A plodding romance

Having taken a generation to court BG, Shell may have to endure a drawn out engagement before the two are finally united, says Nigel Hawkins.

It was widely expected that the sudden plunge in oil prices would bring about consolidation within the energy sector. And so it has come to pass, with Royal Dutch Shell (Shell) announcing in April that it is set to buy BG for c£50 billion. The terms per BG share held are 383p in cash and 0.4454 Shell B (the UK-tax favoured option) shares.

The deal, regulation permitting, is due to close in Q1 2016 and would be the second largest oil and gas deal on record. It would also bring to a close an eventful 20 years or so for BG as an independent exploration and production company.

In 1997, BG was extracted from British Gas, which had been privatised with much hype in 1986. Other segments of the British Gas business went their separate ways. Eventually, Transco became part of National Grid while the retail-facing Centrica remains independently quoted.

Until relatively recently, shares in BG had risen sharply under former chief executive Sir Frank Chapman. BG had built up a valuable asset base, focusing on liquefied natural gas, which remains in high demand in Asia. Much of its recent investment has been in building new LNG capacity in Australia.

For investors, BG’s rating had soared on the back of its jewel in the crown – its stake in the Tupi (now Lula) oil-field far off the Brazilian coast. However, while Tupi’s resource base is formidable, extracting it presents major technical challenges. BG started missing its production targets and experienced serious problems in Egypt, while also admitting to capital expenditure overruns.

Subsequently, oil prices plunged, dragging down gas prices in their wake. Tupi became the jewel of yesteryear.

Followers of Shell will be far from surprised by its BG acquisition. After all, Shell has been tracking BG for a generation. For many years, following its reserves scandal back in 2004, Shell’s reserves replacement ratio has been inadequate. Over time, this depresses production levels.

BG’s asset base enables Shell to redress this balance, adding 25 per cent to its proven oil and gas reserves. BG’s Australian LNG assets will give Shell formidable sector strength in Asia, Brazil is the key market.

Indeed, Shell’s chief executive, Ben van Beurden, recently described Brazil as “the most exciting area in the world for the oil industry”. Furthermore, the new combination should be able to raise production levels there to 550,000 barrels a day. Shell’s current production in Brazil is a quarter of that.

Due to lower selling prices, Shell, like other majors including Exxon, Chevron and BP, has cut back its capital expenditure, although it still plans to invest more than $30 billion (£20 billion) in 2015 alone.

Importantly, this retrenchment should give added protection to Shell’s dividend, which has never been cut, stretching right back to 1945 – probably uniquely for a UK-quoted company.

However, the BG deal is not yet done, which explains why BG’s share price has been trading below Shell’s implied offer price, even though the latter’s own share performance has been lacklustre of late.

Aside from oil and gas price weakness, regulatory issues are a potential deal-breaker. While the EU and the US are not expected to raise major objections, two other jurisdictions may well require significant concessions from Shell.

First, Brazil – very much at the heart of the synergies that Shell hopes to deliver – will closely study the ramifications of the deal. Its Administrative Council of Economic Defence (CADE) bears responsibility for doing so. CADE is bound to consider how the deal affects Brazil’s vast national oil company, Petrobras, which is currently beset by corruption allegations.

Financially, too, Petrobras has suffered from the plunge in world energy prices. However, increased participation from Shell, one of world’s oil majors, in developing new Brazilian energy resources should help to alleviate the stresses on its finances.

China is the second jurisdiction where concerns about the deal are bound to be felt: China is a large importer of LNG. Its Ministry of Commerce (Mofcom) will scrutinise the proposals and may require concessions, as it did with the controversial Glencore/Xstrata mining takeover. In that case, Mofcom’s review took a year and eventually required the disposal of a copper mine.

Assuming the deal proceeds, BG shareholders will be reasonably happy given the attractive premium being paid.

For Shell, the board argues that, by 2018, the BG acquisition will be strongly earnings-accretive. Crucially, though, this belief is predicated on a $90 per barrel oil price. If oil prices remain well below this figure, Shell’s financial case will look far less robust.

Perhaps inevitably, this merger and acquisition activity in the energy sector has given rise to other possible combinations, some involving struggling exploration and production companies in the North Sea.

Some speculation also surrounds Centrica, which has been battered by both politics and lower energy prices. While May’s clear-cut general election result has seriously reduced Centrica’s political risk, primary energy prices remain weak.

Importantly, Centrica’s eagerly-awaited strategy announcement is due very shortly.

Whether its focus moves away from exploration and production, in which it invested around £9 billion between 2007/14, remains to be seen. Similarly, its priorities could shift away from the UK and towards North America, where its Direct Energy business is set for recovery.

Undoubtedly, Centrica is in play and, like Shell, would welcome a recovery in energy prices. As for the latter, having snapped up Centrica’s former British Gas stablemate, it will be watching Opec, and especially Saudi Arabian developments, like a hawk.

Nigel Hawkins, director, Nigel ­Hawkins Associates