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Shell and BG: 1 + 1 = 5

LNG and Brazil will create immense long-term value for Shell and BG Group

Thirteenyears ago, BG Group sold its share of Kazakhstan’s Kashagan project and turned its gaze to liquefied natural gas and exploration offshore Brazil.

The wisdom of those decisions, now, seems unimpeachable. But then - even though more than 40 years had passed since the first commercial shipment of LNG, in 1959 - LNG still felt adventurous, fraught with risk because of its mighty capital requirements, elaborate and time-consuming engineering demands, and uncertain market outlook. Brazil’s Santos basin was in an even more embryonic state, its pre-salt fields still a twinkling in the eyes of geophysicists. And Kashagan, the largest oilfield in development outside the Middle East, hadn’t yet become a poster project for cost overruns and delays.

The benefits of those shrewd strategic shifts are primarily why Shell’s acquisition of BG makes such compelling sense - and why shareholders agreed to it, ignoring last-minute collywobbles about the financial soundness of the transaction. Buying at the bottom or selling at the top of the market are usually more a matter of luck than judgement; and, on paper at least, commodity-price falls since the deal was announced last April certainly make it look less favourable than it did then. Indeed, if Shell - a notable absentee from the round of mega-mergers in the 1990s that saw Exxon buy Mobil, and BP buy Amoco and Arco - had offered pure cash, the deal would be feeling dangerously brittle. In that respect, the considerable share component helps (at the time of writing the merger was valued at about $63bn, including debt - down from $70bn in April). The deal’s economics still stack up, says Wood Mackenzie, a consultancy, and are consistent with a long-term oil price of $70 a barrel.

Rising estimates for cost savings help too. At present, these amount to around $3.5bn a year by 2018. More savings will emerge over time - they always do, says Fadel Gheit, an analyst at Oppenheimer, an investment firm. Capex is being radically cut too: for now, Shell expects capital investment for the combined companies in 2016 to amount to $33bn - 45% lower than combined spending. Asset sales, estimated at about $30bn, could rise as well - helping fund a crowd-pleasing $25bn share-buyback programme between 2017 and 2020.

In any case, while low commodity prices undoubtedly cast a grim shadow over the combined balance sheet, they are only a temporary setback. As oil prices inevitably recover some of their lustre, the merger’s long-term strategic value will become increasingly plain. “With continued reduction of costs inside both companies in 2016 and market balancing now firmly on the horizon, the combined entity will be one of the key winners on the other side,” says Oswald Clint, an analyst at Bernstein, an investment research and management company.

Growth through synergy

In addition to enhanced cash flow, a turbo-boost to reserves and production, and a smorgasbord of cost-cutting possibilities, Shell gains instant access to some of the best acreage in Brazil’s emerging oil frontier. It becomes, by a large margin, the biggest private-sector producer of LNG. It enters the ExxonMobil bracket of supermajors; like its Texas-based rival, Shell’s production could amount to some 4.3m barrels of oil equivalent a day (boe/d) by 2020, says Wood Mackenzie. BG, meanwhile, gets timely financial underpinning and access to world-class technology and expertise in a range of projects - including, most significantly, deep water - while slotting neatly into a much bigger LNG portfolio. “The synergy benefits are one-plus-one equals five - not three,” says Gheit.

The united LNG portfolio has a global footprint as well as industry-leading scale. Excluding BG’s troubled Egyptian LNG assets (no longer exporting LNG because of a government-mandated diversion of gas to the domestic market), BG’s equity share of LNG capacity at plants in Australia and Trinidad and Tobago amounts to over 11m tonnes a year (t/y). That represents a significant improvement on Shell’s already considerable 25 million t/y-plus, with liquefaction assets in Qatar, Australia, Malaysia, Nigeria, Brunei, Oman, Russia, Trinidad and Tobago, and Peru. Their combined capacity dwarfs that of their nearest rival, ExxonMobil, on about 22m t/y.

Growth prospects are good too. Shell has stakes in various new Australian prospects, including its majority-owned Prelude FLNG, a 3.6m t/y floating LNG project in Australia’s Browse Basin, due on stream next year. BG’s prominent position in US facilities puts Shell in command of the nascent North American LNG-export industry. BG has marketing rights to a large chunk of the output of Cheniere Energy’s Sabine Pass LNG plant, which should start up imminently. And the nearby Lake Charles plant - from which BG is entitled to market all exports - recently got regulatory approval for 15m t/y of export capacity. Other possibilities, towards the fringes of the two portfolios, include a proposed 13m t/y plant at Kitimat, on Canada’s west coast, and BG’s Tanzania LNG project (last month, the Tanzanian government said it had finalised a land-acquisition programme for an LNG terminal, which would be fed with gas from BG-operated fields containing resources of some 16 trillion cubic feet). 

