Why Royal Dutch Shell Probably Regrets its $70 billion BG Group Acquisition

Last week, SandRidge Energy Inc., Linn Energy (LINEQ), and Breitburn Energy all filed for bankruptcy.

On this episode of Industry Focus: Energy, Sean O'Reilly and Taylor Muckerman explain what led to all three of the companies going under and where they might go from here. Also, they talk about the alarming wildfires that have spread through Canada recently and how they're affecting oil production; why Royal Dutch Shell (RDS.A) (RDS.B) is thinking about spinning off $40 billion worth of assets; and a few things that investors thinking about dipping their toes into the oil and petroleum space now need to know.

A full transcript follows the video.

This podcast was recorded on May 18, 2016. 

Sean O'Reilly: Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. Today is Thursday, May 19th, so we're talking about energy and industrials. I'm joined by Motley Fool analyst Taylor Muckerman, and we're going to be talking about a possible Royal Dutch Shell spinoff and scores of energy bankruptcies. First, Taylor, why are Canadian wildfires actually effecting oil production?

Taylor Muckerman: There's a lot of oil production in Canada, shockingly enough. These fires closing in on over 700,000 acres of destruction. A lot of homes destroyed. Businesses destroyed. Families displaced. Originally, you didn't see much oil destruction, but this has been going on since the beginning of the month and now they're looking at 1.2 million barrels a day of production taken offline.

O'Reilly: Wow!

Muckerman: Which is...

O'Reilly: That's a lot.

Muckerman: That's a lot.

O'Reilly: The U.S. consumes 15 or 16 so I mean.

Muckerman: Yes. That's basically the overhang that the world was seeing taken offline just like that. When you see these oil prices climbing as they have been the last couple of weeks, it might not necessarily be an honest representation of what's going on in the market.

O'Reilly: Right.

Muckerman: Because you got not only these wildfires knocking 1.2 million barrels a day of Canadian oil offline, but Nigeria's got about a half a million barrels a day of disruption right now. Venezuela is losing production. You're seeing some one-off instances here where these productions is going to come back online. Canada thought it was going to bring back a million barrels of oil sands oil back online, but the fires have reversed course back toward the oil field so nothing is necessarily in danger, but they've shut down the production and a lot of people have been evacuated. Suncor have evacuated 8,000 more folks earlier this week.

O'Reilly: Is this like throwing people on helicopters?

Muckerman: I'm not sure how they're getting out but...

O'Reilly: That's a lot of people.

Muckerman: They're keeping some mandatory personnel there just to make sure that the fire prevention mechanisms that are in place at these production plants, and with Enbridge (ENB -1.21%) at their oil terminal facility, which is one of the largest in the area. The fire reversed course. I believe that I saw within one kilometer of Enbridge's, the Cheecham oil sands terminal. It's a big deal. They say the oil is still running through the pipelines but they have a limited amount of personnel on site.

O'Reilly: Wow.

Muckerman: Yeah. Big deal.

O'Reilly: Good time for a low-cost Canadian vacation?

Muckerman: Yeah. I guess if you... No. Airlines are actually doing the right thing and they were actually offering free airline travel to families that were having to be evacuated from their homes.

O'Reilly: Wow. As they should.

Muckerman: Absolutely.

O'Reilly: Do you, really quick before I move on, oil early this year touched down at $27 a barrel. Now it's in the high 40s. It was interesting me given that we have this 1, 2, 2.5 million barrel oversupply. That wasn't pricing in at anything like this. Everybody the whole time over the last year was like, "This is not pricing in any kind of disruption at all." I guess in a minor way the chickens are kind of coming home to roost.

Muckerman: When the oil prices were above $100 in 2013, 2012, you saw a lot of Middle East disruption and nothing really happened to oil prices, because there was so much oil being produced. People were just giddy with how much was going on. Whenever you see oil prices react to things like this, you can maybe see that things are starting to normalize.

O'Reilly: OK.

Muckerman: Yeah. It's tough to see something like this coming. 700,000 acres destroyed from a wildfire.

