Depressed oil prices have had everyone wondering when big energy players would start snapping up the smaller ones. Some of that speculation was finally put to rest this week with Royal Dutch Shell's (NYSE:RDS-A) (NYSE:RDS-B) decision to buy British natural gas producer BG Group.
The merger has already been very good news for BG investors, but what about Shell? Taylor and Tyler take opposing sides to offer a bull/bear look at the deal and whether acquisition in general and BG in particular were the right move for Shell and its shareholders.
A full transcript follows the video.
Taylor Muckerman: The big fish are finally starting to eat in the energy sector. This is Industry Focus.
We get to talk about something other than just prices moving up and down this week, Tyler.
Tyler Crowe: It is kind of nice. We've been waiting for something to happen. Everybody's been waiting. There are some rumors about mergers and maybe something's going to happen, but we actually saw something happen this week.
Royal Dutch Shell has decided to buy BG Group. It is a British natural gas producer with pretty large, expansive exploration/production all over the world.
Muckerman: They get pretty creative with their names over there in Britain, with the British Petroleum, and British Gas.
Crowe: Yes, they're really, really creative; innovative thinking when it comes to naming something.
Muckerman: Hopefully the company's more innovative than the name.
Crowe: Hopefully. What was the deal, exactly? I can't remember, $70 million?
Muckerman: $70 billion.
Muckerman: $70 billion, 50% premium to the stock price at the time, which is higher than it was back in May. It was only down about 30% until this deal was announced.
Crowe: Yes, it looks like a bit of a deal. One of the things I did like about it -- I ran over the numbers really quick before we came in here -- they basically bought the company at assets plus debt.
If you looked at the asset portfolio of BG Group, it's about $58 billion. If you add the $17 billion in debt that's owned by the company, you get about $70 billion, so they weren't really paying a premium on assets. They say you're paying a premium on equity, but if you're looking at it from an asset base ...
Muckerman: Right. That's just what the market thinks at the moment.
Crowe: Yes, it's what the market thinks, and the market thinks that everything in oil and gas is crap right now.
Crowe: Everything's looking pretty good on that end. But since it is a big deal, we need something to talk about, let's go bull versus bear on this one.
Crowe: You seem a little bit more optimistic about this one than I am, so why don't you give us a bull case on this thing.
Muckerman: Yes, my optimism, without diving too deep into the M&A side and what BG exactly owns, stems from global growth in natural gas demand and transportation, which is only really allowed internationally by liquefaction.
They're going to be, if not the biggest, one of the biggest liquefaction companies in the world. They have ships, they have a marketing arm to sell and buy liquefied natural gas. The combined entity is going to have more natural gas reserves than any major other than Exxon (NYSE:XOM).
That's what I like about this. You look at natural gas climbing rapidly, in terms of its place in the fossil fuel source, as far as energy demand is concerned. It's overtaken coal in North America. It's third to coal and oil in Asia, but it's climbing quickly.
China looks to double its energy use from natural gas from 2012 levels, just in the next five years. That's not just a small doubling. That's a very large doubling, as big as China is.
India is trying to follow the same lead; heavy, heavy user of coal for power, and as a result pollution is pretty terrible over there. Obviously, the second largest population in the world as far as the country is concerned, so the demand -- we're not talking about small numbers here.
Really, the only way that they can get it, based on their geographies... China is a little bit better off, being close to Russia, but Russia has to supply Europe as well, so there's a little bit more competition there for supply. U.S.A. is ramping up...
Crowe: Yes, the Russians haven't exactly been the best when it comes to negotiating natural gas contracts the past couple of years.
Muckerman: Not exactly!
Crowe: Having a little bit of leverage on either side of that has always been pretty helpful.
Muckerman: That's right.
Crowe: We've seen Europe do it like crazy, as of late; Lithuania building LNG facilities, Poland trying to do it, basically weaning themselves off of that Russian monopoly that they have going on over there.
