The Heritage Foundation

Executive Memorandum #47 on Energy and Environment

March 20, 1984

March 20, 1984 | Executive Memorandum on Energy and Environment

Oil Mergers: Economics 101


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3/20/84 47

OIL MERGERS :-ECONOMICS 101.A

Th 'e spate of oil company mergers.is triggering 'complaints about the alleged "non-productive" nature of mergers and the "monopoly power" exercised by large U.S. corporations. Critics have exp .ressed concern about the large sums being spent on "paper transfers". ra t -her than ekplora-- tion and drilling.- As a result, Senator J. Bennett Johnston (D-LA) plans to introduce legislation calling for a sax-month morator -ium' on mergers-among the nation's 50 largest'oil companies.' Senator Johnston's proposal seems to be g a ining growing support on the Hill. But-, before everyone jumps on-the "big is bad" bandwagon, they should review Economics 1-01. For not only are mergers generally undertaken for productive reasons, they.may be necessary for the coritinued-survival of U.S . firms in world markets.- Underlying all-mergers is a belief by the acquiring firm that it can-employ the resources of the acquired firm mote profitablythan the present owners. The -re are a variety of reasons why this may be true. The most obvious is tha t some operations are simply carried on-.more efficiently in larger numbers. This is due to economies of scale and may be true for either the production or marketing of particular products. Merger gains may result too from the diversification of a company' s product line. Providing a-wider range'of products may stabilize a firm's earnings over the business-cycle, thus aiding long-term-planning-_ of research and development or capital investments, for example@ A diversification move may be particularly attrac t ive to a firm whose traditional product-line is in a mature (little or no growth) or declining market. It is often much less risky to-acquire-a going concern than to identify and enter anew market. Mergers frequently are also a response to excess capacity in an industry@ The acquisition of marginal firms can:provide.a smoother, mote rapid transition to a streamlined industry by allowing su'rviving firms tb obtain and retain the more efficient human and capital resources within the industryi The consolidati o n of resources in an-industry with excess capacity helps explain the recent much berated oil industry mergers. In a March 1-2 editorial, the Wall Street Journal noted a stagnant-demand for oil has led to a reevaluation of the worth of energy reserves. Exp loration and drilling for new energy resources has not'been abandoned, it has merely been delayed until increased demand for oil justifies the risks and costs involved in attempting to discover and reclaim additional re- sources.

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M ergers ma y also reflect a simple belief among the management. of the acquiring fi'rm that they possess skil-1s'-superior to those of the acquired firm's management. Perhaps-the.acquiring management anticipates market-opportunities-that have not occurred to current ' decision makers of the acquired firm. Increasingly competitive world markets undoubtedly-'are encouraging some recent mergers@ As M.I.;T. economist tester:ThUrow has--noted, .increased size among U '-9. firms may be necessary to compete with producers fro m countries without antitrust laws,.- It has been suggested by analysts., for example, that by consolidating their reserves, some U.Si oil companies may be attempting to position-themselves to take a. stronger stand against OPECz At the same time, no small ' g'roup of oil firms will- be able to dominate the U.S. market so long as domestic and foreign producers are- free to compete here. Regardless of the reasons for a merger, elementary economics teaches that the funds used to purchase the shares of a firm do not disappear--as some of those who attack mergers seem to suggest-. In fact, stockholders profiting from a merger generally reinvest most, if not all, of the money they receive for their shares, thereby providing capital-for new or expanding companies. C o ntrary to the impression given, then, loans made.to facilitate mergers. are not lost to the larger pool of investment capital. Moreover, it is ironic to hear liberal critics of mergers attacking the allegedly excessive prices offered during takeovers. The y seem to be suggesting that oil companies are-too generous with their money--a surprising charge. once again, the critics overlook the fact that stock prices are merely reflecting the-takeover firm's assessment of the potential profitability of the firm b e ing bought. In conclusion, for a number of reasonsi mergers may lead to increased, efficiencies and a-more competitive market.- As economist-Robert Samuelson-, recently noted in his column for Newsweek, where problems-do exist, they are caused by the curr e nt corporate tax system, which skews corporate decisions toward more debt and retained earnings. The corporate income tax is the chief problemi writes Samuelson, because it provides incentives for firms to grow and to borrow. Change is needed to leave gov e rnment policy neutral toward mergers vis-h-vis internal growth. Yet painting all oil mergers with the broad brush suggested by Senator Johnston,.even for a limited time, could unduly penalize U.,S. consumers. The economic impact of these mergers should co ntinue to be assessed on a case-by-case basis to.avoid an overzealous effort that will throw out the good with the bad.

Catherine England Policy Analyst

For further information: "Oil Mergers," Wall Street Journal, March 12, 1984.@ Robert J.; Samuelson, "Subsidized Mega-Companies," Newsweek-, March 19, 1984, p; 76.- Lester C; Thurow, The Zero-Sum Society (New York: Basic Books, 1980), pp'. 145-150.

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