Strategy of M&A deals in oil industry (on example of «Rosneft» and «Bashneft» deal) сделок слияний и поглощений комплексе (на примере сделки

. I analyzed merges and acquisitions’ transactions and their influence on strategy and development of oil company. For analyses the deal I chose acquisition by Rosneft of Bashneft, which took place in October 2016, applying both traditional and real option models. Real option model is more difficult, but better methodology, because it allows to valuate different scenarios of acquisition, choose more optimal scheme (acquisition time, amount of acquired shares). After building decision tree I calculated NPV of cash flows, which are generated in the deal (in scenarios of high and low oil prices, high and low synergy effects in two periods 2017–2018 and 2019–2020). The main results are the following. Acquisition deals create value for shareholders, only if acquisitions correspond to strategy of bidder company and culture of target company. Under some hypotheses the acquisition of Bashneft creates additional value for Rosneft in most scenarios (except scenario with low oil price and low synergy). Postponing the decision about complete acquisition till 2019 increases probability of successful acquisition as well as maximizes NPV.


Теория и практика стратегирования Introduction
Merges and acquisitions is a trend for economies, where big transnational corporations prevail. Strategies of big corporations are rarely limited to organic growth, but substantial resources give them opportunity to set ambitious goals and expand fast, for example entering new geographical market or developing new products and technologies or getting new licenses for natural resources extraction. But development of new technologies might require a few years. In general the scenario of rapid growth based on internal resources is quite difficult and require much time. Alternatively, strategies of mergers and acquisitions are the fastest way to reach strategic goal, but the cost of these strategies might be very high.
The company's capitalization is the main, but not the only, parameter to be focused on during M&A. We should take into account interests of shareholders, as well as other stakeholders: employees of the company, its partners and clients, the population living in the company's area of operation, regional and federal authorities. For example, in some cases it is more profitable to close divisions in certain regions and move production to other regions or countries. Such a strategy may well serve the interests of shareholders in the medium term, while management, employees, and local authorities may be interested in maintaining production. Multi-criteria and often conflicting interests of different groups make it difficult to evaluate mergers and acquisitions.

traditional valuation
As mentioned in Introduction, traditional purpose of financial strategy is to maximize capitalization [1].
Usually criteria for merges and acquisitions of two companies A and B is that the value of new united company V AB is more than V A + V B . Let us define synergy S as a difference: S = V AB --(V A + V B ). Synergy is a different from goodwill, because main purpose of goodwill is to incorporate new assets in financial statement of bidder company, whenever synergy is economic effect, which is based on economic factors of merges and acquisitions.
Synergy indicates, that for both companies are creation of value are expected. The main reasons for M&A are following: increasing product range, supporting distributional channels and entrance to new geographical markets, increasing manufacturing capabilities and gaining new competences, overcoming state restrictions (bidder company acquires company, which owns some licenses), reducing cost due to optimization of work of two enterprises, supporting pricing power and market share. Actually, many transactions do not create any value to shareholders in case they do not correspond to the strategy of the bidder company.
So, when transaction are support main business of bidder company, corresponds to its strategy, these deals have higher probability to be more successful. I could propose the following scheme Fig. 1 for analyses, which combines traditional approach, developed by Robert Gram [2], Donald Hambrick [3] and Vladimir Kvint [4].
If company A (bidder company) acquires company B (target company), then it means that company A pays to shareholders of company B either money (denote this amount of payment as P) or shares of company A or the combination of the above.
P certainly more than V B otherwise there is no sense for shareholders of company B to sell their shares for less than they can get now on financial market (we assume that financial markets are efficient and market valuation of company B is fair, the company is not under or overvalued). In that case synergy S is divided between shareholders of companies A and B. So: The reasons for synergy S are different and depend on, which kind of merger do we have, vertical or horizontal.
