December 8, 2014

Halliburton/Baker Hughes: Divestiture Commitment, Massive Break Fee Are Drivers; Global Regulatory Concern Regarding Deepwater Markets, Integrated Service Contracts Will Drive Lengthy Review

Conclusion

On November 17, Halliburton Company announced an agreement to acquire rival oilfield services provider Baker Hughes Incorporated in a $34.6 billion cash and stock deal. In an effort to ease regulatory clearance, Halliburton has committed to divest assets accounting for up to $7.5b in 2013 revenue. In addition, Halliburton has agreed to pay a $3.5b termination fee if the deal breaks due to regulatory opposition.

At least a dozen competition authorities will have jurisdiction over the Halliburton/Baker Hughes merger review. At the end of the day, if regulators define overlap markets narrowly, on a sub-product line basis, deal clearance with significant divestitures is the most likely outcome. Given the firms’ size, scope and market leadership in many segments, however, there is a risk that regulators will instead define markets relatively broadly, by product line, division (drilling/evaluation and/or completion/production), or even all oilfield services. Such broad market definitions would not be amenable to a clean divestiture solution, and could instead lead to an outright deal challenge by one or more regulators. Key points for stakeholders to consider include:

 Narrow product market definitions would likely drive clearance—but EC precedent buoys case for a potentially broader approach. The parties reportedly anticipate that regulators will require divestiture of overlap assets, including drill bits, measurement while drilling, logging while drilling, and offshore sand control, of about half of the $7.5b cap. And if regulators define markets relatively narrowly, clearance with significant divestitures is the most likely outcome. However, the European Commission’s 2010 conclusion in Schlumberger/Smith that, despite the individual components’ lack of substitutability, “completion products and services” constituted a relevant product market, suggests that European regulators in particular may be inclined to define markets relatively broadly.

 Complaints from politically powerful National Oil Companies (NOCs) could drive enforcement by non-US regulators. Integrated services contracts (ISCs), through which major oilfield services firms perform essentially the entire job of well drilling/evaluation and completion/production, are increasingly common. National Oil Companies (NOCs), such as Mexico’s Pemex, and Norway’s Statoil have, in particular, increasingly moved to this model. Although DOJ is unlikely to be overly concerned about harm to NOCs, NOC complaints could drive the EC’s DG COMP, Mexico’s COFECE, Brazil’s CADE, China’s MOFCOM, and other regulators to view the deal as reducing the number of bidders for some ISCs from four to three or three to two.

 Deepwater drilling and completion, in particular, is highly concentrated. Even if markets are defined relatively narrowly, regulators could conclude that the deal would lessen the number of firms bidding for particular ultra deepwater tenders from four to three or three to two. DOJ’s investigation, in particular, will focus on potential harm to competition for deepwater jobs in the Gulf of Mexico.

 Onshore US is more competitive—but ongoing DOJ investigation, uniquely close head-to-head competition are red flags. In 2013, DOJ’s Antitrust Division issued CIDs to Halliburton and Baker Hughes seeking information regarding the firms’ pressure pumping services. Even if DOJ’s investigation does not 1 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.

produce evidence of market power, the majors may have certain reputational and technical advantages that render recently-entered smaller firms a poor substitute for larger E&P customers.

Key Points

Deal overview. DOJ’s Transportation, Energy and Agriculture (TEA) Section will lead the Antitrust Division’s review. Notably, TEA lead the Division’s investigation into US Airways/American Airlines, a deal DOJ challenged, contrary to many stakeholders’ expectations. TEA Trial Attorney Angela Hughes will likely lead staff’s investigation. Hughes is a very experienced lead attorney, with over 30 years of experience at the Antitrust Division, and extremely knowledgeable about the oilfield services business. In fact, Hughes has lead investigations into both firms, heading the Section’s 1998 Halliburton/Dresser review, as well as the Section’s 2009 investigation of Baker Hughes/BJ Services.

