For now, calm prevails as consolidation in the North American independent oil and gas industry proceeds at a sedate pace. Ongoing uncertainty in major oil-producing regions, including the Middle East, Latin America and West Africa, has contributed to unusually high commodity prices. Rising prices are increasing valuations and temporarily protecting weaker firms from acquirers. The near-term effect has been a dampening of merger and acquisition activity. But change is looming. As global commodity prices return to historical levels, weaker competitors in the North American oil and gas business will be exposed to cash-rich rivals. Merger activity, which currently lags that of other industries, will continue at a more rapid clip. The question for the oil industry is how to interpret and prepare for the coming rounds of consolidation. According to research by A.T. Kearney, a distinct pattern lies hidden beneath the seeming chaos in merger and acquisition activity in any industry. Consolidation activity passes through four stages over a period of approximately 20 years. Opening stage. A crowded field is full of players of varying sizes. The three largest companies account for only 10% to 30% of the market. Scale stage. Consolidation begins in earnest as companies begin to realize economies of scale. This phase generally lasts five years, during which the three largest companies grow to account for 30% to 45% of the market. Focus stage. Market leaders concentrate less on mega-mergers and more on strengthening core competencies and cleaning up their portfolios. The pace of merger activity remains high, but targets tend to be more focused and strategic. During this phase, the top three industry participants account for 45% to 70% of the market. Balance and alliance stage. At the end of the consolidation wave, the three largest companies in an industry typically represent 70% to 80% of the market. Large mergers and acquisitions become rare, and legal considerations limit the potential for further consolidation. The buying game The Canadian oil business illustrates these concepts and is a precursor to the greater consolidation expected in North America. M&A activity in Canada reached record levels in the 1990s, with many of the largest deals involving oil and gas players. The flurry of M&A activity greatly increased the concentration of the Canadian oil and gas industry-pushing the firms through the accumulation phase to the start of the focus phase of market development. While the Canadian oil industry has become more concentrated, the effect on Canadian independents was much more dramatic. Today, EnCana, Talisman Energy and Canadian Natural Resources represent more than 70% of the total market capitalization of all Canadian independents-a figure that continues to grow. Many of the major transactions in recent years involved firms strengthening their E&P portfolios through acquisition, such as Conoco Inc.'s purchase of Gulf Canada Resources in May 2001 and Devon Energy Corp.'s acquisition of Anderson Exploration Ltd. in September 2001. The result of this activity was the reduction in the number of midsize independents and an increase in the size of the largest players. The Canadian independent industry moved through the accumulation and focus stages and now approaches the alliance market position. While the Canadian independent industry is highly concentrated, the North American market is still relatively dispersed. The merger of Alberta Energy Co. and PanCanadian Energy Corp. to form EnCana Corp. produced a legitimate global competitor, equivalent in stature to Anadarko Petroleum Corp. and Apache Corp.-but these three firms combined still represent only 30% of the estimated market capitalization of the North American independent industry. Research conducted across several industries suggests that North American independents are at the beginning of the accumulation phase, and consolidation is likely to accelerate. In fact, the first moves have begun. An example is Devon's acquisition of Ocean Energy earlier this year, creating the largest gas producer in the U.S. Winners and losers A.T. Kearney research on consolidation patterns in several global industries suggests three dominant firms will emerge among North American independents during the next five to 10 years. The research also points to two main factors that generate shareholder value in the oil and gas industry: growth and profitability. Companies that deliver above-average growth with above-average profitability consistently create more shareholder value than peers that do not. North American independents vary widely in revenue and value growth. A.T. Kearney classifies firms with above-average revenue growth and above-average shareholder return as "value growers," and those with below-average performance in both dimensions as "underperformers." The underperformers make attractive merger or takeover targets. In the late 1990s, for instance, Gulf Canada Resources used debt to acquire Clyde Petroleum and Stampeder Exploration. In part due to the resulting high debt load, Gulf's growth and shareholder value creation fell well below industry par. Despite an uptick in performance, Conoco snapped up the vulnerable firm. Similarly, operational problems chiseled away at share performance and revenue growth at Summit Resources, which then lagged the industry average by a considerable margin. Its weak position made Summit an acquisition target, with Paramount playing the role of acquirer in mid-2002. In 1999, Ocean Energy merged with Seagull Energy, combining two financially troubled firms in a period of weak commodity prices. The combined firm faced a debt-to-equity ratio of almost 70%, forcing Ocean to focus on strengthening its balance sheet while commodity prices rebounded. By the end of 2000, the firm reduced debt to equity to 47%, but concerns over Ocean's