In our case of acquisition of Rosneft and Bashneft in October 2016 we should consider Теория и практика стратегирования 140 the following. These companies in one industry of oil and gas extraction, petroleum production etc., though their strategies might be different: Bashneft mostly worked in Bashkortostan, but had petroleum station in different regions. Rosneft is a national company. Horizontal merger could give a good synergy effect, because companies were expected to decrease their administrative expenses, more efficiently allocate resources (sharing petroleum stations, optimizing productivity of Bashneft's oil refinery factory in Bashkortostan, share technology, integrate oil exploration etc). On the other side, Bashneft is formally an independent company, its shares are still traded on Moscow Exchange, though Rosneft owns over a half of Bashneft's shares.
Merges and acquisitions are considered as an important strategic decision, which could substantially influence the future of both companies. Traditional methodology of preacquisition valuation of company B might be based on DCF analyses, market (or industry) multiples, premiums paid in previous transactions (multiples method) [5]. But all these methods have some limitations. For example, when we use DCF, we usually consider two times horizons: for first we calculate NPV for limited amount of years (usually up to 5-7 years), then we calculate so called "terminal (continuing) value", which might be very sensitive to discount rate. Market multiples, especially using average multiples for industry, are not very efficient, because finding a comparable public company is not always possible. Furthermore, synergy effect is very individual in every transaction. The same is fair for comparable transactions that already have taken place in the past (not only transactions are different, but also market conditions changed) [6].
During M&A is it important to consider all factors and consider the deal, taking into account both financial and strategic issues, and the deal should be considered by both CEO (positive and optimistic view for perspective) and CFO (deep analyses) [ [8].
In order to estimate V B I used market valuation of Bashneft. Figure 2 demonstrates monthly market prices of Rosneft and Bashnent shares from 2014 till middle of 2018. Market values of ordinary shares of Rosneft and Bashneft shares were calculated by multiplying market value of only ordinary shares by issued amount, though correct calculation of capitalization of two companies required estimation market value of preferable shares and other instruments as well.
So V B varied and we might calculate it, taking into consideration that market price of Bashneft share was 3333 RUB on November, 1 2016, or it was 2 989 RUB for the previous 6 months before the deal: 442 ≤ V B ≤ 493 billion RUB. So market value of 50.0755 % of Bashneft's ordinary shares might be from 221 to 247 billion RUB. Actually, Rosneft payed P = 330 billion RUB. So, it means that synergy effect should be at least not less than: S ≥ P -V B , which is 83-109 billion RUB.
Synergy effect S estimated differently. Executive director of Rosneft Mr. Igor Sechin announced at the Annual Shareholders Meeting, that Rosneft will work to maximize the synergetic effect. The powerful synergistic effect will be ensured by the optimization of reciprocal supplies of oil, transportation and logistics costs, reduced cost of drilling services, joint use of the infrastructure of production assets, modern technologies and know-how. The prompt monetization of this effect is guaranteed by Rosneft's successful experience in integrating TNK-BP. In the first two quarters of 2017, the synergetic effect of Bashneft's integration will reach over 40 billion RUB in cash. But later synergy effect was re-estimated for 2017 year as 45 billion RUB [9]. So, if we suppose that synergy (45 billion) would extend for four years (2017,2018,2019,2020) and use discount rate 11 % 2 , then the total synergy would be 140 billion RUB in 2016. According to estimate of Ministry of economic development of Russia, positive effect of the acquiring of state own shares of Bashneft was 150-180 billion RUB, due to economy of oil processing and extraction [10]. If synergy was realized during 4 years and we applied the same discount rate 11 %, we could estimate synergy per a year as 48-58 billion RUB.
UBS believed, that the synergy would be lower [11]. 1 Rosneft owned 102 432 459 shares from 147 846 489 (57,66 %) as it was on June 1, 2018. 2 I use discount rate for Rosneft 11 %,which approximately corresponds to WACC for Rosneft. Until the beginning of 2018 year interest rates in Russian economy were declining and in 2018 rates started increasing because of inflation's growth. In 2019 rates begun declining again.