Muckerman: They've certainly had it, and I think they kind of exposed themselves with the whole Ukraine fiasco, showing that this is really the only way in and out for natural gas to Europe.
I think that they maybe screwed themselves over a little bit. People started to realize that we need to diversify our gas supply, and people are starting to do that.
Shell, they diversified their asset base as far as increasing natural gas versus oil, so I think that's a better long-term play. You could go either way on how they diversified. It's geographic diversification so they're looking at Africa now, they're looking at Trinidad, they're looking at a little bit more off Australia, which they're already kind of operating in.
They've kind of spread themselves out a little bit, but they're not just opening a foray into these regions. BG already operates there, so they're not having to start fresh -- and they have better access to the Brazil offshore.
That's not really a big selling point at the moment, given what's going on in Brazil right now in their energy sector, but I think that's another long-term play with offshore oil.
Crowe: I like everything you're saying here. The idea -- the idea of the merger -- sounds great.
Crowe: I think going on this route was a good idea. But being a little bit of a stick in the mud here, I question the choice of BG Group itself as the acquisition.
Three things that make me a little bit concerned when it comes to acquiring BG: They have a deteriorating asset base, number one. They have been a capital killer, and they are a concentrated bet, like you said, on LNG; Brazil, things like that, but there's not a whole lot of overlap.
I'll just get into those things. On the declining resource base, since 2002 their total potential resources isn't just proved reserves, which we talk about, which are based on prices. We're talking everything that they have assessed, appraised, are ready to start exploring in some sort of way.
That's been down 10% in the past two years, so they have a declining asset base. They haven't been as successful in finding new resources and actually replacing them, on the whole.
Also, their resource costs themselves have been going up rather drastically. Between 2011 and 2014 their per-barrel of oil equivalent cash cost -- so we're not talking about depreciation or anything like that ...
Muckerman: Just to find it and get it out of the ground.
Crowe: Yes. In the cash realm, those costs have increased 64% in the past three years. If you look at that, you're looking at a declining asset that's getting a little bit more expensive, which can make some investors slightly concerned.
Then on that capital aspect, the company's operational cash flow hasn't covered its capital expenditures since 2008. For the past seven years, it's taken on about $15.5 billion in debt to cover its operations, as well as pay any dividend that it wants to pay in any sort of way.
We're looking at a company who has not exactly been the best operator as of late in terms of converting your operations into cash, which has been a struggle for big oil in the first place; Royal Dutch Shell especially, up until last year.
To see them take on somebody who's already negative cash flow really brings into the question that idea of, "Do I want to do this, because I'm trying to actually bring better returns to my shareholders?"
Muckerman: What it sounds like you're saying is that BG is making out like a bandit here, possibly.
Crowe: I think so, actually. I think they're doing pretty well. Then looking at... everybody wants to talk about synergies when you talk about acquisitions.
Muckerman: Yes, you want some layoffs, you want some technology...
Crowe: "We're going to save billions of dollars, yada, yada, yada."
I don't see how there's going to be a whole lot of synergies. I see it almost more like they're going to buy them and kind of chop-shop them a little bit to create those synergies because those concentrated bets that BG has, there isn't a whole lot of overlap between what Shell has done and what BG is doing.
Muckerman: You read a lot, "new exposure" is what people are saying.
Crowe: Yes, everybody says "new exposure," but new exposure means that there's not a lot of cost overlap. It's not like Shell has a partial operation in one thing and BG has it in the other.
Like you said, BG, very concentrated in offshore oil in Brazil. Petrobras (NYSE:PBR) has been a bit of a mess lately.
Muckerman: Yes, and Brazil's government. Well, I guess those would be tied together.
Crowe: Yes, Brazil has been a mess lately in regards to that. With Petrobras' control over everything that happens in Brazil, it really brings into question how lucrative that's going to be over the next couple of years, maybe even further, if things don't get squared away in there.
