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CONSOLIDATION IN BIG OIL—A LOOK AT SHELL–BG
Jul 02, 2015
By Ankit Abraham Sinha, Senior Analyst
In April 2015, Royal Dutch Shell and natural gas E&P company BG announced the agreed-upon terms of a cash and share offer—amounting to £47 billion ($72 billion) excluding debt—put forth by Shell to acquire BG. Shell expects to conclude the transaction with shareholder and regulatory approval by early-2016. The company cleared its first antitrust hurdle on June 16, 2015, when it received approval from the US Federal Trade Commission (FTC).
The takeover of BG, formerly the exploration arm of British Gas (created in 1997 when British Gas split into BG and Centrica), will be the third-largest oil & gas deal of all time (Figure 1). The combination of Shell and BG is expected to be worth ~£180 billion ($274 billion). The move was prompted by plunging oil and BG stock prices.
1
EXPECTED SYNERGIES
“There are clear attractions from Shell’s viewpoint, including its additional exposure to LNG, almost immediate cost synergies and, in due course, asset sales from a partial breakdown of BG’s operations.” – Richard Hunter, Head of Equities, Hargreaves Lansdown (April 2015)
Shell’s offer consists of cash and shares worth £13.50 ($20.58)/share of BG—~50% more than BG’s market value at the time of announcement. This has led some industry observers to conclude that Shell is overpaying for BG. However, a majority of experts believe that synergies from the deal will sufficiently outweigh the large premium being paid by Shell.
The expected savings from reduced exploration expenditure and operational overlap appears to be fairly substantial. Shell has identified pre-tax synergies that would reach ~$2.5 billion in 2018, and include operating cost savings of $1 billion and a $1.5 billion reduction in exploration expenditure. A significant overlap is expected in LNG and deepwater operations—these are strong areas for Shell and BG, wherein they plan to expand too. The deal is also projected to increase the Shell’s proven global oil & gas reserves by ~25% and total oil & gas production by ~20%.
As a result of these significant synergies, Shell expects its cash flow from operations to rise 15%. The company will also liquidate assets worth $30 billion over 2016–2018, as the combined entity will divest some underperforming and declining legacy assets. The allocation of this cash flow will be prioritized as follows:
Debt reduction
Dividends
Buybacks and capital investment
A measure of the extent of this increased cash flow is that even with buybacks on the bottom of the priority list, Shell expects to repurchase shares worth $25 billion over 2017–2020.
Potential Roadblocks
While the Shell–BG merger boasts of a plethora of potential synergies, it will need to surmount significant hurdles to realize these. The deal is expected to face regulatory challenges and will require oil prices to rebound significantly over 2016–2018.
“The acquisition comes at a hefty price. The management will have its work cut out to execute the deal, and generate synergies and asset sales. The risk of indigestion is not small.” – Pascal Menges, Manager, Lombard Odier Global Energy Fund (April 2015)
According to industry observers, the combined entity’s positioning as the dominant player in the global LNG industry and Brazilian deepwater exploration space is expected to make it a target of regulators. While the deal has been cleared by the US FTC, it will require further regulatory clearances from all the countries that the combined entity operates in. The deal is likely to face intense scrutiny, particularly from regulators in China, Brazil, and Australia.
Beyond regulatory challenges, some investors are skeptical of Shell’s ability to keep its promise that the deal will significantly bolster earnings/share, starting in 2018. Oil prices would need to reach almost twice the current level for Shell to meet its stated goals, with the company’s post-acquisition revenue projections assuming Brent oil prices of $67/barrel in 2016—rising to $75/barrel in 2017 and $90/barrel over 2018–2020.
STRATEGIC RATIONALE
Shell’s acquisition of BG is based on its need for new and cheaper sources of oil & gas. Further, Shell views the LNG sector as a key growth driver for future revenue. BG fits these criteria, and the recent tumble in the company’s share price makes it an attractive investment.
Need to Improve Asset Portfolio
Industry watchers are of the opinion that one of the reasons for Shell’s acquisition of BG is a result of the decline and underperformance of some oil & gas resources in its portfolio. BG’s assets in deepwater oil production off the Brazilian coast will offer Shell the chance to upgrade its portfolio. The combination will also provide BG access to Shell’s capital and expertise to help develop assets.
