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Shell, With $70B Deal For BG Group, Becomes World LNG Giant

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Screen Shot 2015-04-08 at 08.12.04Christopher Helman

So this is how the consolidation starts. Royal Dutch Shell is making a smart move in its $70 billion acquisition of BG Group . The deal will gain Shell access to the most exciting deepwater oil projects in the world, in Brazil. While adding in BG Group’s fast-growing liquefied natural gas business will soon make Shell the undisputed world leader in LNG. The combination will set Shell on the path to unseat Exxon Mobil XOM -1.95% as the world’s biggest oil company — at least until the next big acquisition is revealed.

“We have been scanning quite a few opportunities, with BG always being at the top of the list of the prospects to combine with,” said Shell CEO Ben Van Beurden on a conference call this morning. “We have two very strong portfolios combining globally in deep water and integrated gas”.

Shell is arguably the most global of the global oil supermajors, its strengths best utilized in managing large scale megaprojects. This deal for BG’s collection of far-flung assets in Australia, East Africa, Brazil, Egypt and Tanzania reemphasizes that.

This deal is also what analysts at Tudor, Pickering & Holt describe this morning as “a conscious decision to de-emphasize U.S. shale and to stick to its strengths” in LNG and deepwater. Shell tried and failed in recent years to make a go of it in the booming shale plays of the United States, where being cheap and nimble matters. For much of the last two years Shell even lost money on its onshore U.S. business, and recently exited big acreage positions in the Eagle Ford and Haynesville. (See: “What The Hell, Shell?” for more.)

Though Shell has effectively thrown up its hands and given up on pursuing U.S. shale, with this one deal the company could solve some of its more lingering problems.

First off, it will fix its declining reserves problem by adding 4 billion barrels of proved oil and natural gas, an increase of about 25%. Bernstein Research analyst Oswald Clint pointed out in a note today that Shell had been paying the most among the majors to replace its reserves.

Second, Shell will solve its growth problem. BG is currently producing more than 600,000 barrels per day of oil and natural gas equivalents. With big LNG projects coming on line in Australia and elsewhere, and with development underway in Brazil, that output will likely grow to 800,000 bpd in 2016 and more than 1 million bpd by 2020. What’s more, much of that growth will come not from gas, but from higher-value Brazilian crude oil

Third, it gives Shell CEO Ben van Beurden a legacy in the making. He made clear on the conference call today that this deal was driven by him and BG Chairman Andrew Gould, the former CEO of Schlumberger SLB -0.28%. “I called Andrew up and we had a very good and constructive discussion about the idea and it very quickly seemed to make sense to both of us,” van Beurden said today.

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Ben van Beurden, CEO of Royal Dutch Shell, left, shakes hands with the Chairman GB group Andrew Gould during a press conference to announce Royal Dutch Shell has agreed to buy British Gas, in London, Wednesday, April 8, 2015. Royal Dutch Shell has agreed to buy British gas producer BG Group for 47 billion pounds ($69.7 billion) in cash and stock, the companies announced Wednesday. (AP Photo/Alastair Grant)

“In their minds they’ve got it all figured out,” says Dennis Cassidy, head of oil and gas consulting at AlixPartners. But although the champagne may be flowing today, “the challenge is to get all 100,000 workers to bring the synergies to life.”

If Shell can manage to sway those hearts and minds it could soon be on its way to becoming the world’s biggest publicly traded oil company. With the great shrinking of BP following its Deepwater Horizon disaster, Shell has already become the undisputed champion of European big oil. And yet Shell had been losing ground to U.S. champion Exxon Mobil. According to data from WoodMackenzie, Exxon’s total working interest volumes amounted to 4.7 million barrels per day at the end of 2014, up about 100,000 bpd in the past decade. Shell, meanwhile, is at 3.7 million bpd, down 200,000 bpd in a decade. The BG deal won’t quite enable Shell to catch Exxon yet, but it does give them excellent field position.

LNG looks to be the slam-dunk part of this deal. Shell will become the leader in global LNG, with about 32 million tons per year (MTPA) in equity liquefaction capacity, according to Bernstein analysis; Exxon will be second with about 22 MMTPA. According to WoodMackenzie, “Shell will have unrivalled flexibility and exposure to virtually every major LNG supply source and market globally, which means significant scope for portfolio optimization.”

