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The news of the European Commission suspending its review of the proposed business combination between Halliburton (NYSE:HAL) and Baker Hughes (BHI) confirms that the EU antitrust review may prove to be a challenging one.
The suspension is technical in its nature. The Commission stated that the two companies' filing did not contain all the required information. However, as one can see from the status report below, the deadline is being extended by 20 days, which moves the Commission's response deadline into July 2016.
(Source: The European Commission)
The worry over the EU regulatory review goes far beyond simply technical process.
The Commission stated earlier that it intends to "look closely" at the proposed merger to make sure it would not reduce customer choices or push up prices for oil & gas exploration and production services in the EU.
It is also worth noting that the Commission sees an energy security angle in the proposed combination:
Efficient exploration and production of oil and gas resources within the EU form an important element of our Energy Union strategy in terms of ensuring security of supply.
The Commissioner in charge of competition has stated the Commission's awareness that the takeover would eliminate one of the three current main global competitors in global oil services. The Commission has "serious potential competition concerns in more than 30 product and service lines, both offshore and onshore."
Particular concerns relate to the merger's impact on competition in tenders and in innovation. The Commission's preliminary view was that competition from smaller suppliers is limited in tenders for projects of greater complexity, where more challenging conditions and higher costs are involved, such as offshore projects. Quality of service and reputation are particularly important in such tenders.
In addition, it believed that only three suppliers were currently able to provide integrated services that run across many product and service lines, namely Halliburton, Baker Hughes and Schlumberger (NYSE:SLB). In the Commission's view, the ability to offer such integrated solutions represents a significant competitive advantage, for reasons of cost-saving in particular.
Therefore, the Commission's preliminary view was that the merger...
... would reduce the number of integrated service providers from three to two, which may lead to less choice and potentially higher prices for customers. Barriers to entry are particularly high for integrated services as a new supplier would need to enter (or expand into) a large number of product and service lines to be able to compete in tenders.
The second major concern related to the merger's potential impact on innovation:
The Commission is concerned that a reduction of the number of competitors could reduce the incentive to innovate, especially given that Halliburton and Baker Hughes currently compete fiercely with each other in developing new products.
While the Commission is investigating whether these initial concerns are justified "without prejudice," it appears highly questionable if these major objections can be cured via fragmented divestitures that are substantially smaller in scale than Baker Hughes.
It is important to note that the concerns publicly stated by the European regulator will inevitably correlate with the areas of review by regulators in other jurisdictions, including the U.S. and Australia.
How did the market react to the news of the likely delay in the EU regulatory review?
As one can see from the graph below, the deal arbitrage spread widened moderately in the past few days and remains at the high end of the range observed since the announcement of the merger.
It is important to note that both stocks have moved higher since the news, with Halliburton running ahead of Baker Hughes.
What is the probability of the deal closing?
Taking in consideration the $3.5 billion non-success fee that amounts to over $8 per share of Baker Hughes stock, the current deal spread effectively discounts a roughly 50/50 probability of the deal's success, based on my assessment.
Given the nature of the concerns expressed by the European regulator, fragmented divestitures proposed by Halliburton may not be an effective cure. The success of the regulatory review appears to require a solution that may be too big of a sacrifice for the company to accept.
In this context, the market's skepticism with regard to the deal closing is understandable. In fact, the risk of non-closing may be undervalued in the current deal spread.
Low oil prices is a another factor that may influence the review, as the regulators will need to look at the competitive landscape in the aftermath of the potential shake-out and consolidation in the industry due to the current severe downturn.
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