Theory and practice of strategy
Taking into consideration, that revenue of Bashneft for 2016 was 593 billion RUB and synergy valued at from 45 billion RUB till 58 billion RUB (about 7.6-9.8 % of revenue), I suppose really strong efforts of two management teams were required to successfully implement integration of companies and to get necessary synergy. Potential for decreasing Rosneft's costs were not high due to different locations of companies.
Synergy effect at the level of 140 billion RUB was considered by me as optimistic scenario (S H ), because in that case both Rosneft and Bashneft shareholders are interested in the deal, though more than a half of synergy would be received by Bashneft's shareholders.
If we consider Fig. 1, we could see, that before the deal and 2-3 months after it, prices for both Rosneft and Bashneft went up. Growth of share price of Bashneft was higher (coefficient of linear regression to oil price was 1.03, see in Table 1) than Rosneft (0.80). We can conclude that market expectation of Bashneft's perspectives were positive and some rumors about the deal (which started in the middle of 2016) warmed price of Bashneft's shares.
After the deal despite some fall of oil price Bashneft's share fastened its growth (-3.28, negative sign meant, that share price and oil price went in different directions), as well as Rosneft (-2.8). We could say that this short period of time was "market euphoria". In February 2017 oil prices started falling and that negative trend continued till June 2017. Rosneft's share price started decline about twice faster then oil price (1.89), whenever Bashneft's share price were falling even faster (2.53). So market reconsidered the deal.
In June 2017 market trend changed and oil prices started to grow quite fast. Rosneft prices also grown up, but substantially slower (0.32). At the same time Bashneft's price felt

Influence of Bashneft's acquisition on Rosneft's financial statements
Rosneft financial statements already included (from November 2016) the appropriate part of financial assets, revenues and other financial flows of Bashneft (proportional to Rosneft's share). Bashneft's deal was one of many for Rosneft, so it is difficult to estimate how this deal influenced financial performance of Rosneft by analyzing consolidated financial statements in years 2017 (after the deal), 2016 (deal) and 2015 (before the deal).
From Profit or Loss Statement of Rosneft we could see, that structure of revenue and cost did not change substantially. Production and operation costs decreased from 11.3 % (where oil, gas and petroleum sales are 100 %) in 2015 and 11.4 % in 2016 to 10.3 % in 2017. We also could saw some optimization in pipeline costs. Controversary, Rosneft increased most other costs, for example general and administrative expenses increased from 2.6% in 2015 to 2.9 % in 2017. So, synergy effect was not obvious from consolidated profit and loss statement [12][13][14].
On the other hand, we could see that revenue of both companies increased substantially from 2016 to 2017 in absolute amount. If we took 2015 as a base year, revenue of Rosneft increased for 15.9 % from 2015, and Bashneft -for 10 %, whereas average oil price drop for 1.3 %. So, the integration of two companies allowed to grow fast (especially for Rosneft).
From balance sheet we could saw that current assets (liquidity) of Rosneft decreasing. Long-term assets were increasing, for example property, plant and equipment increased from 61.1 % (where 100 % -total assets) in 2015 to 64.3 % in 2016, which was also due to the deal. Goodwill did not change substantial, which might mean that Rosneft management believed, that there was not much premium payed for Bashneft.
Current liabilities increased substantially, especially loans and borrowings from financial institutions (from 10. 8 % in 2015, to 14.2 % in 2016 and 18.2 % in 2017).
On the other hand we could see fast decrease of long-term debt from 23.7 % in 2015 to 14.6 % as well as prepayments on long-term oil and petroleum agreements from 18.5 % to 10.8 % [12-15].
This change of financial structure as well as substitution of long-term debts in USD and EURO to short-term debt in RUB is mostly due to sanctions imposed by the USA and other countries. On the other hand, management of Rosneft could have increased middle-term debts in RUB, not short-term.
Analysis of Cash Flow of Rosneft also supports our conclusions. Net cash provided by current operation decreased substantially from 2258 billion RUB in 2015 to 391 billion RUB in 2017. This was substantially determined by dynamic of long-term prepayments made on oil and petroleum products supply agreements. High cash prepayments (938 billion RUB) in 2015 certainly followed cutting cash in 2016 and 2017.
