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‘Big Oil’ poring over troubled waters

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‘Big Oil’ poring over troubled waters

Screen Shot 2015-01-13 at 09.23.28By Mark Robinson, 17 April 2015

The severity of crude oil’s collapse meant that its effects were always likely to be felt far beyond petrol station forecourts. Reduced assumptions on future pricing convinced oil and gas majors, already given over to renewed capital discipline, to also accelerate the reduction in exploration and appraisal commitments.

The effect on valuations for oil companies and their ancillary industries has been well documented by the Investors Chronicle, but the trouble doesn’t end there. The fall-away in valuations across the wider industry has also made tertiary finance more difficult to attain for mid-tier and smaller oil companies. It also means that secondary capital issues are more expensive to complete – even for oil companies with existing production. The end result is that there are a lot of distressed energy assets up for grabs at knockdown prices.

It’s estimated that there are around £22bn in offshore assets for sale in the North Sea alone. Prolonged weak oil prices usually translate into increased consolidation in the energy industry. And when asset prices wither; scale benefits come into play. The oil majors are able to take a piecemeal approach to building their reserves and production without the inherent uncertainty linked to exploration and appraisal.

Natural gas – the strategic imperative

Royal Dutch Shell (RDSB) certainly couldn’t be accused of taking a piecemeal approach to its acquisition strategy following last week’s marquee deal to acquire UK rival BG (BG.) for £46.7bn, or 1,350p a share. Analyst comment has been mixed as to whether Shell is set to pay over the odds for BG’s assets. A 50 per cent premium to BG’s 90-day weighted average share price is none too shabby, but the one-time utility spin-off had been trading near its five-year low on near-term execution worries and political issues in Brazil and Egypt. But it pays to remember that Shell’s underlying reserve replacement ratio for last year came in at around 47 per cent, with the reported rate a lowly 26 per cent; neither rate is obviously sustainable over time.

But the primary driver of the move, which could still be subject to antitrust appeals, is Shell’s determination to gain ascendancy in the global LNG market. Shell already has major investments in Australia and Qatar and runs a fleet of around 40 LNG tankers. And last year the Anglo-Dutch giant snaffled the LNG suite of Spain’s Repsol SA for $4.1bn (£2.75bn). The pull of BG’s assets, most notably the Queensland Curtis LNG complex, sealed the deal. In three years’ time, following completion of projects under construction, the combined entity should account for around a fifth of global LNG exports.

Global oil & gas M&A versus Brent Crude

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Global prices for LNG will almost certainly soften as new production starts coming on to the markets later this year. And some analysts believe that long-term prices could be undermined by changes to the way in which LNG is contracted, coupled with the growing influence of a spot market in the commodity. But as big Asian economies edge away from coal use, natural gas is set to overtake it as the world’s secondary fuel source by the end of the decade. Shell’s bid to secure pre-eminence in the market could be vindicated by such rapid changes to the global energy mix.

ExxonMobil primed for a tilt

Of course, there’s still an outside chance that an alternative bid for BG could emerge; ExxonMobil Corp (US: XOM) has been mentioned as a possible suitor, although earlier speculation centred on the US giant making a play for BP (BP.). The majors are always running the numbers on prospective deals, even on this scale. But Exxon’s institutional shareholders might be slightly circumspect given that BP’s ultimate liability from the Gulf of Mexico spill is still uncertain. Nevertheless, BP’s shares now trade at a relatively modest 15 per cent premium to book value; it’s conceivable that someone might take account of the break-up value of the group’s assets prior to a bid.

Not all the majors are ideally placed to move into the buyers’ circle, particularly as volatile crude prices have made it difficult for buyers and sellers to come together. Chevron Corp (US: CVX) has decided to expand its asset sale programme by 50 per cent to $15bn, while curtailing new investment for the next two years. Presumably, then, the California-based driller won’t be taking Shell’s lead. But European heavyweights such as France’s Total SA (Fr: TOTF) and Norway’s Statoil ASA (Nor: STL) could certainly enter the fray. Indeed, Repsol SA led the way at the tail-end of 2014 through an $8.3bn deal to acquire Talisman Energy. Given their financial clout, national oil companies are in a highly advantageous position, a point borne out by the recent approach by Dragon Oil’s (DGO) majority shareholder, Emirates National Oil Company (ENOC), to buy out the dual-listed E&P group. Which other companies could find themselves in the crosshairs? Almost certainly those drillers whose shares have suffered hefty markdowns and have questions over their borrowing levels, but with substantial new production in the offing – Tullow Oil (TLW), Ophir Energy (OPHR) and EnQuest (ENQ) readily spring to mind, although they seem to be perennial candidates.

Rebalancing global oil markets

Aside from the potential scramble for undervalued assets, oil price volatility will continue to dominate. With relations between Washington and Tehran thawing, there is a chance that more Iranian oil – perhaps as much as 900,000 barrels a day – could find its way on to world markets next year. Given recent experience, it’s debatable whether Iran’s fellow members in Opec would be inclined to trim quotas in order to mitigate the price effects of any increase.

So it seems curious that speculators increased the net long position on the US West Texas Intermediate benchmark by 21 per cent over the last week of March, according to figures from the US Commodity Futures Trading Commission. Those betting on a near-term recovery believe that the rapid contraction of the US rig count will constrict domestic production by the third quarter. The oil bulls may have a point. The latest Baker Hughes (US: BHI) rig count reveals that increased retrenchments across Texas’s Permian Basin and Eagle Ford shale formation reduced the overall rig count by 42 to 760 in a single week – the lowest level since December 2010. And the latest productivity estimates from the US energy department predict that oil production from the seven shale regions is expected to fall by 57,000 barrels a day in May from April levels. Although US crude inventories remain swollen, a fallback in shale oil output, coupled with a seasonal increase in US refinery demand, could help to rebalance global oil markets.

Shell’s income stream secure – for now

Earlier this year, Shell’s chief executive, Ben van Beurden, said the group was “being careful not to overreact to the recent fall in oil prices”. What he meant was that management wouldn’t imperil the group’s key growth projects through an overzealous cost-cutting strategy. In light of the BG approach, the comment might seem a tad superfluous. But even with BG in tow, Shell is still committed to paring back its capital commitments by a further $15bn over the next three years. If the union ultimately delivers substantial cost synergies – a point currently generating much debate – it may help to allay fears that Shell will struggle to keep its estimable dividend record intact on an expanded shareholder base. Shell is hiving off $30bn in non-core assets to help support dividend coverage over the next few years. We doubt if Shell will be able to fund this year’s dividends internally, but we still think that the Anglo-Dutch major is a viable long-term income play. The ‘B’ shares currently change hands at 2,048p, implying 17 per cent uplift based on historic earnings multiples, and there’s a 5.8 per cent dividend yield into the bargain. We retain our buy rating.

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