Ahead of the final vote for the deal, crude oil prices have dropped significantly, presenting one last threat to the merger – by far, the biggest one of all the hurdles it has faced. Further declines in oil prices could be a deal breaker for Shell and BG.

By Mushhood Khan on Dec 28, 2015 at 6:46 am EST

Royal Dutch Shell plc (ADR) (NYSE:RDS.A), one of the largest integrated oil companies in the world, has been in pursuit of UK-based BG Group plc (OTCMKTS:BRGYY) for its valuable LNG assets and its deepwater acreage. Announced in April this year, the $70 billion deal is the biggest of its kind in the energy sector in more than a decade.

Completion of such a grand deal faces several challenges; companies might not be able to meet the conditions of merger, antitrust laws may pose legal hindrances, shareholders might vote against it, or the change in core business conditions might make the deal unviable over the course of time.

The Shell-BG deal has met all prerequisites and has also received regulatory approval, with the latest green light coming from China’s Ministry of Commerce (MOFCOM). The deal has reached the final stage where shareholders vote for or against the deal. The voting is scheduled to be held in January.

Shareholders are more likely to vote in favor of the merger as the combined group would have a competitive edge in the oil and gas sector. Mark Kelly, CEO of Olivetree Financial Group, believes the deal will complete successfully, and it would be a “huge surprise” if it doesn’t win shareholder approval.

However, things might still get rough for the two companies. Ahead of the final vote for the deal, crude oil prices have dropped significantly, presenting one last threat to the merger – by far, the biggest one of all the hurdles it has faced.

Since 2014, the Organization of the Petroleum Exporting Countries (OPEC) has been raising oil production in order to maintain global market share. The price war over sustaining market share has led to a global oil glut, which has depressed oil prices to 11-year lows. From $100 last year, oil prices collapsed to around $55 per barrel in April 2015, when Shell announced its intentions to acquire BG Group.

Shell made a multibillion dollar bet on crude oil prices to recover, and cited $70 as the price level that would make the deal work. It has all gone bottoms-up since then. Continued oversupply in oil markets saw crude oil price fall towards $34 earlier this month, which is less than half the price desired by Shell for this deal.

West Texas Intermediate crude oil futures are currently trading at $37.70 per barrel, while Brent crude oil futures are trading at $37.71 per barrel. Shell has revised down its estimates, touting $55 per barrel as the new figure that is needed for the deal. The new figure is still well above current prices, and most commodity analysts are citing the possibility that the current downturn can extend into 2016.

Michael Hsueh, a commodities analyst at Deutsche Bank, said in an interview on Bloomberg: “Oil looks oversupplied for the first quarter and actually, most of the year in 2016.” He further pointed out that coming out of the December 5th OPEC meeting, Saudi Arabia could increase production further, which represents a key uncertainty in oil markets.

Low expectations of contraction in oil supply have led many money managers to reduce their expectations of oil price levels. In a recent note, Goldman Sachs’ head of commodities research, Jeffrey Currie, said oil could fall to $20 per barrel in 2016. Citi Group anticipates WTI crude oil could fall below $20 per barrel if storage tanks are filled.

New York Mercantile Exchange (NYMEX) data shows investors are buying put options for 2016 with strike price in the $20-30 per barrel range. Their positions will return a profit if oil prices fall below the strike price. Increase in this activity indicates expectations that oil will fall below $30 per barrel in 2016.

Sustained pressure on oil price and a largely uncertain outlook has increased the downside risk in the BG deal. According to Shell, the value of the deal fell to $53 billion, as of December 18, marking a 24% decline over its initial value.

Further declines in oil prices could be a deal breaker for Shell and BG. Phillip Lawlor of Smith and Williamson Investment believes the deal could fall through if Brent crude falls to a mid-$20s range.

Shell’s shareholders, who are due to vote on January 27, would be wise to factor in the lack of visibility in oil markets when they have their say. The company needs support from 50% of its shareholders, while BG needs backing from shareholders who account for at least 75% of the total shares value.

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