by G. Allen Brooks

In a video from the press conference following the announcement of the agreement by Royal Dutch Shell plc (RDS.B-NYSE) to purchase BG Group plc (BG.L) in a cash and stock transaction that values BG at approximately £47 ($69.2) billion, Shell CEO Ben van Beurden said, “This [the purchase of BG] isn’t a bet on oil prices.”  According to the 2014 annual report of BG, the company’s upstream output was split 36% to 64% between oil and liquids and natural gas.  It is clear from these numbers that Mr. van Beurden’s statement is correct on its face, but the BG transaction really is about oil prices!  By buying BG, Shell is signaling it believes there is a better future profit potential in natural gas than oil, despite holding to a view that oil prices will average $67 a barrel in 2016, $75 in 2017 and reach $90 by 2020.  It is possible that some would construe Shell’s oil price forecast as conservative, but the other side of the oil price equation is the question of finding costs for new oil reserves?  As Shell is about to embark on its next Arctic drilling venture this summer, it knows that the reserves it may find will be very expensive to develop.  In addition, there is the possibility that as the petroleum industry recovers from the current downturn costs to find and develop new crude oil resources may rise equally as fast, or possibly faster, than oil prices, leaving little room for profit margin expansion.  

The timing of the BG deal was interesting when considering Mr. van Beurden’s statement and the implications of the transaction, not only for Shell but for the petroleum industry as a whole.  According to Mr. van Beurden, the talks with BG’s Chairman Andrew Gould only began March 15th.  This was about five weeks after BG had brought on board an all-star exploration and production executive to lead the company’s growth strategy.  Late last year, BG announced it had hired Helge Lund, formerly the CEO of Norway’s Statoil (STO-NYSE) and an acknowledged leader in the global petroleum industry.  The terms of his employment agreement with BG created a firestorm among its shareholders who were upset at the amount of money BG was paying him to come on board.  The contract was reworked and his onboarding award was significantly reduced.  However, based on the contract, he is eligible to receive as much as £28.8 ($43) million in severance and equity payouts once the BG sale is completed.  

According to media reports, Mr. Lund did not participate in the negotiations.  The speed with which the deal came together is somewhat shocking.  It signaled that Shell was anxious to conclude the deal and therefore made a highly attractive offer, which is essentially what Mr. Gould acknowledged in his statement about the combination contained in the BG press release announcing the transaction.  In that press release, Mr. Gould’s comment was:

“This offer represents an attractive return for BG shareholders.  BG has a strong portfolio of operations including growth assets in Australia and Brazil and a highly competitive LNG business, as well as an enviable track record of exploration success.  The BG board remains confident in BG’s long-term prospects under the leadership of Helge Lund.  Shell’s offer, however, allows us to accelerate and de-risk the delivery of this value.  The structure of the offer will provide BG shareholders with an attractive premium and a substantial cash return, as well as enabling them to participate in the benefits of the combination through the share component.  For these reasons, the BG Board recommends the offer.”

Given the speed of the deal and the magnitude of the share price premium, we have a nagging concern.  We have followed Mr. Gould’s career and interacted with him over many years in our analyst role as he built Schlumberger.  During his career he was involved a number of company purchases in which he acquired key building blocks of the present Schlumberger – the world’s largest oilfield service company with the most complete product and services offering and geographic footprint in the industry.  As a shrewd buyer of companies, we wonder whether he may also be an equally shrewd seller.  Only time will provide that answer.

For Shell, purchasing BG adds significantly to the company’s natural gas business and in particular to its liquefied natural gas (LNG) business.  Shell executives point out that the purchase will add 25% to the company’s proven oil and gas reserves and will increase its production capacity by 20%, especially in the Australian LNG market and in the deepwater oil exploration and development business, primarily off the coast of Brazil.  While not named by Shell executives, we have to think that BG’s recent East African natural gas success may also have been an attraction as this is a highly prospective gas basin that has received little notoriety but that offers outstanding long-term potential, especially given its proximity to Asia and the Indian sub-continent markets.