Baker Botts partner Sean Boland, an attorney Halliburton CFO Mark McCollum describes as possessing “unmatched expertise in the oilfield services industry,” is leading Halliburton’s external antitrust team. And indeed, Boland may be the nation’s pre-eminent oilfield services antitrust lawyer. Boland represented Baker Hughes in its 2000 WesternGeco joint venture with Schlumberger, Baker Hughes in its 2009 acquisition of BJ Services, Smith International in its 2010 acquisition by Schlumberger, and Halliburton in its 2011 acquisition of Multi-Chem. Boland has an extensive history dealing with the Antitrust Division on oilfield services mergers, and vice versa. In 2013, Boland represented National Oilwell Varco in its acquisition of rival oilfield equipment manufacturer Robbins & Myers. TEA staff had concerns regarding the deal’s effects on potential competition in the market for offshore blowout preventers in particular. Despite staff’s concerns, however, DOJ’s front office cleared the deal with no conditions.

Wilmer Hale partner Molly Boast is leading Baker Hughes’ external antitrust team. Boast served as Deputy Assistant Attorney General for Civil Matters in DOJ’s Antitrust Division from May 2009 to October 2011. From July 1999 to June 2001, Boast served as Senior Deputy Director, and later Director, of the FTC’s Bureau of Competition. During her time at the FTC, Boast oversaw investigations into a number of high profile energy deals, including Exxon/Mobil, which lead to a settlement the FTC described as the “largest FTC divestiture ever,” as well as BP/Arco, a deal the FTC challenged, and eventually settled after BP agreed to divest ARCO’s Alaska holdings to Phillips for about $7 billion.

Extensive product overlaps. In order to win regulatory clearance for its Baker Hughes buy, Halliburton has committed to divest assets accounting for up to $7.5b in 2013 revenues, a figure representing over one-third of Baker Hughes’ $22.3b 2013 global revenues. Bloomberg reported on November 18, that, according to people familiar with the deal, Halliburton expects to divest assets accounting for roughly half of the $7.5b cap. Specifically, Halliburton is reportedly prepared to divest assets in drill bits (combined 42% share), measurement/logging while drilling (combined 46% share), and offshore sand control, as well as possibly offshore cementing.

Aside from these overlaps, very high projected post-merger two-firm concentration ratios will drive regulatory scrutiny of a number of additional overlaps. In drilling fluids, post-merger Halliburton would have a 35% share, and Schlumberger a 36% share (71%), while in wireline, Halliburton would have a 28% share, and Schlumberger a 45% share (73%). In directional drilling, post-merger Halliburton would have a 34% share and Schlumberger a 31% share (67%), while in cementing, the combined firm would have a 51% share, with Schlumberger holding a share of 27% (78%). Stakeholders should note that, in determining the appropriate scope of the geographic market for particular oilfield products and services, regulators are more likely than not to view the market as worldwide,

2 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.

rather than regional, as oilfield services firms are able to move personnel and equipment relatively easily in response to regional changes in demand.

Although post-merger Halliburton would have very high shares in a number of markets, regulators are likely to view the number of post-merger competitors, rather than market shares, as most probative of potential competitive effects in oilfield services product markets. Oilfield services firms generally bid on a limited number of large jobs and, because of the nature of this bidding market, market shares tend to be relatively dynamic, fluctuating from year to year. Regulators may view relatively dynamic market shares, coupled with E&P firms’ practice of oftentimes splitting contracts, as pointing toward some degree of countervailing buyer power from major E&P firms—a conclusion that would lessen concerns regarding post-merger competitive effects.

Given powerful buyers and dynamic market shares, even if Halliburton would have a relatively high share in a particular market post-merger, to the extent four or more firms are viable competitors post-merger, regulators are unlikely to seek divestitures. Markets regulators view as moving from four competitors to three, however, face high enforcement risk—DOJ complaints in Halliburton/Dresser (1998) (offshore logging-while-drilling) and Baker Hughes/BJ Services (2010) (vessel stimulation services), for example, have emphasized the four to three nature of the transactions, rather than post-merger market share figures.

Narrow product market definitions would likely drive clearance—but EC precedent buoys case for a potentially broader approach. In response to a November 17 analyst question, Halliburton CFO Mark McCollum outlined Halliburton’s expectations regarding market definition, explaining: “each of our product lines, while we tend to define them very – in a large way, like completions, those product lines have many sub product lines and services that are associated with it and, as we go forward, they’re going to be looked at on a sub-[product service line] basis.” “[T]hat’s what gives us confidence that this thing can be very achievable from a regulatory standpoint,” McCollum concluded.