Stronger together

The combined entity, estimates Wood Mackenzie, will control sales of 53m t/y of LNG by 2020 - a very large figure in the context of present global LNG supply, of around 250m t/y. Size, though, isn’t everything. BG has built a reputation as one of the world’s most effective LNG traders, first in the Atlantic Basin and, more recently, in east Asia. Its Global Energy Marketing and Shipping team has assembled a versatile mix of liquefaction capacity and long-term off-take agreements, shipping capacity and access to regasification terminals. And it has led the way in blending stable long-term sales agreements - many signed on advantageous terms when commodity prices were healthier - with high-margin shorter-term deals. Putting the world’s biggest private LNG portfolio into the framework of BG’s logistics creates a world-class LNG operation, with plenty more scope for so-called portfolio optimisation. While large numbers of jobs will inevitably go as a result of the merger - probably 10,000, and possibly more - BG’s LNG-trading set-up should emerge pretty unscathed. 

Then there’s Brazil. Shell operates several producing fields in the Campos and holds 20% of the Santos basin’s Libra pre-salt oilfield, as well as shares in exploration blocks in the Santos and Espírito Santo basins. But its Brazilian presence has never really done justice to Shell’s size and deep-water prowess. Buying BG removes that source of frustration, fast-tracking Shell into the Santos basin’s most desirable pre-salt areas. “BG’s Brazil assets are fantastic,” says Iain Armstrong, an analyst at stockbrokerage Brewin Dolphin. “They’ve proved to be much more productive and must lower cost than we thought they would be.”

Recent growth in BG’s Brazil production, giving a gassy company an oilier tint, has been spectacular, reaching 175,000 boe/d late last year, compared with just 25,000 boe/d as recently as 2012. By 2020, Brazil will be delivering well over three times as much for the combined company - 0.61m b/d, or 13% of group production, estimates Wood Mackenzie.

Brazil isn’t risk free, of course. Low commodity prices, as in other high-cost developments, give cause for concern - especially in light of the chaos at Petrobras. Operator, by law, of pre-salt blocks, the state-controlled company is struggling to manage unwieldy debt and adverse currency movements while hamstrung by low oil prices and diminished by corruption. Doubts about its ability to manage deep-water developments and finance its share of them are widespread. So far, however, Petrobras’s drastic spending cuts have not undermined the outlook for the Santos basin pre-salt fields in which BG is an investor, and - such is their long-term importance to the Brazilian economy - are unlikely to do so. There is even a chance that Petrobras’s crisis might work to the advantage of foreign oil companies, by forcing the government to rethink its terms for pre-salt projects and delegate more responsibility to private investors.

If Brazil is one of the bright spots on a resumé that has made BG a coveted acquisition target for years, BG is not without its gremlins. For instance, Australia’s Queensland Curtis LNG (QCLNG) project - a pioneering, BG-led venture converting coal-seam gas into LNG - overshot its budget by $5bn. Egyptian LNG has been a disappointment. As a result of those and other difficulties, last year BG wrote down the value of its assets by $9bn and turned 2014 into a loss-making year.

These too should be temporary, manageable setbacks. For one thing, the merger will mask some of the sins of both companies, watering down the importance within the combined portfolio of problematic or less successful assets (such as Egypt for BG, and US shale and Nigeria for Shell). Meanwhile, much to BG’s relief, QCLNG is back on track. The two-train project is on stream and should reach plateau production in mid-2016, with its strong fundamentals still intact: much of the output has been pre-sold to China’s Cnooc and Japan’s Tokyo Gas and Chubu Electric under long-term deals; and even a modest improvement in energy prices would transform the outlook. “If oil prices were only about 30% higher than they are now, QCLNG would be generating massive amounts of cash,” says Armstrong.

That goes to the crux of the matter when assessing the value of Shell’s decision to buy BG. Energy projects - including many of the standout assets in the combined portfolio - are capital intensive and take years to develop. Viewing the value of such a large, industry-shaping merger through the prism of present oil prices gives a distorted impression of a deal that - strategically - is of immense long-term value to both partners. That value could seem much more tangible within a few months.

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