The were three articles in last week's Business Guardian that referenced the proposed acquisition of British Gas by Royal Dutch Shell. The Minister of Finance was quoted as saying that while it was too early to tell, the balance of probability suggests that it would be a net positive for T&T.
There was also an article that suggested that the Shell-BG deal may negatively impact the Australian natural gas market and then the final piece from the Energy Chamber that spoke in a broader context that falling energy prices will push energy sector companies towards mergers and acquisitions in order to generate efficiencies.
This article will seek to expand on some of the points raised last week as it is a subject that is relevant to all of us in T&T and one which we will do well to understand.
Why would the Shell BG deal be positive for T&T but maybe not so for Australia?
How may we be affected if at all, by any push for synergies and cost efficiencies?
What are the risks inherent in the transaction which can negatively impact what will likely be the largest operator in T&T?
Starting at the beginning, long before this transaction was announced many of the oil majors announced spending cuts spread over varying periods. Exxon announced cuts to their exploration and production (E&P) budgets (capex) of US$4 billion. BP's cuts of US$3 billion would probably have caught the headlines but Shell itself had announced plans to cut capex by US$15 billion and Chevron a whopping US$35 billion.
Cuts in capex were coming at a time when many of the majors were struggling to replace reserves. Appreciate that shares in an E&P company is essentially a depleting asset as energy reserves are extracted and sold. Replenishment of reserves is therefore a key issue and a fundamental input into the valuation model for companies in this sector.
Both BP and Shell have faced challenges in replacing reserves in the recent past but not so Chevron. This will account for the disparity in capex spending cuts as Chevron has less of a need to engage in E&P activities especially given the uncertain energy environment. At lower oil prices it becomes more difficult to replace reserves as the cost of exploration in more remote areas may not meet the target rate of return. At some point, it becomes cheaper to acquire another company than to go out and explore for new reserves with all the inherent risks in the latter option.
This is what we are witnessing as this transaction will boost Shell's oil and gas reserves by between 25 to 28 per cent. If oil prices stay lower for longer there could be more merger and acquisition (M&A) activity. Prior to the deal with BG, the analyst community saw BP as a potential takeover target given its recent challenges. Speculation was that it would probably take a company with the balance sheet of Exxon Mobil to effect such a deal.
While purely hypothetical, the thought of such a deal should give us cause for reflection as to the speed with which our landscape can change where the two major energy players in the country can change hands resulting in a new set of dynamics. Of course, BP is of a size where it can also be an acquirer so there are many different permutations for the energy landscape going forward.
Returning to the reality of the Shell-BG deal we need to be aware that Shell is making some very aggressive assumptions in this deal. If it works out history will record it as a brilliant move. If not, then we in T&T can experience some knock on effects.
At US$70 billion, this deal is being financed in part by a US$20 billion syndicated loan. Adding leverage at a time of potentially lower- for-longer oil prices creates challenges and Shell has prioritised the repayment of debt in the post acquisition scenario.
There is also the suggestion that Shell would have paid the full price if not a premium for BG as it entails a 50 per cent premium on BG's share on the day before the announcement.
The counter to this argument is that BG's stock is down by 50 per cent since the start of the oil price decline so ostensibly Shell is betting on oil prices returning to US$90 to US$100 per barrel. A report from Bloomberg says as much in that it reports the deal is structured around oil prices at US$75 per barrel in 2017 and then US$90 through 2020.
This is not outside the realm of probable scenarios, however, if it does not materialise then asset sales will come into play in order to bring about the necessary financial flexibility that shareholders will demand.
This is where it can get tricky for T&T depending on how strategic and core our operations are to the combined and larger entity. Even with higher oil prices the company will be seeking to liquidate US$30 billion worth of assets over the next three years. Caution is the word until we in T&T have a better appreciation of the lay of the land.
It may not be well understood but prior to the announcement of the deal Shell was often seen as a defensive stock. This is because it is a big dividend payer consistent with most European stocks. The dividend yield on Shell is around six per cent and in a zero interest rate environment that is gold.
In order to maintain the same type of shareholder base going forward Shell will have to execute extremely well over the next three years and part of the plan also includes share buybacks from 2017 in order to maintain the dividend yield dynamic.
However it is not all in the company's hands. Energy is global and is strongly influenced by geopolitics so getting into a situation with little current wiggle room is reflected in the stock declining in the period post the announcement.
As Shell has stated, oil in this deal is not necessarily the core motive with liquefied natural gas (LNG) being the main driver of synergies going forward. The synergies from this deal will move Shell and BG from a current 14 per cent to 19 per cent of the LNG market in 2018 based on current demand.
It is well understood that LNG is difficult to store, difficult to transport (when compared to oil) and the market itself is not as deep or as transparent as oil. Add to the mix the potential for significant oversupply at varying times and challenges can ensue.
This is the possible scenario in Australia where both Shell and BG have huge interests in LNG projects but it is quite possible that gas can be brought on stream without an off take contract. This could result in sales on the spot market which can push prices down adding to already depressed prices.
China and Japan have been the marginal buyers of LNG over the recent past. However last week we got concrete data that suggests that China is slowing down and this is where the Australian gas would have been earmarked. The challenges of China and Japan along with the increasing strength of the US dollar, a trend that is likely to continue will create some stress for the economies of South East Asia. These are key LNG markets.
Add to the mix the fact that Russia is quickly becoming a rogue state but a rogue state with huge gas supplies. Their increasing alienation by the West pushes them into the arms of China and there is already a deal for Russia to supply China with gas, this time using the cheaper option of pipelines as opposed to having to ship on tankers.
The bottom line is that at the strategic level the deal makes sense but there are a lot of operational details that have to fall into place before the benefits of that strategy can be realised. Even then global geopolitics can put a spoke in the wheel. The Minister of Finance is therefore correct in his assessment that it is too early to tell. However given the risks involved T&T would do well to have contingency plans in place in the event that the soon to be biggest energy player in T&T no longer sees us as strategic.
Ian Narine is a broker registered with the SEC.