O'Reilly: Yeah.

Muckerman: It's pretty crazy.

O'Reilly: Cannot predict that.

Muckerman: No.

O'Reilly: Moving on to our larger story actually in terms of just investing takeaways, Royal Dutch Shell bought British Gas, as you, me, and Tyler Crowe talked about multiple times, for $70 billion. Mostly a natural gas producer. It kind of shifted Royal Dutch Shell's product mix and everything.

Muckerman: Yeah, they had a lot of offshore operations.

O'Reilly: Now they're talking about spinning off $40 billion in assets.

Muckerman: Yeah. Almost a reversal of course if you look at $40 billion versus the $70 billion?

O'Reilly: Did you kind of roll your eyes and shrug at this like I did.

Muckerman: It was a chuckle. It wasn't a shrug. It was more of a chuckle.

O'Reilly: They're just complaining about the balance sheet. They've just got too much debt now.

Muckerman: Which they do. You've seen it go from $43.8 billion first quarter...

O'Reilly: In total liabilities.

Muckerman: Yes, in debt from the first quarter of 2015 to now around $81 billion in the first quarter of 2016.

O'Reilly: So it doubled.

Muckerman: Yes, and cash flow is not doing the same. It's going in reverse order. They're losing cash flow. They're picking up debt. They're trying to figure things out. They've been talking about trying to sell some assets but we've seen Halliburton. They tried to sell some assets to merge with Baker Hughes and it's just not the right time. If you're a struggling small producer or something, there's a chance you're going to get bought out, because we're talking about $40 billion and that's a big acquisition for anybody.

O'Reilly: Right. That's what they're debating. They're like, "We're either going to sell these things or we actually might even be willing to spin these off into a baby Shell in an IPO." Is there a precedent for that?

Muckerman: They've done it before. I can't remember. It was in the last few years.

O'Reilly: They spun off their mid-stream assets.

Muckerman: Right. It was much smaller than this so they've done it but I don't know if it's something they're necessarily... That's probably not their type A, that's not their choice. That's not their number one option but if it needs to happen, I've seen one suggestion that it could happen within 12 months.

O'Reilly: Wow. This even reminded me of you know like, "We're not doing this or we've got too much debt or something." Do you remember when the oil downturn first started and Whiting Petroleum was like, "We're going to put ourselves up for sale." Nobody...

Muckerman: Yeah. They tried several times. Yeah. They were like begging to be bought. Maybe that was them realizing what was to come? Who knows?

O'Reilly: Right.

Muckerman: Maybe they had a better crystal ball than everybody else.

O'Reilly: Yeah.

Muckerman: I haven't actually followed up with them.

O'Reilly: Their stock is down. They're hanging out. Maybe it's a buy now. I don't know.

Muckerman: Maybe Shell will buy them once they spin off $40 billion worth of assets.

O'Reilly: The other little side note to the announcement that Shell made was they're talking about throwing... Their capex budget this year is like $1.7 billion or something and they're planning on putting a chunk of that into alternative energy investments. They did not give any specifics other than the name which is New Energies. Think they're going to buy solar something? I don't know.

Muckerman: That's not a lot of money on a global scale for renewable energy so maybe it's just a small bet. I don't think. Not a public U.S. traded solar company. No.

O'Reilly: Yeah. No way. Cool. Moving on. We got a bunch of news lately and it's probably been a long time coming but... bankruptcies.

Muckerman: The bankruptcy court is doing a lot of work these days.

O'Reilly: They've been busy.

Muckerman: They're making some money.

O'Reilly: They've been busy. Who was first? Was it SandRidge or Ultra?

Muckerman: Ultra Petroleum was, I believe, maybe a couple of weeks ago.

O'Reilly: OK.

Muckerman: I don't remember the exact date but that was a really big company several years ago. Mostly east coast operations, natural gas predominantly. Despite the name "petroleum", it was mostly natural gas.

O'Reilly: Were they just a high cost producer or did they just fly too close to the sun and take on a bunch of debt and now they're doomed or what?

