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FRBSF

WEEKLY LETTER

July 20, 1984

Oil Merger Worries
The recent surge in mergers among oil industry
giants has raised concerns about their impact on
domestic oil exploration and on the credit
markets. Having increased their oil reserves, the
surviving firms could cut back on domestic
exploration and thereby make the u.s. more
dependent on foreign oil supplies. The enormous
amounts of money involved in financing the
mergers cou Id reduce the su pply of cred it left over
for productive investments and drive up interest
rates in the process. Th is Letter wi II debate
whether these concerns are justified.
Anti-competitive effects are less worrisome as
none of the mergers wi II resu It ina fi rm with more
than 10 percent of the u.s. market. The Federal
Trade Commission is dealing with potential problems by requ iri ng the merged fi rms to sell off some
refineries and gas stations to prevent concentrations of market power and any anticompetitive effects on the regional level.

Why merge?
Conservation and the use of alternative energy
sources have created a soft market for oil in the last
few years, leading to a scramble by the oil industry
to maintain profits. One industry response has
been to cut costs by reducing employment. Since
1981, the top dozen oil firms have cut about 14
percent of their combined workforce. This drive to
increase productivity is one reason for the recent
merger activity since the existence of any economiesof scale in the discovery, refining, and sale of
oil will allow the enlarged firms to operate more
efficiently. The industry believes additional gains
are possible, as indicated by Chevron's announcement, after its purchase of Gulf, of plans to cut
10-15 percent of the combined workforce because
of expected gains in productivity. Texaco also has
predicted a reduction in its workforce resulting
from its merger with Getty.
Another possible motivation for the mergers was
the attractiveness of significantly increasing stocks
of domestic oil reserves without having to undertake the risks involved in exploration. The industry
was reminded of these risks after $1.7 billion was
spent on a futile effort at Alaska's Mukluk field. In
the acquisition of Gulf for a record $13.2 billion,

Chevron bought 700 million barrels of proven
domestic oil reserves, and thereby increased its
stock of U.S. reserves by 65 percent.lnaddition, it
acquired 1.2 billion barrels of foreign oil reserves.
Texaco increased its domestic reserves by 118
percent, while Mobil increased its U.S. reserves by
15 percent, with thei r recent acqu isitions.

Effects on exploration
For a country wishing to ensure itself against any
disruption in its supply of foreign oil, these mergers become a concern if they adversely affectthe
industry's efforts tofind new oil. The large jump in
the price of oil in the past ten years and the lowering of the cost of finding new oil through more
favorable tax treatment have had the desired effect
of dramatically increasing the amount of money
spenton exploration. Still, increased expenditures
for exploration have not prevented a drop in U.s.
reserves from 35 billion barrels in 1973 to less
than 30 billion barrels today, although they have
certainly helped to keep the level of reserves
higher than it would have been otherwise.
To finance the mergers, the firms involved
increased their debt burden committing a larger
part of their revenues to interest rate expenses. The
result may be thatthey will be less inclined to take
on the financial risks inherent in searching for oil.
Chevron, for example, raised its debt from $2
billion to possibly as high as $15 billion, depending on how much of its own cash it uses and how
many of its assets it sells. Since the debt is tied to
floating rates, it increases the uncertainty of the
merged firm's profit stream by making profits more
vulnerable to movements in interest rates.
Following the merger announcement, Standard
and Poors lowered Chevron's credit rating from
AA+ to AA-. A firm already has to rationalize
exploration expense in the face of the uncertain
world price of oil (presently $29 a barrel) in comparison to the discounted cost of exploration.
Thus, in the short-run, a merged firm might rationally decide to minimize the downside potential of
its earnings by reducing the amount of funds spent
for exploration.
Increased financial leverage could be an important
factor in reducing the combined firm's exploration

FRBSF
activities below what the total for the two independent firms would have been. However, any
reduction in this regard probably would be only a
temporary phenomenon. After merging, the survivingfirm will move to an optimal financial capital structure (combination of debt and equity) that
may differ from the optimal structure for the separate firms. The merged firm normally will replace
bank borrowing and other short-term debt with
longer term debt and with new equity issues. Thus,
even if it is important in inhibiting a firm's willingness to undertake exploration, the undesired
increase in leverage is likely to be short-lived. For
example, the bank lines of credit extended for the
mergers mentioned are schedu led to be paid back
completely within eight years.
The impact of the increased debt burden on the
recently merged firms' exploration is minor compared to the role played by the price of oil. Since
1981, the number of new wells drilled has levelled
off because of the limited number of prospects
judged to have a sufficient chance for success. The
mergers will not alter the definition of a good
prospect; that will continue to depend on the
industry's forecasts of oil prices in the future.
Furthermore, in the long-run, the merged companies'will need to maintain their supplies of
reserves to meet the demands of thei r expanded
wholesale and retai I markets.

converted to a term loan of six years. The revolvi ng
loan gives Chevron the use of funds while searching for more attractive borrowing opportunities in
debt and/or equity markets, or while selling unwanted assets. After two years, when the revolving
credit terminates, Chevron will determine the
amount of the term loan.
The flexibility of these credit packages is one
reason bank financing has been used. The magnitude of funds required and the short time available
to prepare a deal (in the case of Chevron, a matter
of days) were also important considerations. The
bank credit facilities enabled the acquiring firms
to commit huge sums of money in the effort to
purchase other companies without forcing them
to overextend their own positions in the financial
markets. If a firm's bid fails, as in the case of
ARCO's attempt to purchase Gulf, it pays a
"drop dead" fee (in that case, 1/16 of 1 percent)
and avoids the costs of raising the funds and
then havingto find an alternative use if the money
is not needed.

