When you're on top of the heap, you've got it all, right? Wrong. One of the surprising things about supermajors like ExxonMobil, BP and ChevronTexaco is that, while their existing upstream prospects are huge, these monsters of the oil patch tend to be new-opportunity poor, relative to their recently enhanced size. As a consequence, some of these global giants are struggling to maintain a consistent level of production growth, says Gene Gillespie, senior energy analyst for Howard Weil, the New Orleans-based energy investment-banking firm. "Royal Dutch/Shell a couple of years ago was targeting 5% annual production growth; six months ago, that target was closer to 3%. Now, its real annual output is more apt to be flat." Similarly, ChevronTexaco, which 12 months ago said it was aiming at 4% to 5% yearly production growth, is now staring at 2.5% to 3% volume gains. What to do? With plenty of excess cash flow, these giant integrateds are likely to go after more mergers, this time with second-tier domestic majors like Amerada Hess, Marathon Oil, Murphy Oil, Occidental Petroleum, Kerr-McGee Corp. and the soon-to-be ConocoPhillips. But this group may not be the only targets of the supermajors, cautions Fadel Gheit, senior energy analyst for Fahnestock & Co. in New York. "BP continues to follow a strategy of increasing its natural gas exposure throughout the world, particularly in the U.S; therefore, it might be also interested in large U.S. independents like Unocal, Anadarko Petroleum and Burlington Resources." BP, of course, wouldn't be alone in this thinking. ExxonMobil and Royal Dutch Shell, which wants to grow its U.S. gas presence, have strong balance sheets and the ability to increase their debt by $10- to $20 billion, says Gheit. "That would allow either of them to acquire a large independent without any real impact on their triple-A credit ratings." Steve Enger, integrated oils analyst for Petrie Parkman & Co. in Denver, claims the current commodity-price environment lends itself well to consolidation. During the past few months, oil has been $18 to $22 per barrel-close to what many people see as a sustainable, long-term level. And gas, although volatile, has been about $2.40 per thousand cubic feet, which is closer to its historical average. "This means buyers and sellers can more easily come together on price expectations for combinations at both the corporate and asset level. So don't be surprised to see some trickle down of mergers from the integrateds to the smaller majors, with cost savings one of the compelling triggers." Among the second-tier majors, this trigger figured prominently in the pending Phillips/Conoco combination, says Enger. "The big prize there is $750 million in initial cost savings, which could grow to as much as $1 billion very quickly. That's significant value creation." But don't expect ConocoPhillips to stop growing once that deal closes. James J. Mulva, Phillips' chairman and chief executive officer, has been bold in his recent moves, with the acquisition of Arco Alaska and Tosco, and wants his new company to be much bigger than ConocoPhillips' combined $39-billion market cap, says Gillespie. Stresses Gheit, "Phillips has doubled in size during the past three years, but that's just the start. The company is almost an incubator for a supermajor. Within six months after its merger with Conoco is approved, look for it to acquire a large U.S. upstream independent to balance its downstream operations. A takeover target like Unocal or Anadarko would be just what the doctor ordered." What about the other second-tier majors or large independents? Are any of them likely to get the urge to merge during the next year or so? And which, if any, are thought to be susceptible to takeover? "If you look at Amerada Hess, Kerr-McGee and Occidental, they've all completed acquisitions within the past few years-Amerada, with its purchase of Triton; Kerr-McGee, with its buy of HS Resources; and Occidental, with its acquisition of Altura and Elk Hills," says Enger. "As a result, their debt-to-total-capitalization ratios are fairly high, and they're focused on reining in debt. So I don't see them in the market near-term doing a major acquisition." Also, the valuations of these three companies are so low that they don't really have an attractive currency, in terms of their own stock, adds Gillespie. "Murphy, on the other hand, has a strong valuation and a strong balance sheet. However, because of its size-it's the smallest of the second-tier majors-and the fact that is has so much on its plate, in terms of high-growth exploration prospects, it's the least likely among its peers to be acquisitive." Murphy Oil If you have an aggressive exploration program, and you're experiencing continued success in making discoveries, that's a better way to grow shareholder value than buying assets in the market, where the expectations of sellers are quite high, says Claiborne P. Deming, president and chief executive officer of Murphy Oil, El Dorado, Arkansas. Focused principally on the deepwater Gulf of Mexico, western Canada, the Scotian shelf offshore eastern Canada and Malaysia, Murphy Oil has recently made major discoveries that are expected to boost its current daily production from 120,000 barrels of oil equivalent (BOE) to around 175,000 by 2004. Fueling this growth will be development of the Medusa, Habanero and Front Runner fields in the deepwater Gulf of Mexico; Ladyfern, a 500-billion-cubic-foot gas discovery in British Columbia; West Patricia, a 30-million-plus-BOE discovery offshore Malaysia; and the company's interests in the huge Hibernia and Terra Nova fields offshore eastern Canada. "In the deepwater Gulf of Mexico-our principal engine for future upstream growth-our batting average has been one-for-three, including three 100-million-BOE discoveries," says Deming. "When your total reserves are right at 500 million BOE, that's where and how you can really create a lot of value." In 2000, the company's return on equity was 26.4%; in 2001, 23.5%. Return on capital employed for the corresponding years was 20.3% and 17.7%. Last year, Murphy's stock rose 40%, to around $80 per share. Its current debt to total capitalization is 25% to 30%. No less sensitive to growth in the downstream, the company has rapidly grown its Murphy USA retail gasoline stations in Wal-Mart parking lots, to 400. "Five years ago, we were selling 3,000 to 4,000 barrels of retail gasoline daily; now we're selling more than 60,000 barrels per day as a result of this relationship," says Deming. "We've recently announced we're also going to expand with Wal-Mart into Canada." Might Murphy ever become acquisitive? "Our only North American gas exposure is