BG's Fall Teaches Golden Rule

LONDON -- It was BG Group's (LSE: BG.L  ) turn to shock the market last week in what is turning out to be something of a year of profit warnings for FTSE 100 investors.

Its shares have dropped 17% after the group warned of production delays. Production this year will be up just 3%, and growth will be flat in 2013 against prior expectations of 5% to 6% growth year on year.

Is this the end of the City's love affair with BG, or does it present an entry point for new investors? And what does it teach us about oil and gas investment? Well, namely that diversification is important.

Riding for a fall
To some extent, BG has been riding for a fall. Just a month ago I pointed out worries over its exposure to Brazilian offshore fields, where it is dependent on the operator, state-owned Petrobras. The company has been a victim of its own exploration successes and has shed downstream assets in order to focus investment on developing its discoveries. That has concentrated risk as the challenge turns to getting these fields into production.

In the event, Brazil was only one of the regions where project delays have caused it to scale back production forecasts. It has also suffered from shutdowns and delays in the North Sea and setbacks in Egypt. And like the rest of the industry, it is scaling back U.S. natural-gas production because of the shale gas glut.

Stock price pummeled
The market's reaction was savage, knocking a fifth off the company's value, and it is worth taking some time to consider why this was.

Firstly, BG was highly rated, trading on a historic price-to-earnings ratio of around 14 before the profit warning compared to eight for Shell (LSE: RDSB.L  ) and six for BP (LSE: BP.L  ) . A higher rating depends on expectations of faster profit growth.

Secondly, the communication was bungled. The bad news was slipped into the presentation of third-quarter results, which themselves were delivered a day early to coincide with news that BG had sold a share of its Australian liquid-natural-gas project to Chinese state oil company CNOOC. That deal, which makes BG the largest LNG provider to China, was good news, although some analysts questioned the price.

CEO Sir Frank Chapman, who has overseen a fivefold increase in the share price over the past 12 years and who is due to step down next year, perhaps gave the impression he could take investors for granted. Analysts' reaction was to divine a trend of missed targets.

BG's finance director has unfortunately been absent with illness, which might partly explain the poor communication with the City.

Cash is king
Thirdly, BG could do with the cash. It generated $8.5 billion of cash in the first nine months of this year but is spending it at nearly the same rate on capital investment. There is no immediate risk: Finance costs are low, and the debt has long maturity. What's more, the company is on track to raise $7.6 billion through asset disposals. Nevertheless, the deceleration of cash generation puts some pressure on BG's finances, and Moody's has revised its ratings outlook to negative.

Finally, and to my mind most importantly, the setbacks illustrate the risk concentration. Though its LNG shipping and marketing business contributes a third of operating profit, much of BG's business is focused on inherently risky exploration and production.

Upside
That downside risk goes with a great upside, provided there are no major mishaps. The bull argument is that production has only been delayed and the shares will recover once it gets back on track. Certainly, with the stock at its lowest level since September 2010, it offers an entry point for investors who buy into the long-term investment case.

Disillusionment with management, a change of CEO next year, and risk concentration also make the case for BG as a takeover target. Nomura calculates BG's net assets are worth 20 pounds a share -- nearly double the current price.

What this does show is the need for diversification in oil and gas investment. And investors must do it themselves. The FTSE 100 offers a choice of Shell, which is cheap and has geographically diversified upstream and downstream businesses; BP, which has substantially reduced its Russian risk; and Tullow Oil, with a geographically different risk profile. You can learn more about building a low-risk oil and gas portfolio in this free report from the Motley Fool: "How to Unearth Great Oil and Gas Shares." You can download it by clicking here.

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Tony owns shares in BG and Shell but no other shares mentioned in this article. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.


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