Moreover, there are even possible benefits from
this merger activity. The new firms, by having
access to two Iists of possible oi I sites, wi II be able
to devote their resources to the most Iikely candidates. In addition, the pooling of talents and the
end to redundant efforts may lead to economies of
scale in discovering new sites.

While the magnitudes required to finance these
mergers are too large for a single lender, the
domestic and foreign institutions involved in loan
syndications can raise these funds quickly through
world financial markets, e.g., certificates of deposit, commercial paper, Federal funds, and
Eurodollar CDs, without significantly affecting
interest rates. In addition, the credit risk is also
spread out among a wide base of lenders. In the
record Chevron commitment, the maximum single
bank participation was still a sizable sum of $500
million, but most institutions limited themselves to
$100-200 million, a small fraction of the amount
Chevron would have had to raise on its own.

Effects on credit
All three of the recent major oil company mergers
involved financing by a syndication of a large
number of domestic and foreign banks. The initial
credit packages or "facilities" used in financing
acquisitions were actually lines of credit, which
are commitments from the banks to lend in the
future at agreed upon terms, such as loan size,
maturity and pricing. The commitments give the
borrower the option to borrow, but by themselves
are not loans. They offer flexible credit arrangements to.firms by providing access to billions of
dollars at relatively low contract costs. In the case
of the Chevron merger, the credit facility set up a
revolving line of credit for two years that will be

It is because of these advantages that bank financing was used. Contrary to some speculation,
these mergers are not an "unproductive use of
scarce capitaL" They also are not likely to significantly affect the availability and cost of capital for
other borrowers who depend on the banking system. These financing arrangements have only a
transitory impact on the credit markets because
they are essentially transfers in the ownership of
financial assets. For instance, the Chevron purchase of Gulf will not put pressure on the overall
credit and equ ity markets (although it wi II alter the
debt-equity mix), since the credit extended to
Chevron will simply be used to make payments to
Gu If shareholders. Little reason exists for these

loans to cause interest rates to rise and borrowers
to be crowded out as long as the payments to Gu If
shareholders are reinvested (at least temporarily)
in financial instruments such as bank deposits,
debt instruments, and the stock market. Investment is reduced only to the degree that the
Gulf shareholders fail to reinvest their capital
gains, that is, to the extent they spend their gains
on consumption.

Conclusion

industry probably will not have a significant negative impact on the industry or the economy.
Money spent on exploration will likely continue to
depend more on the price of oi I and the number of
good prospects, than on the size of a firm's oil
reserves. Furthermore, these mergers alone should
not disrupt the financial markets because they
represent only a transfer of ownership, not a nonproductive use of investment capital.

Thomas Klitgaard and Gary C. Zimmerman

In its economic aspects, beyond considerations of
competition, the recent rash of mergers in the oil

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and Liabilities
Large Commercial Banks
Loans, Leases and Investments 1 2
Loans and Leases 1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.5. Treasury and Agency Securities2
Other Secu rities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances4
Total Non-Transaction Balances6
Money Market Deposit
Accou nts -Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Weekly Averages
of Daily Figures
Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed( - )

Amount
Outstanding
7/4/84

Change
from
6/27/84

183,113
163,817
49,503
60,389
28,666
5,030
12,152
7,144
194,341
50,259
28,883
12,808
131,275

1,530
1,404
116
80
168
41
230
104
7,627
6,776
433
984
- 132

38,625

144

-

972

-

4.7

708
1,163

-

1,266
2,032

-

6.3
17.0

39,431
20,975
Period ended
7/2/84
140
96
44

-

Change from 12/28/83
Percent
Dollar
Annualized

-

-

-

7,088
8,462
3,540
1,490
2,015
33
355
1,019
3,344
1,022
2,448
33
2,290

Period ended
6/18/84
45
131
86

1 Includes loss reserves, unearned income, excludes interbank loans

2 Excludes trading account securities

u.s.

3 Excludes
government and depository institution deposits and cash items
4 ATS, NOW, Super NOW and savings accounts with telephone transfers

S Includes borrowing via FRB, TT&L notes, Fed Funds, RPs and other sources
6 Includes items not shown separately

7.7
10.4
14.8
4.8
14.5

-

-

1.2
5.4
24.0
3.3
3.9
15.0
0.4
3.4