financial health persisted. Slow revenue growth and below-par stock market performance had positioned Ocean as an underperformer. Devon purchased Ocean. Such experiences suggest that companies with the highest potential for future takeover plays will continue to be those in the underperformer quadrant of the value growth matrix or those that significantly lag peer shareholder value creation. The ability of these companies to move to the value grower category during the next few years will likely dictate their long-term survival prospects. Underperformers are not the only potential takeover targets. Devon, with above-average revenue growth and below-average increases in shareholder value, is classified as a "simple grower." Firms in this position risk being swallowed, generally by firms looking to buy growth. As with all acquisition targets, Devon needs to focus on more than growth; it also needs to generate shareholder value by increasing the productivity and profitability of its existing asset base. Most telling about the value-building growth analysis of the North American independents is that larger firms appear to have positioned themselves best for growth. None of the largest firms among Canadians or in the North American market are underperformers-most are either value builders or border on that quadrant. This leads to a hypothesis that, as has been the case in the Canadian oil patch, the future North American independent sector will be bipolar, consisting of a limited number of large firms and many smaller, newer companies. Today's midsize players will either grow to become one of the larger firms, or they'll be bought by weighty competitors. Becoming a value builder The A.T. Kearney research results indicate that most variability in shareholder value creation between companies can be explained by two factors: growth and profitability. The value builders most rewarded by the market are those that consistently grow at a higher rate than their peers, while maintaining above-average profitability. A.T. Kearney's research produced clear messages for companies that wish to emulate the success of today's value growers, including the following. • Value-building growth follows a specific pattern that companies can learn and follow. • Value growers have a vision for growth that is well defined, ambitious and well communicated. The vision helps focus the company's direction and keep it on track even during unavoidable downturns. • Innovation, geographic expansion and risk-taking fuel value-building growth, with top performers expanding nearly twice as fast geographically and four times as fast in future and unidentified "white space" (areas outside of the company's traditional area of operation) opportunities as other companies. For example, who knew of horizontal drilling in the early 1980s? • Value growers' cultures encourage empowerment, rely on open communications and instill a competitive spirit to fend off complacency. • Strong, stable long-term growth is a decisive factor in share-price increases. Globally, during the past 10 years, $100 invested in a value grower would have grown on average to $743, nearly 90% more than the $394 for a company focused on profit growth alone. The same $100 invested in a company solely targeting revenue growth would have shrunk to $90 after 10 years. The research found that value builders grow both organically and through mergers and acquisitions. Regardless of the means, execution is the key factor in determining successful growth. North American companies considering a merger or acquisition have about a 50-50 chance of creating a merged company that will outperform its peers, regardless of the industry. The study found that one year after completing a merger, 52% of North American companies examined had not increased shareholder value as much as other companies in their industry. Two years after the merger, 45% of Canadian companies and 69% of U.S. companies still underperformed the average shareholder value growth for their industries. These studies and our client work show that successful mergers share several attributes, including the following. • Moving quickly to instill a sense of urgency in integrating the merged companies. • Selecting top-level leadership and committing to the merger's success. • Articulating clear synergy goals to manage market expectations. • Focusing on retention of key customers and measurable service goals. • Communicating openly and regularly. • Maintaining a strong central integration office with decentralized integration teams. • Applying rigorous risk management and results tracking to chart success. Conclusion As it turns out, the M&A free-for all is not as chaotic as it seems on the surface. History does repeat itself, and the patterns that have emerged can be a valuable tool for companies setting their strategies for the future. While the Canadian independent industry is approaching its maximum level of concentration, the North American market has a long way to go. As consolidation in the North American independent industry picks up the pace, which firms will thrive? Empirical evidence suggests that the value growers stand the best chance. And the largest North American independents-EnCana, Anadarko and Apache-are positioning themselves well for both growth and profitability. The winners in this merger game are yet to be determined, but they will be companies that create significant shareholder value. A sound strategy, superior execution and focus on sources of value differentiate the top performers, both in North America and globally. Paul Weissgarber and Vance Scott are vice presidents and Neal Walters is a principal with management consulting firm A.T. Kearney's energy practice, one of the firm's major industry sectors. They are based in Dallas, Chicago and Toronto, respectively.

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