Shell is consolidating this business as a time when the LNG market is in chaos. Historically LNG has traded off of oil prices. This was good for the producers but bad for the buyers while oil was high. But now that oil has plunged, so too have LNG prices. This has clearly eroded the economics of many LNG projects on the drawing boards. Because LNG projects take years to plan and build, a slow down in project commissioning now will dramatically decrease the likely volumes hitting the market in 10 years.

This would be bad news for big buyers like Japan and Korea and China, whose demand for gas has helped boost the LNG trade 85% in the past decade to about 240 MMTPA (or about 32 billion cubic feet per day). According to Cowen & Co., LNG now accounts for 10% of the global gas trade, up from 6% in 2003. And LNG is not done growing. Bernstein figures that demand will hit 355 MMTPA by 2020 and 440 MMTPA by 2025.

But sufficient supplies will not be there to meet that demand unless the supermajors are inspired to build them. And that means the price of LNG will have to go up. To be sure, there are massive growth projects in the works, like the $60 billion Chevron CVX -1.79%-operated Gorgon project in Australia, in which Shell also has a part. And Shell also has built the Prelude, the first-ever floating LNG liquefaction plant that at $13 billion and 600,000 tons is the biggest ship the world has ever seen. But analysts see plenty of need for additional LNG liquefaction projects.

Among BG’s giant projects is Queensland Curtis LNG in Australia — the first ever to export gas recovered from coal seams. QCLNG’s two plants will eventually total more than 8 million TPA. This project could eventually dovetail with stranded gas that Shell is sitting on at its Arrow coal-bed-methane site in Australia. BG also has a great position in U.S. LNG, with 5.5 million TPA of capacity reserved at Cheniere Energy’s LNG +0.54% nearly completed Sabine Pass export terminal. BG is also working with partners to redevelop the existing (but unused) Lake Charles LNG import facility in Louisiana as an export site. That will likely be a more cost-effective deal than the $20 billion Shell decided not to spend on a massive gas-to-liquids plant in Louisiana.

There is some execution risk here. “Shell is arguably too big already and so adding BG could create an even less efficient organisation,” wrote Tudor, Pickering analyst Anish Kapadia in a morning note. “However there is scope for considerable cost savings and synergies.” Kapadia is at least in favor of Shell’s plan to sell $30 billion in assets between 2016 and 2018.

The companies expect that closing the deal will take the rest of the year. New CEO Helge Lund, formerly CEO of Statoil , will stay on during the transition period (and get about $40 million for his trouble). Lund came on board in January, nine months after BG CEO Chris Finlayson resigned unexpectedly. Finlayson had been criticized for not doing more to spread BG’s risk around. Instead of bringing in more partners for big projects, Finlayson was in effect forcing BG to fight above its weight class, with years of big capital expenditures that outstripped cash flow from operations. In Brazil alone, BG is partnered with Petrobras on the construction of 15 so-called FPSOs, floating units which will process oil recovered from Brazil’s deepwater fields and load it into tankers.

It’s ironic then that Finlayson was onto something. BG’s big stakes in big projects is likely just what Shell was ultimately looking for. And Shell is acquiring the company at just the right point in its capex cycle. According to analysis from Credit Suisse, BG’s capex obligations are fast fading away, and next year BG would have entered into a new period of harvesting cash from investments. Shell says that the deal would be accretive to earnings per share in 2017 and strongly accretive from 2018 onwards.

Shell has offered to pay GBp383 in cash plus .4454 Shell B shares per BG share, for a valuation roughly 50% higher than BG’s 90-day average share price. Shell says it will maintain its dividend at $1.88 per share, which implies a yield of 6.2%.

Dennis Cassidy of AlixPartners previously worked on the transition teams after the Exxon/Mobil merger and the Chevron/Texaco merger. He expects this to trigger a wave of follow-on deals as other CEOs fear getting left out. This deal will be a catalyst, he says, because it shows that reasonable people in opposing parties can put aside their hopes and dreams for oil prices and come to agreement on a final valuation. If such big deals are possible in this environment, so are the myriad smaller deals being hashed out around the industry. “History would suggest people are not going to sit idly by,” Cassidy says.

So what will the next deal be? Exxon for Anadarko Petroleum APC +0.99%? BP for Genel Energy? Total for Cobalt International Energy CIE -4.09%?

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