Exhibit 3.  East Africa Is A Potentially Rich Gas Region
 
Source:  Mapofworld.com

In the BG 2014 Annual Report, the company states that it has drilled 16 consecutive successful exploration and appraisal wells in Tanzania since 2010.  BG says that these wells contain 16 trillion cubic feet of total recoverable natural gas resources, the equivalent of 2.5 billion barrels of oil.  This is a significant new potential gas supply source.  According to data from Ray Leonard and Art Berman in their paper, “The Changing World of Natural Gas 2015-2030” presented at the 6th International Gas Technology Conference in Dubai in mid-February, the Indian Ocean is the home of deepwater gas with an estimated total of 300 Tcf of gas reserves discovered to date, or about two-thirds of all the deepwater gas reserves discovered worldwide.  Of that basin’s total, approximately 130 Tcf lies in the East Africa portion of the basin and is represented by discoveries off Tanzania, Madagascar and Mozambique.  The BG reserve estimate suggests it holds about 12% of the region’s total.  

The potential importance of this gas resource is highlighted when one considers a chart from a presentation by independent LNG expert Jim Jensen to the CSIS Gas Market Study Group Session at the end of March in Washington, D.C.  His paper was titled, “The Impact of Low Oil Prices on International Gas Markets” and shows that in a $60-a-barrel Brent oil pricing environment, which equates to about $9 per million British thermal unit (Btu), LNG from a Mozambique terminal (adjacent to Tanzania) is $1 per million Btu cheaper than all the other future competitive supplies.  Moreover, if the market clearing price were based on an $80-a-barrel Brent price, the equivalent of an $11 per million Btu price for LNG, then the East African gas supply has nearly a $2 per unit cost advantage, making it the least costly natural gas supply available.  

Exhibit 4.  BG’s East Africa Gas Resources Are Attractive
 
Source:  Jensen presentation at CSIS

BG also has a dispersed oil and gas supply profile that will provide Shell with a greater range of global energy supply options, and if some of these supply sources don’t fit they could be attractive sources of cash from asset sales.  But what may be very important for Shell is the strengthening of its LNG franchise that comes with the BG deal.  As Mr. Jensen pointed out to a reporter for a news story following the announcement of the transaction, BG is an expert at buying cheap commodities and selling them for a higher price elsewhere.  He thought that may have been an additional attraction for Shell.  As Mr. Jensen said, “They have extremely good trading skills.  And that's something that they are better at than Shell is."  

Exhibit 5.  BG Provides Shell With Diverse O&G Supply 
 
Source:  BG 2014 Annual Report

BG’s ability to trade commodities better than Shell is a capability that shows up when one looks at some of the information from the 2014 BG Annual Report.  A table and chart in Exhibit 6 below from the report shows the sources of BG’s LNG cargoes and their destinations in 2013 and 2014.  Two things stand out.  First, the total number of cargoes sourced was the same in both years, but due to social unrest in Egypt, BG was only able to obtain one cargo in 2014 compared to 25 in 2013.  The company offset this supply loss by increasing its cargo purchases from Nigeria and on the spot market.  Second, there also were shifts in the markets were BG delivered its LNG cargoes as fewer went to Asia and North America while more landed in Europe and South America.  This trading skill is likely to prove of greater value in the future for the newly combined Shell enterprise as the historical regionally-linked supply and use markets break down and a truly global gas market evolves.

Exhibit 6.  BG’s Active LNG Trading Business
 
Source:  BG 2014 Annual Report

Even though Shell has a $90 a barrel future price for oil in its exploration and production price deck calculations, the recent strategy thrust of the company under CEO van Beurden suggests a path much more committed to the dynamics of natural gas, which the company believes offers greater growth along with price stability.  Anyone who has followed the flow of information about the scenarios Shell uses in its long-term strategy planning can see this focus, or bias as the case may be.  Not long ago, Shell unveiled two new scenarios for the evolution of world economies and energy markets.  The two scenarios – Mountains and Oceans were spelled out by the company on its web site.  One can also obtain detailed scenario documents that go through each scenario and its implications that Shell managers, and anyone who wants to utilize the scenarios, work through.  

Briefly, the two scenarios are as follows:

“Mountains:  The first scenario, labelled ‘mountains’, sees a strong role for government and the introduction of firm and far-reaching policy measures.  These help to develop more compact cities and transform the global transport network.  New policies unlock plentiful natural gas resources – making it the largest global energy source by the 2030s – and accelerate carbon capture and storage technology, supporting a cleaner energy system.”  

