Major changes for the Majors?

Breaking up is increasingly hard to do in the oil business

By Tony Jackson

After last week's damning Baker report on BP's safety record, there have been predictable calls for the oil giant to be broken up. I have no special knowledge of how likely that is to happen. But the underlying issue goes well beyond the oil industry. In today's markets, what is the case for vertical integration?

The theoretical position was set out 70 years ago by the Nobel Prize-winning economist Ronald Coase. On the one hand, Coase said, firms will produce goods and services in-house whenever that is cheaper than buying them in. But the more they do that the more inefficient they become, eventually defeating the object.

In spite of that, vertical integration remained the norm until comparatively recently. Take the food and detergents manufacturer Unilever, which, as late as the 1970s, owned palm oil plantations, a shipping line, oil mills, packaging plants, truck fleets and supermarkets. Everything in the supply chain was controlled, from raw material to the final customer.

That kind of thing is long gone - except in the oil industry. The majors typically find oil, ship it and refine it. They have vast petrochemical operations. They are brand managers, both of petrol and motor oils. And they are retailers on a huge scale: Exxon, for instance, has 35,000 service stations worldwide.

Granted, the degree of integration varies. At one end of the spectrum is Exxon, which describes its intense integration as "a key differentiator versus the competition". More than 90 per cent of its petrochemical capacity, for instance, is directly linked to its own refineries or gas plants.

At the other end stands BP. In part, this is a matter of historical accident. In the second oil shock of the early 1980s, BP lost 40 per cent of its crude supply, mainly because of events in Iran, and therefore had to develop expertise in the spot markets in very short order.

The experience turned the company away from the integrationist philosophy, to the extent that in 2005 it sold its entire petrochemical operations - a feat that in Exxon's case would presumably be impossible. But BP is still bizarrely integrated by any standards other than the oil industry's. Like Unilever of old, it controls the entire process from the oil well to the final retail customer.

Hence the break-up argument. In the version proposed by JPMorgan Cazenove, this would involve an upstream and a downstream company. The first would comprise oil and gas production and pipelines, the second refining, shipping, marketing and retail.

The arguments for and against this are lengthy, and turn mainly on the short-term effects on the BP share price. But what concerns us here is the wider context. Is this the right time to be considering radical surgery of this kind?

Bear in mind that the disintegrationist philosophy has been dominant for almost two decades. From 1990 onwards, the demise of communism opened up vast new areas of cheap production, from China to Eastern Europe. Why make a thing yourself when the market price keeps falling?

In addition, the information revolution made the markets for goods and services more efficient and transparent. One of the main planks of vertical integration - the sheer difficulty of finding secure supplies at a good market price - fell away. And finally, the rise of shareholder power meant the gigantism favoured by managers went out of fashion. Break-ups became not only possible, but actively desirable.

Now, however, the pendulum may be swinging back. The China effect has been reversed. Rather than cheap goods, it now means dear commodities. In several industries, manufacturers are setting up strategic alliances to secure raw materials. And in the oil industry, companies are finding it much harder to wring supply from host governments on the old easy terms.

In such a world, creating a free-standing oil refining and marketing company might seem a dicey proposition. Such companies exist - Valero in the US, for instance, and Neste in Finland - and they have prospered greatly from recent shortages in refining capacity. But this is an acutely cyclical industry, and in time those shortages will go away.

So even if BP does decide to split itself up, I doubt if it will create a precedent for its rivals, as the UK chemicals group ICI did when it de-merged 14 years ago. Apart from anything else, one company that would certainly not follow BP's example is Exxon. And, sadly, these days it is Exxon, not BP, that commands the respect of its oil industry peers.

Tony Jackson is a writer for The Financial Times.