You've also got this very, very early -- it could be promising -- offshore gas in East Africa. BG is going really, really deep into this. It looks promising. There's a lot of gas there, but this is going to be extremely capital intensive because we're looking at a place that has zero infrastructure whatsoever, when it comes to developing natural gas. That's a lot of money.
Shell has been working on things such as floating liquefied natural gas stations.
Muckerman: Yes, they've got the big, what's it called?
Muckerman: The Prelude facility, yes.
Crowe: You have an opportunity there, but at the same time we're looking at extreme capital costs that Shell wasn't planning on doing anything previously.
Then on the LNG space like you said, this is basically the crown jewel of what Shell was buying BG group for, was LNG, so we're going to expand this.
The thing that makes me scratch my head about this, though, is that Shell had a very large interest in an Australian company, Woodside Petroleum, up until last year, who was a very large LNG player in Australia.
But then they ditched that, only to come back on with BG Group. It seems a little funky, where "I'm going to get rid of these LNG assets, but I'm going to add these," when there's very little overlap in that.
When I look at those three things I think Shell had the right idea. I just get the feeling that the execution wasn't as great as people might hope.
Muckerman: That's definitely a valid point. I don't really have an argument against that, because everything you're saying is correct.
My whole argument was that LNG is the future in terms of fossil fuels. You seem to agree. Only time is going to tell. Investors sold off what, about 5% yesterday?
Crowe: Yes, about 5%. I think they're off 1-2% today, but BG Group made a killing.
Muckerman: Yes, they're doing all right!
Crowe: They went up 40% on one day! If I was a BG Group investor, I would be celebrating, popping champagne corks right now.
Muckerman: Apparently the CEO has only been there for two months. He stands to make about $50 million off this deal.
Crowe: That sounds like a pretty good cut, right there.
Muckerman: Yes, I'm not complaining if I'm him. It'll be exciting to watch. Then you talk about all these analysts and reporters coming out and saying this is going to be a floodgate that's opened into the M&A space for energy now. Do you think we're going to see a rush of deals just because of this?
Crowe: It's so hard to predict these sorts of things. There were rumors, last month or so, that Whiting Petroleum (NYSE:WLL) was going to be for sale.
Muckerman: Yes, that was the first one to really come out.
Crowe: Then when they started getting bids on their company they said, "No, it's not worth it. You guys aren't paying us well enough so we're going to take on the debt. We'll raise a little bit of equity and we'll take care of ourselves for a little bit longer."
So there is that sort of thing going on. Yes, everything's really cheap right now, but some companies aren't going to be so willing to give up just because they're cheap.
Muckerman: Yes, they don't want to be sold cheaply.
Crowe: It's really, really hard to predict. Does it look like an opportune time for somebody like an ExxonMobil or a Shell to buy somebody? Absolutely. The question is, are the sellers ready to sell?
Muckerman: Yes. As far as Shell shareholders are concerned, they're just hoping this isn't another... was it ExxonMobil that acquired XTO Energy?
Crowe: XTO Energy, yes.
Muckerman: That shot them in the foot for a while.
Crowe: That took a couple years to recover. We'll see what happens with this one. But for now, we're going to have to just wait and see what happens next; no predictions on what's going to happen next because we have no idea, and guess what? Those analysts out there, they don't have a clue either.
Muckerman: No, they're just fighting for headline space.
Crowe: Members of The Motley Fool such as Taylor and myself may have interests in some of the stocks that we are talking about here today, so don't simply buy and sell on what you have heard on this podcast.
If you have any feedback for us, feel free to email us at IndustryFocus@Fool.com. We'd love to hear from you, and we'll talk to you next time. I'm Tyler Crowe, for Taylor Muckerman, thanks for listening!
Taylor Muckerman has no position in any stocks mentioned. Tyler Crowe has no position in any stocks mentioned. The Motley Fool owns shares of ExxonMobil. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.