known players.

However, the reaction of investors to the growth prospects resulting from the combination of Russia's number 1 and number 5 oil producers cranks up the pressure on independents to increase production through drilling or further acquisitions.

YukosSibneft, as the new Russian entity will be called, will pump about 2.4 million barrels of oil per day, slightly above Canada's total daily output. It will rank behind only such super-majors as BP, ExxonMobil, Royal Dutch/Shell, and ChevronTexaco. The merger of Yukos and Sibneft likely deals a short-term blow to Shell or France's TotalFinaElf. The two companies, along with others, were rumored to be in discussions on purchasing Sibneft.

The longer term effects will be felt most acutely by independent producers, although either Shell or TotalFinaElf would have been happy to gain a foothold in a country which recently attracted a $6.8 billion investment from BP. (For more details on BP's purchase of a 50 percent stake in Tyumen Oil Co., see Oil and Gas Advisory's Feb. 26 edition.)

News of the merger pushed American depository receipts of Yukos and Sibneft to record highs, giving the combined company a market capitalization of $35 billion.

The growth potential of YukosSibneft partially explains the enthusiastic response by investors. Yukos' output jumped 20 percent last year while Sibneft's climbed 28 percent, and this year's increase for the merged firm has been estimated at 20 to 25 percent.

The contrast between those ambitious targets and first-quarter results starting to trickle out shows why the bull's-eye is painted on the backs of North American independent producers.

Only a handful of companies have released their January through March figures, but early indications are not encouraging. Both Apache and Burlington, for example, reported lower quarterly oil and natural gas production than in the first three months of 2002. Output declined even though commodity prices were flying almost as high as the Concorde, making it economic to drill and produce just about every prospect presented by exploration and exploitation teams.

This week's decline in oil prices illustrates a key factor driving investors. Unless Middle East production is severely disrupted by terrorist attacks motivated by the U.S. victory against Iraq, crude prices are going to fall and stay a long way below the lofty heights seen earlier this year. The fragile state of the U.S. economy, the most important determinant in global crude prices, means production growth is the only way energy companies are going to increase earnings in upcoming quarters.

Besides rising crude volumes, competition for capital is another important issue. The size and liquidity of YukosSibneft will make it a must-hold stock for numerous pension and mutual funds, putting pressure on Canadian independents as money managers rationalize their energy holdings.

It's a lot easier for financial managers to convince themselves to buy a large and liquid producer, such as YukosSibneft, than Canadian Natural Resources, Nexen, and Talisman Energy. The latter three firms all have market capitalizations of less than $5.4 billion, compared with $16 billion for EnCana and almost $10 billion for Apache.

Although they will be flush with cash because of record first-quarter profits, Canadian firms resemble an elephant trying to turn around in a motel room--there is room to maneuver but it has to be done carefully.

The consolidation frenzy of two years ago has wiped out easy acquisition targets in Canada, and oilsands projects are long-term, capital-intensive developments that do not appeal to some investors.

The smaller size of most Canadian independents is another obstacle to bulking up through acquisition, assuming a suitable target can be found. One recent analysis found U.S. firms and EnCana traded at 4.3 times estimated 2003 cash flow versus a ratio of 3.5 for firms like Canadian Natural, Nexen, and Talisman. The lower multiple makes it harder for the Calgary-based companies to arrange paper-based transactions that are not too dilutive to existing stockholders.

A good example of what the future likely holds for independents comes from Devon Energy's purchase of Ocean Energy in February. The deal brought together two acquisition-oriented firms in a $5 billion transaction that boosted the survivor's production, reserves, and liquidity.

Executives at independents, proud of their record of success over the past decade, face some difficult choices as a result of the premiums put on size and growth. The merger of Yukos and Sibneft shows the next round of consolidation is not far away, a decision that will be made by managers or by the market. Either way, more respected names in the North American energy industry are soon going to be nothing but memories.