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Demand for gas will rise by over 50% says IEA

For the past few years industry executives have been talking up natural gas. Excited by the possibilities of a hydrocarbon that is, thanks to shale, considered globally abundant, relatively clean to burn, and easy to ship, the enthusiasts have proclaimed that the 21st century will belong to the fuel.

The International Energy Agency said demand for gas will rise by more than half by 2040, a pace of consumption growth far higher than oil’s. Electrification of transport and the gasification of electricity all point to a bright future for the fuel. Shell’s “New Lens Scenarios”, a collection of slightly woolly long-term predictions, talk of the “ascent of gas”.

The company is certainly putting its money where its mouth is. Assuming Shell’s $70bn deal for BG Group goes ahead, the new amalgam will enjoy a commanding position across the world’s natural gas business, beaten only by Gazprom and National Iranian Oil Company in terms of production. In liquefied natural gas (LNG), it will be the world’s largest traded producer, with 56m tonnes a year of supply at its disposal by 2020. From Egypt to Tanzania, Sakhalin, Australia, the US Gulf and Canada’s Pacific coast, Shell will be a major player in all the main established and future LNG production centres. If gas is the future, then the 50% premium analysts say Shell is paying for BG probably makes sense.

On the oil side of the ledger things are more complex. Overall, the acquisition will increase Shell’s total reserves by 25%, to 17bn barrels, and production by 20%, to 3.7bn barrels of oil equivalent a day. In deep water, its output will leap by 107% by 2026, says Bernstein, a research firm. In Brazil, the new firm will produce 550,000 b/d by 2020, more than 10 times Shell’s output in the country last year. Those are big numbers, which should encourage Shell’s shareholders to think the deal can bring them value. After years of underperformance in the upstream, Shell has fixed its reserves replacement problem. BG gives it volume where its own efforts have fallen short. 

But the deal says something about the industry’s productivity, too. When it is cheaper to buy reserves from rivals than it is to find more oil, things have gone awry. Some will say this is a healthy part of the everlasting oil market cycle. Price falls always prompt takeovers. And the latest bout of merger and acquisition (M&A) activity will simply consolidate the field, kill off the weaker players, and leave fewer buyers competing for services, forcing down costs. The sector will shrink as the redundancies grow. This should be deflationary for many inputs. Take just the Shell-BG deal. Engineers working for Shell will think twice before asking the boss for that pay rise now that a slew of rivals from BG will soon be arriving to compete for desk space. Many analysts like the deal because of its cost-cutting potential.
 
But just because all this is part of the cycle doesn’t mean it is healthy. Oil is the global economy’s lifeblood, not just some other commodity. Whatever the appearance of supply abundance now, demand growth in the next 20 years means the world needs a lot more oil to be found and produced. To do so means companies must keep investing in the upstream, even while they’re in the grip of low price despondency. It will be no surprise to Big Oil’s opponents to discover that what is good for Shell and its shareholders now — acquiring new reserves relatively cheaply while killing off a rival’s supply — will do nothing for the wider good. The 25% addition to Shell’s reserves adds a big fat zero to the global resource base.

As a one-off, the deal will hardly devastate global oil supply prospects. But if — as many predict — Shell and BG have simply kick-started another round of M&A activity then things could get rough for anyone working in or relying on the sector. The merger mania of the late 1990s hardly left the industry in good shape. It was a crazy few years, as BP’s takeover of Amoco and Arco was swiftly followed by Exxon’s purchase of Mobil, Total’s acquisition of Petrofina and Elf Aquitaine, Chevron’s deal with Texaco, and eventually the merger of Conoco and Phillips. Thousands of people lost their jobs and an entire generation of scientists was deterred from going to work for energy companies.

It’s hard to conclude that big deal-making always creates value. Some BP insiders trace the Texas City and Macondo disasters back to the cost-cutting and redundancies that followed the Amoco and Arco deals. (BP’s blunders since then have been so severe that it is probably safe from takeover.) For every $74bn Exxon-Mobil merger — deemed one of the more successful deals in the industry’s history — there is an overpriced $41bn ExxonMobil-XTO deal. 

Above all, the M&A activity of the 1990s represented a period when oil companies lost their enthusiasm for oil. Some wanted to go beyond petroleum altogether. It was a strategic blunder that left the companies and their consumers exposed when the great price surge got under way just a few years later.

By making gas its priority, Shell risks doing the same now. Gas will undoubtedly grow in global importance, perhaps even eventually threatening oil’s share of the transportation market. But not soon. Given the sheer abundance of gas and LNG supply, a recovery in global oil prices looks a safer bet than a surge in natural gas markets. Indeed, it is ironic that just as Shell makes its statement of gassy intent, the deal itself depends on the oil market. To be accretive, the transaction needs oil to trade by 2018 at more than $90 a barrel (/b). That’s an 80% premium above the long-term inflation adjusted historical price of $50/b – and in any other industry, that would look like an exceptional return for your product.

If Shell and other investors believe the oil market is going to regain that kind of strength, they should will need to do more than just buy reserves. Gas may be the future, but unless the majors keep looking for oil, they will make the same mistakes made the last time they started buying one another.

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