In other words, narrow market definitions would drive simple divestiture solutions for problematic overlaps, and eventual clearance. Halliburton will advance a number of arguments for such an approach. E&P firms typically purchase oilfield products and services on a standalone, sub-product line basis. And various products are not generally not interchangeable—for example, drill bits, which enable a drill to bore into and create holes in rock, are not substitutable for drilling fluids, which clean the bottom of wells and cool and lubricate drill strings. As a result, DOJ has, in prior reviews, defined markets in oilfield services narrowly—although, in those circumstances, parties actually argued for broader market definitions. DOJ has taken this approach in, for example, Halliburton/Dresser (1998), in which DOJ rejected parties’ argument that wireline occupies a product market with logging while drilling. Likewise, in Baker Hughes/BJ Services (2010), DOJ did not credit parties’ arguments that skid-mounted pumps were a plausible substitute for vessel stimulation services. That said, Halliburton/Baker Hughes is the first proposed merger of major integrated oilfield services providers—a category that only global number one Schlumberger, and possibly Weatherford International, could be said to occupy.

Both Halliburton and Baker Hughes have two major divisions—“drilling and evaluation,” essentially drilling an exploratory well and evaluating whether it will be productive (BHI $7.7b 2013 revenue) and “completion and production,” ($13.3b BHI 2013 revenue) by which an exploratory well is “completed,” or prepared for production. The most significant risk facing Halliburton/Baker Hughes is that regulators will conclude the deal would lessen competition in broadly defined markets for “drilling and evaluation” and/or “completion and production,” or broadly defined product lines within those categories.

3 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.

The European Commission’s 2010 Schlumberger/Smith decision, in particular, may be uniquely problematic for the parties’ proposed narrow approach to market definition. In evaluating a proposed “completion products and services” relevant product market, the EC conceded that such a market would include various sub-product lines “which are not substitutable with each other.” The Commission, however, concluded that “even if the individual components of completion products and services are technically distinct…[they] exhibit a high degree of complementarily…[t]hey are part of a chain flow and may be also purchased by well operators on a single contract basis.”

The parties pushed back on the proposed completion products and services market definition, arguing that “liner hangers, packers (and their accessories), multilateral junctions, sub-surface safety valves, bridge plugs, formation isolation valves, flow control valves, reservoir monitoring systems, downhole pumps, sand control tools, sand control screens and expandable screens,” constituted separate markets. The EC, however, rejected this argument, noting that the majority of respondents to the market inquiry “confirmed that the market for completion products and services constitutes the relevant product market and that further segmentation is not required.”

The combined Halliburton/Baker Hughes would have a roughly 54% share in a broadly defined “completion products and services” market, Schlumberger (14%) and Weatherford would be number two and three with shares in the 10-20% range, and a host of smaller competitors would account for the remaining share. It is not clear for how much 2013 revenue the firms’ completion systems product lines accounted—completion systems are just one of the six product lines composing each firms’ larger completion and production divisions. And Baker Hughes’ counsel, no doubt familiar with the EC’s 2010 decision, is presumably comfortable that, even if regulators require divestiture of one firm’s entire completion products and services business, required divestitures will still be below the $7.5b cap.

That said, this precedent, as well as the increasing trend toward integrated services contracts, in which oilfield services firms provide a bundle or package of drilling and evaluation and completion and production services, would support a broad approach to market definition. Although a number of firms are capable of providing discrete services in conventional plays, there are only four major global integrated oilfield services firms—Halliburton, Baker Hughes, Schlumberger and Weatherford. And while Schlumberger would maintain its global leadership position even if Halliburton/Baker Hughes combine, Weatherford is a relatively distant number four, and not invited to bid for many IOC megaprojects and NOC tenders. As a result, regulators could view the deal as lessening the number of significant players in those markets, or an even more broadly defined integrated oilfield services contracts market, from four to three, or three to two.

Complaints from National Oil Companies (NOCs) could drive enforcement by non-US regulators. In recent years, E&P companies have increasingly opted to contract with a single oilfield services firm to handle most or all aspects of a project, rather than using multiple companies for standalone services. E&P firms, and NOCs in particular, benefit from these integrated services contracts, as the oilfield service firm may offer bundled rebates and contractually accept some level of risk. For example:

 In 2009, Halliburton announced that it had won a five year integrated turnkey drilling contract from Saudi Aramco, which called for Halliburton to provide “drilling rigs, directional and horizontal drilling, logging while drilling, cementing, mud engineering, wireline logging, completion, perforating, and other well construction activities, including engineering and management of the entire drilling operations.” Halliburton noted that the contract was Saudi Aramco's first-ever award for an integrated turnkey drilling contract, and

4 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.