Muckerman: They were bought of that early land grab that Chesapeake (CHKA.Q) and SandRidge in the early 2000s. They all...

O'Reilly: I cannot believe Chesapeake is hanging out by the way.

Muckerman: Yeah. They're doing a lot better than what most people would've expected.

O'Reilly: Do you think that's because they just have so much stuff that they have more wiggle room? Kind of like too big to fail, kind of a "we can sell this little thing that we don't care about?"

Muckerman: They are very diversified. You got that right, and they have done some sales and I think some of their creditors have been a little more lenient with them. Maybe doing some restructuring of individual. Not a bankruptcy-style restructuring. They've gotten not hand-outs but something along the lines of, "Hey, we're going to give you a little bit longer leash if you can sell some things," which they've been able to successfully do so a lot better situation than I probably would've expected two years into this.

O'Reilly: Why do you think Chesapeake has been so successful selling things but Shell, we're like sitting here giggling about them selling some of these assets. Like, "Haha, yeah right."

Muckerman: I think just the sheer size of what Shell would need to sell and Chesapeake, to his credit Aubrey McClendon, he knew where and what to buy. Maybe not when, but knew where and what to buy so they had some good assets.

O'Reilly: Right. OK. A lot of reserves, low-cost reserves.

Muckerman: They're in natural gas, oil. They had a lot of it and so they're able to kind of pick and choose not only... They weren't just going to sell out of an entire region. They could kind of pick and choose around the United States what they wanted to shed and they've been able to raise cash as a result.

O'Reilly: Got it. Then came... Was it SandRidge then Linn? SandRidge was next.

Muckerman: No. I think it was Linn. SandRidge I feel like just reported. SandRidge was the latest.

O'Reilly: OK. Linn, they even at the end of last year, they had a negative equity value on the balance sheet. I was looking at their production costs a couple of weeks ago and I was like they just took on too much debt, man.

Muckerman: They were one of the first production MLPs. They had to just keep on taking on debt in order to continue driving that distribution higher because that's what everyone was investing in them for was distribution growth because the shares weren't going anywhere. They had to keep drilling in order to produce that cash flow to service the debt and the distribution. It was a snowball. They got out way ahead of themselves.

O'Reilly: Yeah, it's a sad thing because what distinguished them from the other MLP that we're going to mention in a minute, Breitburn, was they actually kind of went out and found the oil as opposed to Breitburn which just bought slightly declined wells from other players and just milked it for cash.

Muckerman: Which, you know, arguably maybe that was the wrong move because producing it, drilling, finding it, all that is more costly than you see a lot of these enhanced oil recovery techniques where if that's all you're doing you can kind of specialize in that, whereas if you're going out exploring and producing, there's added cost and there's potentially greater mistakes.

O'Reilly: Do you, in your opinion, is that why Denbury, is holding up OK? They just go in there and throw some carbon dioxide into the ground.

Muckerman: Enhanced water floating, carbon dioxide, they refract these wells with a greater degree of sand and pressure. If that's your specialty, and Devon Energy's very good at enhanced oil recovery so if you can go back in, they're leaving a lot of oil in the ground and not just one or two companies but everybody is leaving a lot of oil in the ground. If you can figure out how to go extract it and avoid the cost and time to drill, then you're eliminating a lot of cost out of your overhead.

O'Reilly: Were you surprised when Breitburn which declared on Monday -- I mean this is... Body's not even cold.

Muckerman: We don't want them to get cold.

O'Reilly: We don't want them to get cold. What they want, somebody else is going to get these assets. They're still producing. They took out $75 million in debt earn possession financing. The wells are going to still keep going.

Muckerman: Yes. SandRidge, they're going to be able to produce through this restructuring. They're going to concentrate on Oklahoma and Colorado projects. They don't plan on laying anybody off. Breitburn -- I don't know about layoffs in their case but yeah -- they plan operating right through this refinancing.

