BEYOND THE JOINT VENTURE: TRUE COLLABORATION FOR LONG-TERM SUCCESS

May 1, 2009

Sampat Prakash & Rachael Goydan, Deloitte Consulting LLP , Houston

Opportunities for further industry consolidation appear to be likely for many entities, but in what form? Of the four likely scenarios that we describe in this article, the most complex to execute a hybrid IOC-NOC collaboration offers the greatest potential for sustainable returns. Is this new model viable? What will it take to make the risk-reward equations work for both sides? When companies such as BP/Amoco/Arco, Exxon/Mobil, and Chevron/Texaco combined between 1998 and 2001, a key driver of the megamerger trend was the need to gain scale to reduce cost and remain profitable in the wake of $12/barrel oil. While scale and cost efficiencies are still relevant, integrated oil companies (IOCs) are focused on access and managing fiscal take by the national governments of the countries involved. These issues are increasingly complex, as they involve national oil companies (NOCs) and governments, and necessitate a model that is sustainable and which manages the interests of both the IOCs and NOCs in a new form of partnership. When considering the IOCs, US independent oil companies, and NOCs, four combinations are likely, each playing on the strengths and weaknesses of particular players.

Megamerger An IOC merges with another IOC to increase scale in strategic locations or diversify its portfolio while extracting costs from the business. Strategic acquisition IOCs buy one or more US independents to gain access to lower risk domestic reserves with the ability to apply superior technology as it evolves. Minimerger Two or more US independents join forces to become a more dominant player in the US. The new entity would not rival the smallest IOC, but could potentially dwarf the remaining US independents. IOC-NOC partnership An IOC links with one or possibly two significant NOCs by providing necessary funding and expertise to expand operations, in turn gaining access to substantial reserves. Historically, these partnerships have seen varying success and a new model could be the key to success. For NOCs, new partnership models could be a way to develop high-caliber people and expand internationally. For IOCs, new partnership models could lower the risk of changes in fiscal take resulting from regime change in the nations that own the NOCs.

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As Figure 1 shows, none of the four likely combinations of companies can optimize both axes. Since all options lay close to the efficient frontier, significant uncertainty remains in which combination will first emerge or whether it makes sense to proceed at all. For example, an IOC megamerger is possible, although only a few select IOCs have the necessary financial resources. Most IOCs would struggle in the current environment (in this industry, merger and acquisition (M&A) deals tend to be more acquisition than merger), additionally the regulatory implications are daunting, particularly in cross-border scenarios. Moreover, todays climate is different from 10 years ago, when the megamerger trend was robust. The 90s goal of realizing synergies to save costs and increase margins is not as relevant today as the need to gain access to significant reserves and manage fiscal take two fundamental issues that a megamerger will not likely solve. In the second scenario, an IOCs strategic acquisition of one or more US independents is also possible. The benefits include low risk to the IOC and the opportunity to buy at (relatively) reduced valuations. It could allow an IOC to acquire specialized technology, gain access to the US independents resources (perhaps unconventional, like shale), or simply acquire a promising, but distressed, company at a bargain. However, these types of acquisitions are relatively common and not likely to be dramatic developments for the industry. A fairly typical M&A scenario is a minimerger between two or more US independents. Whether undertaken as a defensive move to avoid acquisition by an IOC or an effort to expand scale and scope and realize synergies, such activity may suffer from the current financial climate and lack of available credit. While noteworthy, a combination of this type is unlikely to make substantial waves.
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The fourth scenario, an IOC-NOC partnership, offers transformational potential for the industry. While the most complex and risky to execute, such a combination also offers the greatest returns potential for both parties.

The challenges of IOC-NOC collaboration

While operational JVs are quite common, to date, we have seen few examples of truly effective IOC-NOC partnerships and collaboration. One of the greatest hurdles has been the vast cultural, political, and philosophical differences between the two parties. Consider how these typical NOC roles run contrary to those of an IOC.