In cash flow we also could saw gain on outof-court settlement (100 billion RUB), which was caused by court decision that Rosneft should receive from AFK System (former owner of Bashneft) the above amount (in profit it was in 2017, but cash payment would be in 2018) due Bashneft losses were partly caused by nonefficient AFK System execution etc. [16] Cash used in investment activities increased from 813 billion RUB in 2015 to 1162 billion in 2017, which also supported that Rosneft tried to grow fast by increasing capital expenditure, not only by acquiring other companies.
Rosneft increased its borrowing very fast. In 2017 and 2016 the company attracted financing (cash) for 645 and 381 billion RUB accordingly, whenever in 2015 Rosneft repaid its debts for 1091 billion RUB. Also important that the structure of borrowings had changed -long term debts were repaying, and short-term -increasing.
In general, Rosneft had weak cash flow, because operating activities in 2017 generated only 391 billion RUB, whenever interest payments in 2017 were 219 billion RUB. This is caused by Rosneft's fast grow, in particular acquiring of Bashneft. Government and even a court decision (AFK System case) supported financial stability of Rosneft, but anyway the company needs to stop acquiring assets, more accurate finance its activities (stop substitution of long-term debt by short-term borrowings), try to grow organically.

Real option model
Real option model is very efficient model in M&A. It gives agile approach for valuation, as well as decision making in M&A [17][18][19][20].
In real option model valuation is based on assumption that Rosneft had not to acquire all Bashneft's shares immediately in 2016. Rosneft had an opportunity to make two steps acquisition of Bashneft by acquiring 50.08 % in 2016 and considering opportunity to buy more 49.92 % shares in 2018 (or do not buy, depending on market situation in 2017). Traditional method does not give such flexibility and Rosneft either buy 100 % or 50 % shares of Bashneft in 2016.
So, when I valuate opportunities for acquisition of Bashneft (base year is 2016), we would consider different scenarios -with high and low oil prices, as well as high (S H ) and low synergy effect (S L ). I would prove further that if oil price is high in 2017-2018 and synergy is maximum, then Rosneft should invest more in Bashneft (otherwise -buy only 50.08 %).
Rosneft might take one of two decisions: first -buy 100 % of Bashneft shares in 2016 (this case is considered at the end); second -buy 50.08 % of Bashneft shares, wait and in 2018 either buy more 49.92 % Bashneft shares or do not buy (see decision tree in Fig. 3).
Oil price in 2017-2018 might be high with probability 50% or low with probability 50 %. For simplifying decision tree, I assumed that if oil price were high in 2017, it would be high in 2018 and afterwards.
Synergy might be either high (S H ) or low (S L ) in 2017-2018 (we could not predict it in 2016) and continues afterwards for more 2 years. No any synergy after 2020. If synergy is successful (S H ) in 2017-2018, it is more probable that synergy would be successful afterwards. If synergy in 2017-2018 is low (S L ), then it is more likely that it will be lower in 2019-2020.
So, we have different decision branches. We suppose, that probability of successful integration (high synergy) of two companies is 50 % in 2017-2018. But in following years situation is different. If synergy was high in 2017-2018, it is more likely, that it would stay high in the following period. I also suggested that owning of a greater share of Bashneft's capital gives higher probability of successful integration of companies in the second period. So, if synergy was maximal in 2017-2018 and Rosneft owns 100 % of Bashneft shares, then the synergy would be also high in 2019-2020 with probability 80 %; if synergy was maximal in 2017-2018 and Rosneft owns only 50.08 % of Bashneft, then probability of successful synergy in 2017-2018 is 60 %.
If synergy effect is low in 2017-2018, it will stay low with probability 60 %.
I have to make some assumptions about high (S H ) and low (S L ) synergy effects for a year. As mentioned above synergy effect in optimistic scenario was estimated 140 billion RUB or S H = 45 billion RUB for one year.
