THE WALL STREET JOURNAL: COMMENT FROM breakingviews: Oil: “Oil M&A is back, with a slew of companies looking to do deals. Chevron is fighting with China's Cnooc over U.S. oil company Unocal, and Royal/Dutch Shell suggests it is ready to take to the warpath again.”: Monday 4 July 2005   

Edited by Hugo Dixon

July 4, 2005

Oil M&A is back, with a slew of companies looking to do deals. Chevron is fighting with China's Cnooc over U.S. oil company Unocal, and Royal/Dutch Shell suggests it is ready to take to the warpath again. But aren't these companies crazy to buy oil assets given that crude is trading around $60 (€50) a barrel? If the high oil prices fell, so would valuations.

In many ways, the companies don't have a choice. High demand means that many companies are now pumping their reserves quicker than they can replace them. This has produced a scramble for assets that can produce oil quickly. M&A is the obvious solution. At the same time, oil companies are bulging with cash, thanks to high crude prices. The longer this cash sits on their balance sheets, the longer their returns will be diluted.

So much for why companies might want to do deals. What about the terms on which those deals are done? Thankfully, the situation isn't as bad as it looks. Spot crude prices might be at nearly $60 a barrel, but back out the oil price implied by equity valuations, and companies trade on an implied long-term oil price nearer $35 a barrel. That is also less than the $55 futures price of oil several years out. In theory, a chief executive could purchase a company, lock in high oil prices by selling forward its production, and reap an immediate return.

The snag is that it is one thing to buy a single share in an oil company at an implied oil price of $35 a barrel. It is another to try buying the whole company. Then you generally have to pay a premium.

That means there is still a danger that plenty of bidders will end up overpaying. Cnooc, for example, is offering a premium over Chevron's bid for Unocal, which in turn only really works financially if oil prices are higher than $40 a barrel. Against that, takeover premiums are generally coming down -- in Europe last year they were about 10%. All told, this suggests there will be some good oil deals during the months to come, and some duds.

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