“Oceans:  The second scenario, which we call ‘oceans’, describes a more prosperous but volatile world.  Energy demand surges, due to strong economic growth.  Power is more widely distributed and governments take longer to agree on major decisions.  Market forces rather than policies shape the energy system: oil and coal remain part of the energy mix but renewable energy also grows.  By the 2070s solar becomes the world’s largest energy source.”  

By the move to purchase BG, it would seem that Shell’s senior management and its Board of Directors are tilting in favor of the Mountain scenario.  If we look at Europe and the United States, it is clear that strong government involvement in the energy sector has already made its mark and is reshaping energy supply choices.  

Under that scenario, natural gas is the clear beneficiary.  On the other hand, even the Oceans scenario, while leaving open a meaningful role for oil and coal, suggests that the share of global energy supply derived from renewable energy grows and thus opens the door for increased consumption of natural gas, too.  But a world that derives a growing share of its energy from solar has to have benefitted from significant improvements in battery technology.  

What other observations might we draw from Shell’s move to buy BG?  We think about other oil company bets on natural gas.  First was the bet by James Mulva, the then-CEO of ConocoPhillips (COP-NYSE), who bought Burlington Resources in December 2005 for $35.6 billion in cash and stock.  The deal increased ConocoPhillips’ gas reserves, excluding its Alaska holdings, by 88% and increased its gas output by 77%.  The deal was announced a week after natural gas spot prices hit a record of over $14 per thousand cubic feet.  One analyst who questioned the deal’s metrics suggested that the purchase price was the equivalent value for Burlington’s oil and gas reserves of $15 per barrel of oil equivalent (boe).  This was at a time when ConocoPhillips’ oil and gas reserves were being valued in the stock market at only $10/boe.  

The second big bet on natural gas was made by Exxon Mobil Corp.’s (XOM-NYSE) CEO Rex Tillerson when he engineered the purchase of XTO Energy for $31 billion in December 2009.  Until then, ExxonMobil had missed the gas shale revolution.  To catch up, Mr. Tillerson opted to purchase XTO for shares and established the company as an independent unit within ExxonMobil in order to exploit its success in drilling and producing U.S. gas shale resources and boost the fledgling ExxonMobil effort.  This deal occurred at the point when domestic gas prices were collapsing and shale producers were forced to shift their attention from dry gas drilling to crude oil and liquids-rich shale plays.  

Exhibit 7.  Big IOC Natural Gas Bets With Little Success
 
Source:  EIA, PPHB

Based on this history, one has to wonder whether there is a roughly five-year half-life in thinking about the future for natural gas – 2005, 2009, and 2015.  Given the timing of the ConocoPhillips and ExxonMobil purchases, we note that Shell has an advantage of buying at nearly the lowest gas price since the beginning of this century.  That should give Shell executives some comfort that there may be upside to the value of their purchase.  

What is probably more important is the LNG business infrastructure of BG.  BG has a diversified portfolio of gas supply sources, an excellent gas marketing and trading staff, and ownership or control over liquefaction, regasification and LNG shipping assets.  Offsetting these positives, however, is the fact that the global LNG market appears to be slowing in response to reduced economic activity.  Another troubling aspect of the global LNG market is that current low oil prices are pulling down the price of oil-linked LNG contracts, especially in Asia where LNG prices have been extremely high for many years.  The Asian LNG market is being disrupted not only by reduced demand, but by increased competition from cheap coal and new transcontinental gas pipelines linking the huge gas resources of Russia with the insatiable gas needs of China.  As the Leonard/Berman paper concluded, the forces at work within the global natural gas market are converging gas prices at a lower price than what has prevailed in Asia and Europe.  A converged global natural gas price will erase much of the arbitrage advantage that has driven, and mistakenly continues to drive, North American LNG export developments.  

Quite possibly, Shell’s purchase of BG isn’t a bet on oil prices, but it certainly is a bet on the development of a global natural gas market.  Shell, with BG’s reserves and LNG infrastructure, appears well positioned to help develop a global natural gas market.  Hopefully, Shell’s strategic analysis of the evolution of the gas business is right, or at least the company doesn’t have to survive years of low gas prices.  Shell’s insurance policy will be its ability to deliver cheap gas anywhere in the world.  We will be watching how the global gas market develops with great interest.