There are five major reasons for big oil companies to vertically integrate:
The oil embargo and the consequential scarcity and price increase in 1973 (see exhibit 6) resulted in a crisis for the big oil industries. Since they were dependent on their oil suppliers, they had to deal with the price increase. Vertical integration assures the steady supply of oil and minimises the level of dependency. Not only the amount but also the quality of the supply can be controlled in big, vertically integrated oil companies.
Avoidance of new entrants
Since the supply chain of oil is quite complex and requires big companies to be vertically integrated, it takes a great financial effort to enter the market to compete on a same level.
Increase of profitability
Improvement of coordination of upstream (production) and downstream (distribution) will lead to synergies and an increase of profitability.
As integrated oil companies handle the whole supply chain, they will have more opportunities to increase value to the product by developing new technologies. Especially, in the upstream process it can help to decrease the required input to produce a given output.
Integrating up- and downstream can save time and costs of the selling and buying process that usually occurs between two different companies. In particular, market research, advertising, and sales promotions.
In conclusion, incomplete markets, transportation shortages, and unstable relationships between firms gave oil companies the incentive to integrate vertically, matching the capacities of their production, refining, and marketing operations.
BP in particular, saw the advantages coming from unpredictable regulated markets. Thus, they use the integrated structure to expose interbusiness subsidies, and to force businesses to perform more competitively. However, the amount of vertically integrated oil companies decreased from 1979 to 1999, while the non-integrated companies decreased (see exhibit 7).
How favourable were the economics of the oil and gas industry before the BP-Amoco merger? What were the effects of the recent mergers on industry structure and on BP’s profitability?
As prices were on a minimum in 1998 (see exhibit 6) the former industry structure could not persist. The economy of the oil and gas industry was struggling. Especially, the lack of returns compared to other industries and the fact of continuously dropping oil prices forced BP to respond.
Moreover, most of the expansion opportunities were already maxed out. Oil had been discovered in more than 80 countries. Oil and gas field became more challenging to access and to develop efficiently. Thus, gaining profitability was the major driver for further growth.
Also, BP wanted to move from its middle ranked position to a truly global player. However, there were missing pieces that did not allow them to do so. These “strategic gaps” could be filled with the acquisition of Amoco.
In contrast to its competitors, BP had the first mover advantage and was able to pick its partners to develop to a “supermajor”. Considering the given statistics on income figures, it turns out that this was a real advantage. Income increased from 6,895 to 18,866 million Dollars between 1998 and 2000 (see Exhibit 20). Within the same time period, BP´s return on fixed assets increased from 12.8 to 21.6 per cent (see Exhibit 19).
Because of the latest acquisition of BP, other oil companies could not compete on the same level anymore, unless they were also “supermajors”. As a result, the industry structure changed from many integrated and a few non-integrated oil companies to a shrunken number of vertically integrated and a grown number of non-integrated companies. Most of these non-integrated companies came from acquisitions of assets sold by vertically integrated and formerly integrated firms. Consequently, smaller companies specialised in one part of the value creation process, such as refining, marketing, exploration and production, or energy services.