Baker Hughes Inc. struck a cash-and-stock deal valued at $5.5 billion shortly after midnight Monday to acquire shale fracturing expert BJ Services Co., in the largest oilfield services acquisition in more than a decade.

BJ Services is one of the largest pressure pumpers in the world, a process used in unconventional natural gas plays to break up rock. Pressure pumping now accounts for 75% of BJ Services’ business; it is expected to be 20% of the combined company’s revenue. In 2008 pressure pumping accounted for 1% of Baker Hughes’ revenue.

The merger would give the combined company the ability to compete around the world, said Baker Hughes CEO Chad Deaton. Because of the complexity involved in drilling today, services companies often work together by “bundling” their service offerings.

“While we are merging with BJ now, as the industry consolidates, we see opportunities to grow, both in individual shale markets in North America and in the rest of the world in the future, and in deepwater drilling,” said Deaton. “We’ve begun discussing the next step to integrate the business. We know each other; our organizations have worked closely with each other…

“Our two companies have highly complementary products and services with very little overlap,” he told energy analysts during a conference call. “Baker Hughes has a long record of partnering with BJ Services on major projects. The proposed merger will make Baker Hughes a stronger, more efficient service provider for our customers worldwide, by integrating pressure pumping with Baker Hughes’ wide range of products and services.”

The impetus to merge was a natural, Deaton explained. The two companies began talking about possibly merging around two months ago, and the companies reached an agreement “at 12:40 a.m.” Monday, he said.

Companies with an array of oilfield services have an edge worldwide, said BJ Services CEO Bill Stewart.

“We are seeing many of the pressure pumping jobs are being bundled into larger integrated projects,” Stewart said during the conference call. By combining services, Baker Hughes expects annual cost savings of about $75 million in 2010 and $150 million in 2011.

“BJ Services broadens our portfolio by adding products, technologies and talented people that are key to helping our customers unlock value in their reservoirs, particularly in unconventional gas and deepwater fields,” said Deaton. “It will better position us to drive international growth and to compete for the growing large integrated projects by incorporating pressure pumping into our product offering.”

The transaction also is a bet that natural gas will play a bigger role internationally.

“We think the conventional type opportunities are the main driver” for the transaction today, said Deaton. “But U.S. unconventional gas will get bigger and prices will rebound. Down the line overseas these shale plays will come on, but three or four years down the line.” Baker Hughes expects to see “some recovery” in gas rig drilling in 2010, but “not real aggressive.”

Frost Investment Advisors’ Ted Harper said the transaction “fills a product hole” at Baker Hughes, and the combined company will “look to benefit as to what they hope to see as higher activity rates for land rigs somewhere down the line.”

Baker Hughes is “doing the right thing at generally the right time,” said Tudor, Pickering, Holt & Co. Securities Inc. There is a “clear operational fit,” and the merger makes Baker Hughes “more competitive as pressure pumping is currently a gaping hole” when bidding for international work and bundled U.S. services. The merger “puts more on the plate while in the middle of transitioning to a geomarket organization…”

Baker Hughes would move into the No. 3 spot in market value behind oilfield services leaders Schlumberger Ltd. and Halliburton Co. National Oilwell Varco Inc. is now the No. 3 oilfield services provider. Based on Monday morning stock prices, BJ Services stockholders are to receive 0.40035 shares of Baker Hughes stock and $2.69 in cash for each share they own. BJ Services’ share price closed at $15.43 on Friday; the transaction was a 16% premium in early trading Monday, but the Baker Hughes share price fell after the announcement.

Once the merger is completed, BJ Services shareholders would own more than a quarter stake in Baker Hughes, and two of its board members would join Baker Hughes’ board. The transaction requires regulatory approvals, and it also requires approvals from both companies’ shareholders.

Deaton said he doesn’t think his company’s merger announcement will be the last of the year. There is “a lot of talk” about more acquisitions in the oil and gas business, he said. “We haven’t seen any deals yet, but there’s lots of chat.”

Morningstar analysts said they had “long anticipated such a deal between the two companies, as it fills major holes in both product lines and makes a great deal of strategic sense. Baker Hughes will be better able to compete by offering a more complete bundled services offering, which could help it win international integrated project-management efforts. The deal gives BJ Services’ pressure pumping operations a bigger global platform, and probably makes reentering Russia a much more palatable option.”

Some BJ Services shareholders were unhappy with the merger price offered; the share price has fallen by more than half in the past year. Stewart was asked why the company would agree to a merger with gas prices so low.

“We’ve been consistent in our belief that there is a tremendous surplus of natural gas,” said Stewart. “We are doing well in a competitive North American market, but we don’t expect to see a rebound real soon unless we get some consolidation [in the industry]. We do think there’ll be some capacity come out of the market…wear and tear, if you will, from shale formations wearing on equipment. Demand is down, significantly, and that is contributing to an extended period of market recovery.

“What BJ Services needs is a broader scope of product offering, and what BJ Services needs is a better position than what we currently have in the marketplace. What BJ Services needs is products, services other than pressure pumping .It just so happens that now is when Baker Hughes decided they were interested, and it fills a tremendous void in their service offering, and it makes us more competitive throughout the world.

“You can’t pick and choose the exact time that a combination comes together,” Stewart said. “It just so happens that now is the time, and it’s a good deal for both sets of stockholders.”

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