“The acquisition of BG by Shell has occurred for two main reasons. First, although BG had some first-class assets, it has struggled to develop them as smoothly as hoped in recent years. Shell has a wider pool of expertise and substantially greater access to investment capital. Second, this gives Shell presence in the productive zone off the coast of Brazil, and will ensure that Shell’s own production is maintained over the medium term, taking away the requirement to make large discoveries to offset natural depletion.” – Michael Clark, Portfolio Manager, Fidelity MoneyBuilder Dividend Fund (April 2015)
Move Away from Expensive Production Techniques
With the average WTI crude oil spot price for the week ended June 26, 2015, hovering at $60/barrel, more expensive oil production techniques seem increasingly unviable. According to a June 2014 report by Rystad Energy, production from ultra-deepwater, oil sands, and arctic oil fields may not be feasible at current prices. BG’s assets in Brazil will allow Shell access to cheaper sources of production.
“This shows that big oil’s growth strategy over the last 10 years is bust. Having bet enormous sums on eye-wateringly expensive oil production from oil sands, ultra-deepwater, and arctic fields, the supermajors are now ill-placed to cope with a low oil price.” – Pascal Menges, Manager, Lombard Odier Global Energy Fund (April 2015)
“In Brazil, BG’s assets would give Shell a further foothold in one of the lowest-cost basins in the world.” – Biraj Borkhataria, Analyst, RBC Capital Markets (April 2015)
LNG Push
The acquisition also strengthens Shell’s position in new LNG projects, with BG holding strong interests in Australia’s LNG market.
“BG’s LNG portfolio combined with Shell’s would represent ~40 million tonnes/annum or ~16% of the global LNG market, further propelling Shell’s position as a leader in this area. In addition, Shell will likely acquire significant growth options, including in Tanzania and Lake Charles.” – Biraj Borkhataria, Analyst, RBC Capital Markets (April 2015)
IMPACT ON PENSION SAVERS AND LNG SHIPPERS
Pension Savers Face Lower Dividends
Shell’s acquisition of BG is important for all UK pension savers. Prior to the combination, Shell accounted for ~10% of the UK’s dividend income. The purchase of BG will increase this to ~11%. Shell will be taking on a portfolio of potentially riskier assets, given the tumble in BG’s share price in the recent past. Further, this may put some strain on dividend payouts, as Shell redirects cash flows toward repaying debt.
“We think Shell’s acquisition of BG will likely be viewed as strategically smart and opportune; however, should oil prices stay low for longer, while it will be good for the UK consumer, it could pressurize UK dividends and be detrimental to UK pension investors.” – Matthew Beesley, Head of Global Equities, Henderson Global Investors (April 2015)
LNG Shipping Expected to Benefit
Shipping is mired in a slump that began after the 2008 economic crisis, which dealt a blow to world trade. However, the shift of governments and energy producers to cleaner fuels, such as LNG, is spurring demand for vessels transporting such petroleum products.
Energy producers lease rather than own most ships used to move their products. Given that Shell and BG together own 12 LNG carriers and charter ~60, the merger is expected to be good news for LNG shippers. According to an April 2015 article by The Wall Street Journal, the leases generate $75,000/day for a ship; the breakeven point for such vessels is ~$50,000, demonstrating the lucrativeness of LNG shipping.
“The merger offers owners more flexibility and better utilization of LNG fleets, which could mean long-term leases offering a steady income.” – Ted Petropoulos, Head, Petrofin Research (April 2015)
GasLog and Maran Gas Maritime are expected to be two major beneficiaries of the acquisition. Of its fleet of 27 carriers, GasLog charters 15 LNG carriers to BG and 2 to Shell. The company’s shares closed 4% higher on the date of the acquisition’s announcement.
CONCLUSION: FURTHER ACQUISITIONS BY OIL MAJORS?
The Shell–BG combination raises expectations of further consolidation in the oil & gas sector. Potential acquirers include ExxonMobil, Total, Eni, Statoil, and BP. Potential targets include Tullow Oil, Premier Oil, and Petrofac.
“The deal between Royal Dutch Shell and BG Group will prompt sector consolidation. The decline in oil prices over the past year has battered some stocks, which clearly seem attractive now. In the last year, shares of BG fell 30%, those of Tullow Oil fell 65%, Premier Oil was down 55%, and Petrofac declined 20%. In comparison, sector behemoths BP and Royal Dutch Shell shed only 10% over the same period, leaving them in the position of predator rather than prey.” – Marc Kimsey, Senior Trader, Accendo Markets (April 2015)
With oil prices at low levels, oil companies must identify targets that are long-term strategic fits before jumping on the M&A bandwagon. The Smart Cube will continue to monitor deal activity in this sector and inform readers of important updates.