“an important part of Saudi Aramco's plan to explore new avenues of collaboration with major oil field services providers.”

 In 2010, Baker Hughes announced that it had won extensions of two drilling and evaluation services contracts from Statoil, Norway’s NOC. The contracts obligated Baker Hughes to provide a number of products and services, including “drill bits, directional drilling, formation evaluation (measurement-while- drilling, logging-while-drilling and mud logging) and related services” for rigs operating in multiple North Sea fields.

 In 2011, Statoil awarded Halliburton a contract to provide “directional drilling and logging-while-drilling services, surface data logging, drill bits, hole enlargement and coring services, cementing and pumping services, drilling and completion fluids, completion services…and project management” in the North Sea.

 In 2011, Baker Hughes announced that it had won a contract from India’s NOC, ONGC, to provide drilling and evaluation services for an Indian Ocean deepwater project, including “directional drilling, measurement-while-drilling, logging-while-drilling, surface logging services, drilling fluids, liner hangers, cementing and coring services.”

 In 2011, LUKOIL awarded Baker Hughes a contract “to provide full drilling and completion services” for the firm’s wells in the West Qurna field in southeast Iraq, including “drilling services, formation evaluation, casing and tubing running services, completion tools and services, wellbore intervention services, and wireline logging as well as perforation operations.”

 In October 2014, Halliburton announced that it had signed a contract with Ecuador’s NOC, Petroamazonas, “to provide field development and project management, as well as drilling and completions services, across nine mature fields.”

Notably, the trend toward integration is relatively recent—as Halliburton explained in winning the Statoil contract in 2011 “Traditionally, Statoil has procured drilling and well services on a discrete basis. This is the first time Statoil has awarded an integrated well services contract in Norway.” And by virtue of these integrated services contracts’ terms and scope, at least some regulators may be inclined to evaluate competitive effects not narrowly by product or service line, but more broadly, by drilling and evaluation, completion and production, or even all oilfield services.

Although NOCs are more likely than IOCs to award integrated services contracts, IOCs have increasingly tested the model as well. In 2010, for example, Baker Hughes announced that it had won an integrated services contract to provide drilling and evaluations services to a consortium of seven IOCs: Wintershall, OMV, Nexen, E.ON Ruhrgas, Rocksource, Front Exploration and Bridge Energy ASA, for an offshore Norway project. The contract obligated Baker Hughes to provide “directional drilling, measurement-while-drilling (MWD), logging-while- drilling (LWD), mud logging, drilling fluids, wireline logging and coring services.” And American majors, although generally procuring oilfield services on a discrete basis, increasingly offer integrated services contracts too. In 2010, for example, ExxonMobil awarded Halliburton an integrated services contract in Iraq’s West Qurna field, through which Halliburton agreed to provide, in addition to “on-site logistics and technical support,” services including “provision of a workover rig, coiled tubing, slickline services, logging, production enhancement and well testing.”

5 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.

Halliburton’s approach to this issue appears to involve convincing large E&P firms, and NOCs in particular, that the Halliburton/Baker Hughes combination would be pro-competitive, creating a stronger competitor to global number one Schlumberger. In a post-deal announcement interview, Halliburton CEO Dave Lesar explained that “National oil companies (NOCs) in particular, they see that…a stronger, more well-developed organization can help them in a way that neither of us could standing on our own.” That said, to the extent NOCs increasingly prefer integrated services contracts, and this deal lessens the number of firms capable of bidding for such projects from four to three or three to two, the parties could see real objections from NOCs. NOCs will have particular influence over Mexico’s (Pemex), Brazil’s (Petrobras), China’s (Sinopec), and even the EC’s (Statoil) reviews, and influence from these politically powerful NOCs could drive enforcement from these non-US regulators. DOJ, however, is relatively unlikely to take into account objections from foreign, state-owned oil companies in its review. The Division’s 2010 Baker Hughes/BJ Services complaint provides some insight to this approach—although the deal would have lessened the number of vessel stimulation services providers from four to three worldwide, DOJ’s complaint focused solely on harm to the Gulf of Mexico geographic market.

