A year ago, Douglas T. Terreson, the domestic and international oils analyst for Morgan Stanley Dean Witter in Houston, warned, "Fasten your seatbelts because the energy business in 2000 and beyond will bear little resemblance to the one we know today." He noted then that the oil and gas industry had failed during the 1990s to generate the kind of returns that investors can get in other sectors of the S&P 500. The remedy? "Combine forces to create larger entities with superior scale and globalization," he suggested. "This is a move that will translate into superior risk-adjusted returns, and is the basis on which more mergers are going to occur." Today, many analysts and industry observers echo that sentiment. "Whether one looks at the past three-year, five-year, or 10-year period, not a single oil company has outperformed the S&P 500, according to our data," says Fadel Gheit, senior energy analyst for Fahnestock & Co. in New York. "That's a dismal record. So the recent wave of giant mergers in this mature industry isn't surprising. It's a good way for oil companies to achieve lower costs, higher efficiencies, and ultimately higher profitability, valuations and returns for their shareholders." Stresses Gheit, "We're just at the beginning of this consolidation trend, which will eventually filter down through every segment of the industry. In fact, within two years, we're likely to see just half the number of oil companies we have today. That goes for oilfield service companies, too, as they try to be the biggest and best in their field, to win contracts with fewer and larger oil companies." The analyst believes that the recent roadblocks thrown up by the Federal Trade Commission to the proposed BP Amoco merger with Arco are just a bump along the consolidation road. "There's a better than 50-50 chance that this merger will be completed soon, but it may involve more concessions to the FTC, such as further asset divestitures by the two companies." If BP Amoco is unsuccessful in winning approval for this combination, Gheit doesn't rule out BPA making a bid for Chevron, or even an independent like Triton Energy. "Triton is a pure E&P company with operations outside the U.S. that are synergistic with those of BP Amoco, plus there'd be no U.S. or European regulatory hurdles to overcome." Beyond consolidation, however, oil companies face a major issue. And that's whether they want to remain oil companies or become more complete energy companies that provide customers a broader array of alternative energy services, such as power generation and solar energy, says Gheit. "Ultimately, that's the path to real growth and profitability. Enron Corp., which provides an integrated solution to energy needs, is a good model." Bill Montgomery, Dallas-based energy practice leader for Towers Perrin, the worldwide consulting firm, noted last year that greater scale was needed by the majors to compete with the national oil companies for giant projects in the global arena. In line with that observation, he said, "We should look for more combinations among the majors, whether that involves Chevron, Texaco, Conoco or Arco." Since then, three of those names have been involved in merger talks. What's more, the former Argentina national oil company, YPF, was recently acquired by Repsol, a Spanish oil company. "This illustrates that non-U.S. major oils also recognize the need to achieve scale and lower units costs to remain competitive in the global marketplace," says Montgomery. "In addition, both U.S. and foreign oil companies recognize that bigger companies are being rewarded with higher valuations in the stock market." Another driver for future consolidations? "Bigger oil companies have the ability to mitigate exploratory risk because they can afford to participate in more drilling opportunities, which increases their chances of success." Adam E. Sieminski, director and energy strategist for Deutsche Banc Alex. Brown in Baltimore, agrees that the recent round of giant industry consolidations are, in part, defensive moves by the majors to enable them to better compete with the national oil companies. "However, the majors are also undertaking these mergers to remain competitive with their peers, and the marketplace is rewarding them for doing that," he says. Sieminski sees more pressure on the rest of the industry to continue to consolidate in order to deliver improved shareholder returns. "There will be more full mergers or joint ventures, perhaps more so among independent E&P companies, which have underperformed the major oils in the stock market during the past two years. So their time is coming."