Boiling the Oils Some More: Chevron and Texaco Talking Merger - TheStreet

If you thought Middle East

tensions rocked the oil world this week, merger news late Friday is certain to light a fire under oil stocks as traders return Monday morning.

Chevron

( CHV) and

Texaco

(TX) - Get Report

are discussing a merger, sources familiar with the talks told me Friday night.

The pact, which could be announced as early as Monday, will exchange approximately 0.77 shares of Chevron stock for each share of Texaco, the sources said. Further details were not available and neither company could be reached for comment.

Reports of a potential deal hit after the

New York Stock Exchange

closed Friday. In after-hours trading Friday, Texaco was bid at $66, up about 11 from the NYSE 4 p.m. close of $55.13. Chevron closed during regular trading at $84.25. An after-hours quote was not immediately available.

If completed, the deal would combine the third-largest U.S. oil company -- Chevron -- with Texaco, the fourth largest. The companies have approached each other before. Merger talks between the companies broke down late last year over issues of price and which company would control the board of directors.

A Chevron/Texaco deal would eclipse any possibility of a deal that was rumored

earlier this year between Chevron and

Phillips Petroleum

(P)

.

The Chevron/Texaco deal would create a company that could compete with the oil super-majors such as

Exxon Mobil

(XOM) - Get Report

and

Royal Dutch Shell

.

"It certainly makes a lot of sense," says Stephen Smith, an energy analyst with

Dain Rauscher Wessels

in Houston. "Both stocks have not kept pace. The gap between the multiples they carry compared with the super-majors has continued to widen." Smith rates Chevron and Texaco buys and his firm has not provided banking services to either.

Smith said he isn't surprised by the merger, citing the pressures of trying to compete with the super-majors. "There is just a significant cost advantage to super-major size," he says. "The pressure has been building for both companies. It's just getting past natural resistance like personal chemistry."

Underperformers Getting Hitched to Compete?

As a result, the stock prices of both Chevron and Texaco have lagged their larger rivals. "Both Chevron and Texaco have been selling close to their asset values, while Exxon Mobil is selling at nearly a 70% premium to its break-up value," says Smith.

Smith also sees significant benefits to a combination of the two companies. "In the U.S., both companies have some presence in the Gulf of Mexico, and integration of those operations will certainly be a plus."

He also sees a significant benefit to combining projects in Africa: Chevron's presence in Angola and Texaco's discoveries in Nigeria make a nice fit. "The combined companies achieve critical mass in West Africa," he says.

However, the biggest benefit, Smith says, is a reduction in overall risk in the combined companies' exploration programs. "You will get better diversification of your mega-projects and it brings their risks in the Caspian region more in line," he says. "The key for companies like Exxon and Shell is they have a dozen or so mega-projects that insulate them. Both Texaco and Chevron are a little thin in that area."

Smith sees very few possible problems with the merger, although a retail joint venture between Texaco and

Royal Dutch Shell

may pose an issue. Combined, the two companies hold about 13% of the retail gas market in the U.S., edging up on leader Exxon Mobil. "I don't know how the joint venture is handled in the merger," says Smith. "That could be an issue."

That the combinations of Exxon and Mobil as well as

BP

and

Amoco

(BP) - Get Report

passed regulatory scrutiny (with conditions) bodes well for this merger, though regulators always take a look.

"Typically, the most significant issues are in refining and retail operations," says Dan Pickering, director of research at

Simmons & Company

, a Houston energy-research boutique. "You don't know until regulators look if there will be issues." The companies' retail operations likely will undergo careful scrutiny and may require some divestiture.

In the end, however, the deal makes a great deal of financial sense both for the companies and their shareholders.

"You've got a deal where one plus one equals a little more than two in this merger," says Pickering. "And you should get some multiple expansion which will benefit shareholders. It becomes a darn significant company when it is all said and done." Smith also believes the deal will be accretive to Chevron's earnings almost immediately.

And, Pickering says, it looks like this time it will be completed. "It looks like it's resurfaced and will finally happen," he says. "It makes a lot of sense for both companies."

Christopher S. Edmonds is president of Resource Dynamics, a private financial consulting firm based in Atlanta. At time of publication, Edmonds was long Phillips Petroleum, although holdings can change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Edmonds cannot provide investment advice or recommendations, he welcomes your feedback and invites you to send it to

Chris Edmonds.