Onshore US is less problematic—but ongoing DOJ investigation, uniquely close head-to-head competition are red flags. US onshore markets, although relatively more competitive than global integrated services or deepwater markets, are likely to be the primary focus of DOJ’s review. In the onshore hydraulic fracturing technology which has driven the recent North American oil boom, post-merger Halliburton would have a 39% share, more than double Schlumberger’s 20% (Bloomberg/Reuters). That said, the three largest fracking operators’ market share has fallen significantly in recent years, from 70% five years ago, to 63% in 2013 to 59% today, as new firms enter the space and capacity has increased. Indeed, the hydraulic fracturing market’s story, in which the majors’ dominance was eventually eroded by new entry, is a relatively positive story for deal clearance.

However, even in this increasingly competitive market, DOJ may have concerns. On May 30, 2013, DOJ issued Civil Investigative Demands pursuant to the Antitrust Civil Process Act to both Baker Hughes and Halliburton, seeking information regarding “the possibility of anticompetitive practices involving pressure pumping services performed on oil and gas wells.” The DOJ investigation, which is apparently still ongoing, indicates that DOJ may believe the firms have some degree of market power in hydraulic fracturing—or at least did so up until relatively recently.

Although the US onshore market is relatively fragmented for many products and services, DOJ may conclude that Halliburton and Baker Hughes compete uniquely closely for business from the largest E&P firms. In particular, IOCs such as BP and Shell, or large domestic firms such as Chesapeake and Anadarko, typically contract with the three major firms—Schlumberger, Halliburton, and Baker Hughes. So although US onshore fracking and directional drilling markets have seen new entry in recent years, smaller, and less technically adept new entrants tend to service smaller independents, who generally operate less complex and valuable wells. In addition to technical prowess, larger firms’ preference for a Big Three firm is, at least in part, owing to reputational and experience issues—“no one gets fired for having Halliburton or Schlumberger or Baker Hughes screw up a well,” noted an executive with a Houston-based E&P firm.

Although the deal is ostensibly less problematic in US onshore, the source explained “I think producers in general are going to be worried about that loss of an alternative.” As oil prices move below $80 a barrel, “if these two companies were to go forward in a competitive environment right now they would want to keep their crews at work and so they would start bidding down the price on drilling and completions so they could keep their customers drilling,“ he predicted. “In the big scheme of things I’m going to be a little annoyed, whereas before I was bitching and moaning about just 3 or 4 people to bid on it, now it’s just going to be 2 or 3, and there will be a lot fewer crews

6 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.

and a lot fewer alternatives,” he continued. The source also expressed concern about potential loss of innovation— given that Baker Hughes and Halliburton (along with Schlumberger) have the most prominent oilfied services R&D departments, “there will be a loss in the industry of technological advancement,” he predicted.

Offshore and deepwater. Although onshore US is relatively more competitive, it is the relatively harsh environments, deepest waters, and most remote locations where the majors are truly dominant. In particular, Schlumberger is the market leader in the deepwater drilling market, while Halliburton and Baker Hughes are two and three, respectively. Deepwater wells present challenging production issues, given extreme temperatures and pressures, as well as other complex production issues. As a result, DOJ has consistently concluded that deepwater oilfield service product lines occupy separate product markets from their onshore analogues. In Ecolab/Permian (2013), for example, DOJ concluded that “production chemical management services for deepwater oil and gas wells” were a separate market from “onshore or shallow water PCMS,” while in Baker Hughes/BJ Services (2010), DOJ argued that vessel stimulation services for deepwater jobs in the Gulf of Mexico likewise did not compete with onshore stimulation services.

IOCs in particular have increasingly moved to large, complex and unconventional fields in remote, deepwater locations. These “megaproject” operators generally have eschewed the integrated model, opting instead to procure best-in-class standalone oilfield products and services. Although this purchasing behavior counsels against viewing integrated services for deepwater projects as a relevant market, Baker Hughes’ and Halliburton’s overlap market shares in standalone products may understate their importance for these deepwater megaprojects, in which the two firms, along with Schlumberger and possibly Weatherford, may be the only plausible providers for some products and services. Megaproject operators are unlikely to accept bids from firms with no deep water experience or expertise. And American IOCs spearheading such projects, even if outside of US waters, may mount an aggressive campaign to DOJ and other competition authorities to the extent they believe the Halliburton/Baker Hughes deal will drive lessened post-merger competitive intensity.

7 You are a subscriber to The Capitol Forum. Please contact 202-601-2300 for editorial or sales questions.