Suncor and Petro-Canada build their oil sand castle

The merger and acquisition market in the oil and gas industry has been like a ballroom at the start of the evening. Everyone knows there will be a lot of pairing-up going on, but everyone is nervous about making the first move.

Now Suncor Energy and Petro-Canada have taken to the floor, others are likely to start dancing too.

Chris Sheehan of IHS Herold, the advisory firm, argues that the fall in the oil price and the financial crisis have created conditions similar to the industry downturn that precipitated the merger boom of the late 1990s.

“The industry is facing similar pressures in terms of the squeeze on operating margins, and companies are looking to do deals that will create cost savings. The conditions are right for large-scale consolidation,” he says.

However, there are still good reasons for some to hang back.

First, the deal is centred on Alberta’s oil sands, “unconventional” oil that cannot be extracted by the traditional method of simply drilling a well. Unconventional resources such as oil sands, US shale gas and Australian coal bed methane, have been a growing focus of M&A activity, and accounted for almost 40 per cent of the $104bn of oil and gas deals last year.

But they tend to have higher costs, making companies particularly vulnerable to the plunge in the oil price, which has dropped from more than $147 a barrel last July to about $53 today.

Although costs in Alberta, which had been soaring because of shortages of staff, materials and equipment, have now begun to fall, they are still among the highest in the world.

Industry estimates suggest existing oil sands projects need oil at about $40 per barrel to cover costs, and a new project might need $100 oil to be commercially viable.

Suncor and Petro-Canada on Monday emphasised the savings expected from the deal, particularly the C$1bn ($813m) reduction a year in the cost of investment.

Capital costs in oil sands are huge: the delayed Fort Hills development, in which Petro-Canada holds 60 per cent, had a budget of C$24bn: more than the value of the company.

To succeed in oil sands, companies need to cut costs by moves such as making more effective use of upgraders, the expensive facilities used to transform the sludgy extract into a form of crude that can be sold.

Other mid-sized Canadian companies such as Encana, Canadian Natural Resources, Husky Energy and Opti Canada, suddenly find themselves facing a much larger competitor, and will be reassessing their positions. Companies with lower costs will feel they are under less pressure to do deals.

The second reason for hanging back is that Suncor is making an acquisition in a rich developed country. Several western oil companies are now starting to stress their focus on developed countries, even though it is emerging economies that hold most of the resources of conventional oil and gas. After the bruising treatment handed out to investors in Russia and Venezuela in recent years, many are still cautious about assets in those countries.

Third, the deal is entirely for shares. The largest international oil companies such as Royal Dutch Shell, BP and StatoilHydro are raising money in the bond markets at attractive rates to finance investment programmes, but even they would probably face difficulties raising tens of billions of dollars for a deal. For a mid-sized company such as Suncor, it would be out of the question.

Any company seeking to do a large deal will have to do it in shares, or not at all.

There are exceptions. Some national companies, particularly the Chinese, are well-financed and seeking assets. ExxonMobil, with $31bn in cash, could buy almost any company, although its chief executive has suggested he is not keen.

If you had to guess where the next big deal might be, Canada could be the place.

EDITOR’S CHOICE

Copyright The Financial Times Limited 2009

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