Minimum (or low) synergy I assume to be S L = 15 billion RUB. This scenario also implies, that acquisition does not create enough synergy and destroys value of Rosneft (Rosneft overpays for Bashneft).
The next step is the forecast cash flow of Bashneft.
I have estimates cash flow from historic cash flow as well as by using Gordon's formula (second method). The sustainable net cash flow from operating and investing activities (NCF OIA ) was about 42 (average, see Table 2, in optimistic scenario) and 30 (low oil price scenario). If we use discount rate R = 11 % and suppose, that growth rate G = 2 %, then we get the following value First I analyze scenario of high oil price, which generates net cash from operating and investing activities NCF OIA = 42 billion RUB in 2017 (which is increasing with G = 2 % per year, see Table 2).
If price for oil is high in 2017 (and in my model it will stay high in future), then Rosneft has two options in 2018. One possibility is to buy the rest 49.92 % shares of Bashneft for 207 billion RUB in 2018 (cash payment). But in 2018 Rosneft already would know, whether the synergy was successful in 2017 (and we expect the same synergy in 2018). If the synergy is high (S H = 45 billion RUB in 2017 as well as in 2018, expected synergy in 2019 and 2020 calculated as weighted average S = 39 as shown in Table 2), then discounted cash flow NPV = 135 billion RUB.
In case oil price high and synergy are high and Rosneft would buy only 50,08% shares of Bashneft in 2016 (would not buy more shares in 2018, so in 2020 the terminal value would be 248 billion RUB, which is 50,08% of market value of company), then  Table 2) and discounted cash flow NPV = 72 billion RUB. Information about oil prices as well as synergy effect (high or low) in 2017 would available for Rosneft in 2018, so it could be easy to make the right decision: buy more 49.92% of Bashneft's shares if oil price is high and synergy is high. In case synergy is low, Rosneft should not acquire more Bashneft's shares.

Theory and practice of strategy
The same analyses is performed for low oil price. The result is that better to leave 50.08 % of Bashneft's shares and do not buy any more shares.
According to Real option model: ( ) So, according to traditional model there is no difference, whether to acquire 100 % of Bashneft's shares immediately in 2016, or only 50.08 % (anyway, NPV = 59 billion RUB). But real option model allows to reach a better result by acquiring 50.08 % of Bashneft in 2016 and wait two years, observing market trend and synergy. If synergy was high in 2017, then more 49.92 % Bashneft should be bought in 2018. Real option model allows to generate higher NPV. We also can conclude, that value of the real option is 2 billion RUB.

Conclusion
Only in one scenario with low oil price and low synergy effect, Rosneft should not buy 50,08 % of Rosneft. Probability of this scenario is only 25 % and in all other scenarios acquisition creates substantial positive value.
Real option model gives a more flexible approach for decision making. Merges and acquisitions are strategic decisions, and it is very difficult to forecast market environment and synergy effect simultaneously.
I would recommend Rosneft to acquire 50.08 % in 2016 (as it did) and wait two years in order to watch synergy effect. According to real option model, if synergy was high in 2017, then Rosneft should complete acquisition and buy more 49.92 % of Bashneft. 1 These scenarios were based on trends in 2016-2018 and could not take into account the "Black Swan" of 2020situation with coronavirus. Furthermore, is most cases M&A strategy should be analyzed on data with limited horizon (2 years) after the deal.
Fast growth of Rosneft, including acquisition of Bashneft, requires a lot of long-term financing (assets and liabilities should correspond in time). Because company does not generate enough cash for such expansions, I believe, that better to move to organic growth and postpone takeover. At the same time Rosneft should be recommended to issue additional shares in order to decrease its high debts.
M&A deals in oil and gas sector in 2016 were considered as mega transactions.
[21] The deal, which we discussed in the article, was one of them.
We should take into account not only financial calculations, but also correlation of strategies of both companies. In the case above both companies were operating in the same segment and used similar business models, but in different regions. That definitely improved probability of synergy effect and allowed to complete the deal successfully.