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Will China’s Ministry Of Commerce Block Shell-BG Deal?

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Jun. 4, 2015 3:15 PM ET

Will China’s Ministry Of Commerce Block Shell-BG Deal?

Summary

  • Shell-BG deal is likely to face most scrutiny in China.
  • MOFCOM is likely to approve the merger with conditions.
  • These conditions could involve both structural and behavioral remedies.

Ever since Royal Dutch Shell (NYSE:RDS.A) (NYSE:RDS.B) announced to acquire BG Group’s (OTCPK:BRGXF) natural gas assets and deep-water oil fields in a $70 billion deal, there have been concerns that the deal may be delayed, if not blocked, due to prolonged scrutiny from regulators around the world. While the deal could face potential hurdles in EU, Australia, China, and Brazil, I think it is unlikely to be blocked by any country. However, I think China is likely to raise majority of the concerns and therefore, I’m going to focus on China in this article.

The complex nature of the transaction and the increasingly forceful role that China’s main antitrust agency has been playing lately mean that the deal could take longer than expected to be approved in China. Shell recently named Huibert Vigeveno, its head of operations in China, to spearhead the company’s merger with BG Group and present the merger case to Chinese regulators.

Shell’s Strategic Rationale

Shell is the market leader in LNG trading and by initiating a takeover of BG; the company has chosen to focus on its strengths in LNG and deep water. While the deal has come at a rich valuation, it makes strategic sense for Shell and repositions the company down the cost curve. Unlike Shell’s immature asset base in the U.S., BG’s unproductive share of capital is set to drop. As I mentioned earlier Shell is the market leader in LNG trading, with BG its closest competitor. The combined company will be double the size of the next biggest player. The scale will provide Shell with flexibility, which is important for value creation.

RDS is focusing more and more on gas. The CEO, Ben Van Beurden, commenting on the shift recently said that, “his company has changed from an oil-and-gas company to a gas-and-oil company.” Shell in an effort to high-grade its asset base and to be more focused on key themes is doing a strategic review of its upstream portfolio. The company is targeting $30 billion in divestments in the next three years from areas once deemed more important. The company plans to use the proceeds from these divestments to return cash to shareholders through buybacks and dividends.

Entry into Deep Water Brazil

Shell is already part of a consortium of companies which in 2013 won a 35-year production sharing contract to develop the giant Libra pre-salt oil discovery located in the Santos Basin, offshore Brazil. Libra’s recoverable resources are estimated at between 8 to 12 billion barrels of oil. BG also provides Shell entry into deep water Brazil. BG’s capital intensive period is behind the company and it is looking at period of strong growth ahead. Shell and BG combined will have less capital intensive business, which will allow the combined company stronger cash flow generation over time.

The Potential Regulatory Hurdles

Shell expects the regulatory issues to push the deal to early 2016, but both Shell and BG do not expect any major problem. The European Commission, which is usually more sensitive to the impact of prices on consumers, is unlikely to block the deal. However, the Commission is likely to focus on the combined size of the entity post-merger and is likely to force some divestitures in areas of greatest overlap between the two companies. However, the deal could face major hurdles in China. China is the world’s largest importer of energy and has a history of opposing high profile deals. This is why I think China poses the biggest threat to the merger and is likely to raise most of the concerns.

Chinese Ministry of Commerce Has Blocked Two Deals Recently

China is a growing buyer of LNG and the Chinese Ministry of Commerce or MOFCOM, the country’s main anti-trust agency, has blocked at least two deals involving non-Chinese companies in recent years. Beijing passed anti-monopoly law in August 2008. Three Chinese ministries that have the authority to enforce the anti-monopoly law are Ministry of Commerce (responsible for reviewing mergers), National Development and Reform Commission or NDRC (responsible for price related violations), and State Administration for Industry and Commerce (responsible for violations not relating to price).

According to a Credit Suisse report (published June 2, 2015); MOFCOM has been the most active of the three and had reviewed over 600 transactions by mid-2013 out of total of 693 filing by 3Q13. However, it is important to note that out of 693 filings, the Ministry cleared 672 unconditionally and 20 were cleared with conditions and only Coca-Cola’s (NYSE:KO) bid for Huiyuan was blocked. In 2014, MOFCOM also blocked the P3 shipping joint-venture.

What Could China Demand?

China relies heavily on oil and gas imports for its economic development and it’s understandable if the country forces some remedies before it approves the merger. These remedies could include structural remedies, such as disposal of assets, or behavioral remedies, such as access to the merged entities infrastructure or termination of exclusivity contracts. China could also demand a combination of these structural and behavioral remedies.

A set of remedies that include an entire assets sale for the approval of the merger is unlikely. Chinese national oil companies have never operated an LNG project and outright sales of existing LNG assets will require their own complex approval process similar to when RDS bought the Repsol LNG business. Buying into an asset seems more likely and this may already be reflected in Shell’s divestitures target of $30 billion over the next three years.

Chinese regulators often consult with the state owned companies before making a final decision and its worth mentioning here that both Shell and BG enjoy strong relationship with Chinese state owned companies. This should help with the approval process. According to Credit Suisse, Shell supplies 12% of the firm contract supply into China. With the BG deal, this figure will rise to 42%. Both BG and Shell have been successful in marketing LNG into China.

Conclusion

The merger of Shell and BG will create a market leading position in LNG. In addition, BG’s position in Brazil also represents a quality resource base of material size to Shell. The deal makes strategic sense for both companies as the value of the combined LNG business should be greater than the sum of its parts. Size matters in LNG and the merger will allow Shell to capture higher margins through greater levels of destination flexibility. The deal could face regulatory hurdles in China, Brazil, and Australia. Especially, Chinese MOFCOM has become increasingly forceful and has rejected two merger deals involving non-Chinese companies recently.

It is understandable that the deal in its current form would worry China, which plans to double its consumption of natural gas by 2020. Any consolidation in the industry is likely to impact China’s bargaining power as a customer. Therefore, I think the deal is likely to be approved with conditions, and these could involve both structural and behavioral conditions. Especially structural remedies are likely despite Shell’s good relationship with Chinese state owned oil companies. However, till the deal is approved it is important for both Shell and BG to continue to work autonomously to improve their own operational efficiency.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.

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Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 

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