O'Reilly: It was just so surprising to me because you look at the balance sheets of these guys at the end of last year and they just declare so they didn't really bother putting out quarterly reports, Breitburn has $4.9 billion in assets and $3.5 billion in liabilities so that leaves $1.4 billion in equity as of December 31st which was just five months ago. Linn was up there. They had $10 billion in assets and $10.25 billion in liabilities. It wasn't... I've seen worse.

Muckerman: That was the largest... Linn was the largest bankruptcy since the oil downturn started.

O'Reilly: Since Thanksgiving.

Muckerman: Since 2015 essentially.

O'Reilly: Wow. I'm kind of surprised. I don't know if Breitburn's cash flow was just so bad or what. I was just surprised from just a balance sheet perspective that they declared.

Muckerman: As an energy producer, cash flow is the life blood.

O'Reilly: It's the name of the game.

Muckerman: Yeah. I think if oil prices hadn't been... If they had still be in the $25, $35 range, I don't know if creditors would have been as friendly as they've been with these companies because maybe they have a little bit of faith if they just give them a little bit more time oil could come back to $50 or to $60.

O'Reilly: You think we'd be having this bankruptcy conversation about these names months ago had oil not come back a little bit?

Muckerman: Yeah. We've seen this these bankruptcies take place but I don't know if they would have the restructuring capabilities.

O'Reilly: Oh, I see.

Muckerman: They could've waited this long to go bankrupt but I don't know if they would've been able to operate through the bankruptcy restructuring because I don't know if creditors would've given them not necessarily a leash but they wouldn't have just given them the needle and said, "Sorry, we're putting you down."

O'Reilly: Yeah. What do you think dragged down SandRidge?

Muckerman: SandRidge, again, not enough cash flow or race to produce. This has been a long time coming. These shares were $80 a share in 2008 and they're like $0.02 now.

O'Reilly: Yeah.

Muckerman: If you look at the chart even since 2012, it's just a steady decline until 2014 and it's a much steeper, steeper [...]

O'Reilly: Which is really, yeah.

Muckerman: To pinpoint one exact thing of why it's going bankrupt, that's a little tough. I think it was happening slowly and then it happened quickly.

O'Reilly: The key takeaway that's slightly more positive is, that I seem to be getting here -- correct me if I'm wrong -- investors looking to kind of get dip a toe back into the oil game. It's come back a little bit.

Muckerman: Yeah.

O'Reilly: Oil prices are about to give $50 a high five which...

Muckerman: It's almost 80% up since the $25 range.

O'Reilly: Yeah. Seems to me like these names that have stuck around like the Devon, Denbury and stuff, it seems like the guys that have waited this out, that can go in there and specialize and make strong use of these assets are a decent way to go.

Muckerman: That's true but they've also moved quite a bit since February in terms of price appreciation. Don't get ahead of yourself because the markets might have. If you want to dip in a little bit, like you said, dip in is probably the best way to go right now, because who's to say that these oil prices aren't going to fall right back once Canada brings 1.2 million more barrels on a day, back to what they were originally producing before these fires started in early May. We're looking at some potential oversupply again in the very near future.

O'Reilly: Are there any subsectors that you like right now before we head out?

Muckerman: Subsectors.

O'Reilly: Like pipelines or something. You know.

Muckerman: I would stick with the pipelines. Not necessarily because I'm in love with them, but if you want to invest in energy, the bigger pipelines that dealing in natural gas because it's cheap, but we continue to use it. The pipelines are full. Demand for natural gas isn't expected to decline like the demand for oil. I like the pipelines. Probably stay away from any producers under a certain market cap. You're looking at the big guys that can weather anything. I would also steer away of shares that have popped significantly.

O'Reilly: Got it. Cool. Thanks for your thoughts, Taylor.

Muckerman: I appreciate it.

O'Reilly: Have a good one! That is it for us, folks. If you're a loyal listener and have questions or comments, we would love to hear from you. Just email us at [email protected]. Once again, that is [email protected]. As always, people on this program may have interest in the stocks that they talk about and The Motley Fool may have formal recommendations for or against those stocks, so don't buy or sell anything based solely on what you hear on this program. For Taylor Muckerman, I am Sean O'Reilly. Thanks for listening and Fool on!