National breadwinner. Governments rely on NOCs to provide revenue in the form of fiscal take royalties, taxes, and profit sharing. For some countries where there are low to minimal corporate and personal taxes, the NOC can provide almost 90% of total state revenue. The need for these revenues may conflict with the desire to produce reserves as efficiently as possible. For example, the NOC may overproduce, shortening the life of the reserves, or under produce, limiting revenue. Benevolent employer. NOCs often place a premium on keeping citizens employed acting as an ecosystem of local businesses health. While a private company may choose to operate lean, both streamlining processes and reducing headcount, these are generally not high priorities for an NOC. Some academics suggest NOCs can be overstaffed by as much as 35%. Trustee for future generations. An NOC is not just a business. It is responsible for overseeing what may be the nations only viable natural resource, and a source of national pride. NOCs must constantly weigh the need to open access to IOCs to develop these resources against the need to be prudent custodians of national assets and protectors of national interests. Regime codependent. As the government goes, so most often goes the NOC, making it imperative for IOCs to seek partnerships with NOCs in countries that are politically and fiscally stable.

The social and cultural norms that influence an NOC and the overarching national agenda are often counter to an IOCs operations. Nevertheless, IOC-NOC joint ventures occur regularly. The difference is, while the industry calls these JVs and partnerships, most others would think of them as specific purpose investments. The operator retains control and makes all decisions, allocating costs and payments to each investing party according to its stake in the venture. The degree of joint decision making, sharing and development of talent and technology, and the ability to expand the operation, are not at the level expected from a true partnership.

A new type of venture a NEWCO

Consider the potential that emerges from a different kind of IOC-NOC collaboration a completely new company (NEWCO) to develop a specific resource in a specific area, such as a substantial deepwater or permafrost/arctic area. Unlike a JV, the NEWCO is an independent entity, separate from the NOC and IOC, run by its own jointly appointed
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executive team and staffed by its own employees. It is not bound by the NOCs cultural, economic, and employment constraints, nor is it subject to the IOCs direct control. A NEWCO of the type described above offers advantages for both parties over a traditional JV arrangement.

The IOC gains access to the NOCs reserves. The NOC has greater influence over the majority of its national resources and infrastructure, while gaining access to financing and the IOCs more efficient operating capabilities to make better use of its reserves. The NOC also gains a valuable means of talent development, giving its best and brightest the opportunity to work in a Western-style business environment. Both parties benefit from the others technology and specialized knowledge.

Furthermore, the NEWCO has the freedom to expand beyond its initial mandate. For example, it can take its deepwater expertise to other locations, or perhaps become an attractive business partner to other IOCs or NOCs. In doing so, both parties gain the benefits of diversification. For the NOC, diversification offers the freedom to operate beyond its own borders and seek sources of income apart from its own natural resources. For the IOC, risk is diversified by operating outside of the NOCs national boundaries and being therefore better able to manage regime change views on nationalization and fiscal take.

How to make it work

We believe the NEWCO model is transformational for the industry and offers superior potential for IOCs and NOCs to address their fundamental challenges gaining access to reserves, sustaining economies and cultures dependent on finite domestic resources, harvesting abundant but challenging unconventional sources and doing so profitably and safely. The model applies to others in the industry, such as a NEWCO between a US independent and a smaller NOC. While a NEWCO improves some of the difficulties of IOC-NOC collaboration, such as significant cultural differences, it is still a daunting prospect. To make it work, the IOC and NOC must effectively complete a lengthy to-do list, comprising tasks like these:

Structure a partnership, complete with shared governance, appropriate exit clauses, and an efficient legal structure. Address the complex tax and financial planning requirements inherent in global operations and significant foreign government control. Allocate purchase transaction price to NEWCOs tangible and intangible assets and liabilities. Agree on NEWCOs Internet Providers ownership and an independent valuation process now and in the future. Establish management and regulatory reports, tax filings, and internal controls that meet the standards of both partners.

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Manage employee selection, organization design, compensation, and benefits for employees. These programs will likely need to be a hybrid to attract and retain the right talent. Define services or outsourcing agreements for core infrastructure processes prior to launch, with termination, pricing, penalties, and compliance spelled out.

While this list is complex (and not comprehensive), these are not insurmountable tasks, in fact, many are typical for global business start-ups. We are not expecting NEWCO collaborations to happen quickly many factors must fall into place: the right IOC, the right NOC, the right venture, the shared incentive, and commitment to hammer out the details.

But as we have seen time and again, when business drivers for change exist, change happens. As IOCs must gain access to reserves to remain viable, and NOCs want a model that improves their ability to operate both inside and outside of its borders to sustain their economies, the time appears ripe for meaningful groundbreaking collaboration between the two. A NEWCO partnership represents the type of bold action required to provide for the long-term viability and growth of both IOCs and NOCs. While other consolidation scenarios are possible, we believe the rewards of the NEWCO are superior and outweigh the inherent risks.

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