The combination of Conoco Inc. (NYSE: COC) and Phillips Petroleum Co. (NYSE: P), to be called Conoco Phillips, will be the third-largest integrated U.S. oil company and the largest U.S refiner. Worldwide, it will be the sixth-largest energy company, based on hydrocarbon reserves, and the fifth-largest global refiner. "For quite some time, we have argued that both Phillips and Conoco lack the critical mass to be fully competitive within today's global oil and gas industry," says Paul Cheng of Lehman Brothers Inc. in New York. "Although the new company will remain substantially smaller than their major competitors, it is a giant step forward in the right direction." In addition to simply increasing mass, the merger of Conoco and Phillips will help patch holes in each other's portfolios, analysts say. "I can't imagine two companies that fit together better," says Gene Gillespie of Howard Weil in New Orleans. Phillips, for example, is a very oily company, while Conoco picked up some major North American gas assets with its recent acquisition of Gulf Canada Resources Ltd. Plus, Conoco has a substantial presence in some high-impact areas such as the deepwater Gulf of Mexico and Southeast Asia, whereas Phillips does not. "Phillips is a lot bigger company than it used to be, and its prospect portfolio relative to its size had some holes," Gillespie says. Credit-rating service Standard & Poor's Corp. notes that while Conoco's future growth has increasingly relied on projects in emerging markets, Phillips has numerous legacy assets in areas of lower political risk such as North America and the North Sea. And, although Conoco is highly levered toward heavy-oil refining processes, Phillips balances the portfolio by contributing downstream assets levered to light-oil processes. Executives of the two companies acknowledged these merger advantages. "Together, this portfolio should lower exposure to any one commodity and lessen volatility," says Archie Dunham, Conoco chairman and chief executive officer, who will be the combined company's chairman. Phillips shareholders are to receive one share of ConocoPhillips per share of Phillips, while Conoco shareholders will receive 0.4677 share of ConocoPhillips per share of Conoco. Based on the companies' closing share prices on Nov. 16, 2001, and their debt as of Sept. 30, 2001, the new company would have an enterprise value of $53.5 billion of which $34.9 billion is equity and $18.6 billion is debt and preferred securities. Phillips shareholders will own about 56.6% of the new company. The transaction is structured as tax-free to shareholders. Approximately $750 million in annual costs will be cut within the first year. Phillips chairman James J. Mulva will be president and chief executive officer of the new company. Dunham will delay his scheduled retirement to 2004, at which time Mulva will assume the title of chairman. The board of directors will consist of 16 directors, eight from each major, and include Dunham and Mulva. ConocoPhillips will be headquartered in Houston, Conoco's current headquarters, with a "significant and continuing presence" in Bartlesville, Okla.-Phillips' home city. The deal is expected to close in the second half of 2002. "It's really a merger of equals," says Steve Enger of Petrie Parkman & Co. in Denver. "From an accounting point of view, Phillips is acquiring Conoco. But they've gone out of their way, I think, to call the new company ConocoPhillips, and Archie Dunham is the chairman. There are eight directors elected from each company. So it's about as much a merger of equals as you could make it." But while the merger is being billed as a merger of equals rather than a takeover, some analysts say Conoco's shareholders might be upset that Phillips did not pay any premium for the Conoco stock. "Look at the previous deals. Most of the deals actually got a 25% to 30% premium on the purchased company's equity," says Matthew Warburton of UBS Warburg Securities LLC in New York. "And if it seems that Conoco is in fact getting purchased by Phillips, you can see why the Conoco shareholders are disappointed." There's been speculation that another company might try to woo Conoco shareholders by offering to buy Conoco at a premium. Warburton says, "While the two companies have agreed [to] a $550-million reciprocal break-up fee, the appointment of six investment banks to advise on the deal raises questions as to whether they are concerned about competing offers for either of the two companies while the merger process proceeds." Morgan Stanley, Credit Suisse First Boston and Salomon Smith Barney advised Conoco. Goldman, Sachs & Co., J.P. Morgan Securities Inc. and Merrill Lynch & Co. advised Phillips. In the upstream segment, the combined company will have pro forma year 2000 hydrocarbon reserves of 8.7 billion BOE and daily production of 1.7 million BOE, based on the companies' estimates for 2001 year-end production. ConocoPhillips will have numerous legacy asset positions, including those in Alaska, Canada, the Lower 48, the North Sea, Venezuela, China, the Timor Sea, Indonesia, Vietnam, the Middle East, Russia and the Caspian area. Even though ConocoPhillips will have impressive size, it still could have trouble expanding into new areas, Warburton says. "Certainly, there are certain areas they cannot compete on in terms of the entry to new areas. Notably, if the area requires substantial signature bonuses, they may feel less willing to undertake that up-front investment. On the E&P side, they're still relatively small compared with the supermajors, but they certainly have ambitions to grow. There are issues on their actual finding and development cost performance that they need to address as a combined company before their arrival among the best in the industry." Executives estimate the combined company will deliver E&P production growth of at least 4% per year. While it will initially have 57% of its portfolio in the upstream business, the executives' long-term goal is to expand exploration and production to as much as 70% of the company's operations. ConocoPhillips' oil and gas mix currently is 64% oil. A 50-50 split is the long-term goal. In refining and marketing, ConocoPhillips will operate or have equity interests in 19 refineries in the U.S., the U.K., Ireland, Germany, the Czech Republic and Malaysia, with a capacity of 2.6 million bbl. a day. It will also have a strong marketing presence in the U.S. In addition, ConocoPhillips will continue Phillips' equity participation in the gas gathering and processing joint venture, Duke Energy Field Services, with Duke Energy Corp. (NYSE: DUK) and in the chemicals and plastics joint venture, Chevron Phillips Chemicals, with ChevronTexaco Corp. (NYSE: CVX). There is speculation that the companies will have to shed some refining assets to get the deal approved by the Federal Trade Commission. But analysts say the companies shouldn't have to sell much. "We don't envision any material asset divestments to come into this deal," Warburton says. "Certainly there's going to be some regional overlap in marketing, and there's going to be some overlap at the terminal end. So you could see selective issues being addressed by the FTC. If anything, the proposed combination could accelerate Phillips' desire to remove those marketing assets it identified after the Tosco Corp. acquisition-$1 billion of disposals-from the business as soon as possible, so they can then approach the FTC with a less-concentrated position." Cheng says the companies will likely have to sell some marketing assets, pipeline interests and perhaps one or two small refineries in the Midconti-nent/Rockies-"a relatively small price to pay for a transaction of this size." The debt-to-capitalization ratio of the combined company will be about 34%, which executives want to reduce to 30%, Mulva says. While that is larger than the debt of ExxonMobil Corp. (NYSE: XOM), for example, analysts are not worried. "If you compare that to the smaller companies, the domestic integrated companies, it's not unusually high at about 35% debt-to-cap," Enger says. "I don't think it's a problem." -Jodi Wetuski