Ladyfern and a large Gulf Coast production base, so we need additional gas assets," he says. "Finding compelling buys, however, is very hard because of the high price-floor on gas properties and companies. So my bias is not to go out and buy gas assets, but to explore for them. That's what we do best, and that's how we plan to get bigger." This doesn't mean Deming is dismissing the likelihood of consolidation within his peer group. "There's a drive to get bigger, and with good reason. It's becoming more difficult and expensive to find large oil and gas fields. So companies need greater size and scale to economically sustain drilling programs these days." Kerr-McGee Corp. Luke R. Corbett, chairman and chief executive officer of Oklahoma City-based Kerr-McGee Corp., emphasizes that his company is growing shareholder value both through the drillbit and acquisitions. "Last year, we added 529 million BOE, which increased our reserve base from about 1 billion to more than 1.5 billion BOE," he says. "About 60% of that growth came from internal drilling projects in the deepwater Gulf of Mexico, the North Sea and selected domestic onshore areas. The balance came from the $1.8-billion acquisition of HS Resources, which gave us some 1.3 trillion cubic feet of gas reserves in a concentrated area of the Rockies-the Wattenberg Field in the Denver-Julesburg Basin. Now we have a critical 56%-44% oil-gas mix. During the next five years, the company plans to continue emphasizing drilling in core areas, supplementing that with timely, strategic acquisitions that add to the bottom line. Since taking the reigns of Kerr-McGee in 1997, Corbett has, through the inauguration of a five-year growth plan, presided over a near quadrupling in the company's asset size, from $3 billion to $11 billion currently. "While the majority of that gain has come from upstream projects, we've also ramped up our chemicals business, moving from the seventh-largest producer and marketer of titanium dioxide pigment in the world to the third-largest." With its year-end 2001 net debt to total capitalization at 59%, and a goal of cutting that leverage ratio back to 45% within the next several years, Kerr-McGee today is focused on developing major upstream projects. In the deepwater Gulf of Mexico, these include its Nansen and Boomvang fields, which collectively have estimated gross reserves of 210- to 280 million BOE, and its Gunnison Field, where estimated gross reserves are more than 120 million BOE. The company is also moving ahead with projects in the North Sea, including its 100%-owned Leadon Field, which has estimated reserves of 120- to 170 million BOE. Says Corbett, "The North Sea is an area where we'd like to see more opportunities open-and signs are that this may happen. For a large independent like ourselves, a 100-million-barrel oil field there is very meaningful." The biggest challenge facing Kerr-McGee? "If commodity-price volatility continues, which can affect the ebb and flow of drilling programs, it'll be to maintain daily production volumes this year and next at around 330,000 equivalent barrels-which itself represents a 10% gain in output over 2001," says Corbett. "There is, however, an upside to volatility. It always creates [acquisition] opportunities." Takeover possibilities While Marathon Oil has had a poor exploration track record, high finding costs and negative reserve additions in the past three years, its new president, Clarence Cazelot, has taken aim at beefing up reserves and production, says Gheit. "Whether or not the company can achieve the economies of scale to be competitive in the upstream remains a question, however." Enger points out that Marathon has been quite open about the fact that it's actively looking at acquiring additional assets, with the goal of adding some 10,000 barrels of oil equivalent to daily production this year. "With output essentially flat in recent years, management is doing the right things, looking not only at domestic opportunities, but also at the acquisition and/or development of large fields outside the U.S." Because the new stand-alone company doesn't have an extensive prospect portfolio, it needs to be acquisitive, emphasizes Gillespie. "Yet, given Marathon's depressed stock price as of early March, its shareholders would probably suffer dilution if it went after a reasonable-sized acquisition. In the end, the company may find shareholders might be better served if it solicited a bid to sell at a higher stock price rather than acquire." Gheit notes that while Marathon has been wanting in the upstream, it nonetheless has one of the most efficient, profitable downstream operations in the industry. "That makes it an ideal takeover target for ChevronTexaco, which has strong West Coast downstream operations, but an R&M vacuum in the Midwest. Such a combination would also balance ChevronTexaco's upstream and downstream operations, and make its earnings less leveraged to oil and gas prices." There are yet other drivers for consolidation being mulled over throughout the global patch. "A lot of the top integrateds, second-tier majors and large independents are very bullish on North American gas," says Enger. He says evidence of this is Royal Dutch/Shell's failed run at Barrett Resources; Marathon's purchase of Pennaco, a Powder River coalbed-methane gas producer; and Kerr-McGee's purchase of HS Resources, a major gas player in the D-J Basin. In line with this perception, Gheit believes Unocal is a highly attractive takeover target. "As noted, Shell wants to expand its gas footprint in the U.S., and Unocal, active in the deepwater Gulf of Mexico, would provide almost a billion cubic feet per day of domestic gas production." Also, Unocal would give an integrated like BP-which is desperately trying to increase its gas exposure worldwide-a tremendous foothold in the Southeast Asia gas market. In addition, ChevronTexaco, which lags in its international gas exposure, might be an interested party. "And don't rule out a bid by ConocoPhillips." Gillespie views not only Unocal, but also Kerr-McGee as a takeover candidate. "Both have good production-growth potential and Kerr-McGee, an excellent prospect portfolio. Yet both stocks are valued like they're going out of business." Kerr-McGee, is trading in the low $50s-a steep discount to an estimated net asset value in the mid-$80s. Unocal, meanwhile, has been been trading in the mid-$30s versus an estimated NAV in the mid-$40s. Gheit, for his part, doubts Kerr-McGee is a takeover target. "The company, which bought both Oryx and HS Resources, is likely to continue acquiring additional assets, as its financial flexibility increases from its deepwater Gulf of Mexico projects."