Vertical Integration: A Way Out Of The Downward Spiral?

In 2011, ConocoPhillips announced to the world that it would be splitting its $94 billion dollar company into two separate halves, one for exploration and production (E&P) and the other for refining and marketing (R&M).

In doing so, Conoco bucked a long-established trend for vertical integration in an oil and gas sector that has been particularly voracious in its pursuit of M&A. But are vertical mergers such a bad thing in the current global recession cycle? We take a look at the pros and cons of two major drivers for M&A.

FILLING UP THE BASKET & KEEPING THE GOOD EGGS

PRO

As the global economy continues to feel the squeeze of crunching credit, margins across the business sector remain under pressure. Providing a basket of services and products in these lean times is one of the best ways to insulate your offering against a "race to the bottom" in terms of price.

An inclement financial climate will naturally make investors look towards the "all in one" type company that boasts a broad and innovative product and asset portfolio as well as a wide range of capabilities.

Consolidation is the name of the game in a downturn, and with the additional products, services and assets that a merger can provide, a vertically integrated company can better maintain margins and be in a position to win new market share in a volatile economic situation.

CON

Merging companies means merging management teams. This invariably leads to triage and the possibility of strained relations from the outset. Keeping the top people from both companies may be a bridge too far, especially with headhunters circling at the mere rumour of a merger in the offing, so to keep the key players onside it is vital to establish a clear organisational structure from the outset as well as a raft of financial incentives to prevent the best and brightest from jumping ship.

FULL SPECTRUM DOMINANCE OF YOUR SUPPLY CHAIN

Full-spectrum dominance is a concept, coined by the US military establishment to describe how a joined-up military structure can control all elements of the universal battlespace through a mixture of land, air, maritime and spaced-based assets.

Take the definition out of the military realm, and the joining of two organisations that have expertise in a wide area can also provide that kind of full spectrum dominance especially in terms of supply chain.

PRO

Cost synergy - the savings in operating costs projected after two companies join is a key asset to branch out into new markets, consolidate excess capacity and rationalise distribution channels. All of these things in turn will enable you to better master supply chain challenges and allow for:

• More effective procurement of services.
• More punctual delivery of objectives.
• Revenue protection in during times of transition.

CON

If you don’t manage your supply chain in minute detail then the consequences could be deleterious to the overall well-being of your organisation. Communication is key here to ensuring that supply chain managers in the merged companies are singing from the same hymn sheet and volatility is kept to a minimum. The ramifications of getting it wrong are:

• Negligible cost synergy
• Logistical problems
• A drop in service quality leading to stakeholder and customer disquiet
• Disruption in the sales
• Incremented supply chain operating costs

2011 was a tumultuous year for global business, and if energy companies are going to avoid the quagmire that 2012 may become, vertical integration will surely have to remain firmly in the minds of the CEOs and CFOs across the board.

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