The rumours that surfaced earlier this week that Shell might be taking a closer look at BP are not that ridiculous and in the current climate of lower oil prices and falling profits they actually make perfect sense. The first reason is that BP looks like a sitting duck.
THE TELEGRAPH
Why Shell could buy BP for just £5 a share
One of Britain’s largest and oldest oil companies BP could be about to be sold for just £5 per share
One of Britain’s oldest oil companies BP could be about to be sold to its biggest rival for a fiver per share.
The rumoured deal, if realised, would complete one of the most ignominious falls for the once great Persian Oil company that powered Britain’s Navy to victory during the First World War.
BP is now a sitting duck after the Gulf of Mexico disaster, Russian sanctions and the falling oil price combined to drive down the share price to £4.25. Analysts estimate the deal could be done if rival Shell offers a 16pc premium to that price, or about £5, to seal one of the biggest corporate takeovers in the history of the oil industry.
The rumours that surfaced earlier this week that Shell might be taking a closer look at BP are not that ridiculous and in the current climate of lower oil prices and falling profits they actually make perfect sense.
The first reason is that BP looks like a sitting duck. The oil major has been drifting ever since the Gulf of Mexico disaster trashed its share price and its reputation. Its share price, at 425p, is still 35pc below the 650p level just before the deep sea oil rig blowout. BP’s reputation in the US is still in tatters despite the company once again being allowed to bid on US exploration licenses from March this year.
BP also has problems at its Russian assets. BP relied on Rosneft for almost a fifth of its underlying profits in the first half of this year, so both dividends and profits are almost guaranteed to fall sharply next year as sanctions against Russia bite. There could be worse in store after the Russian government passed a resolution for the partial privatization of 19.5pc of Rosneft.
Furthermore, its position in the Russian oil sector seems do have demonstrably weakened under Bob Dudley, chief executive, who was hailed as a Russia expert.
The company has gone from being co-owner of a Russian oil company which would allow it greater control over assets to being merely a shareholder in a Russian state owned oil company. Sure, BP received $55bn from exiting the TNK-BP venture last year. However, the company’s position is now far weaker; by taking the cash plus a 20pc stake in Rosneft it went from being the co-owner of a company with the ability to withdraw regular cash flow, to a mere shareholder reliant on the success of Rosneft to receive dividend income. Although BP received its annual dividend from Rosneft, worth just under $700m, in July, Rosneft is now in the eye of the Russian sanction storm.
When you throw the falling price of oil into the mix BP shares look destined to be getting closer to 400p a long time before they get back up to 500p.
The next question is whether BP management would be open to an offer. Usually being subject to a takeover brings out a Churchillian defense in all management teams, but there are a reasons why this is not necessarily the case at BP. Bob Dudley, chief executive, has endured four bruising years at the top of BP after succeeding Tony Hayward who resigned in the wake of the Gulf of Mexico disaster. The management team could leave on a high having completed one of the biggest mergers in corporate history, and they would be well paid for agreeing the deal. The alternative is facing the shares falling below 400p next year and humiliating problems from the stake in Rosneft.
Would investors be open to an offer? BP is no longer the dividend machine it once was with annual payments of 39c (24.5p) still more than 30pc below the 56c (35.8p) paid out in 2009. Investors offered 500p or more would probably bite the hand off anyone offering that cash given the shares are currently drifting towards 400p. They would also be offered safer income by holding Shell shares in the future.
The trickier question to answer is why Shell would want to buy BP. BP is a company with many problems. But the first clue is around timing, with oil prices hovering above $70 per barrel, Numis analyst Sanjeev Bahl thinks it is time to buy: “We haven’t seen an opportunity like this since 2009.”
With BP’s specific problems dragging down the shares, opportunities such as this only come along once in a generation, and everything has a price. Shell merely has to balance the amount of money it can save from combining the two companies, with the potential future costs from Gulf of Mexico damages and lost earnings from Rosneft.
One thing that looks certain is that Shell could save billions from reducing the cost of borrowing for BP. Shell’s credit rating is about four or five notches higher than BP depending on which agency you look at. When that debt comes due, Shell could agree lower interest rates because it is considered less risky by the market. Small movements in interest rates matter when you have $22.4bn in net debt as BP did at the end of September.
Shell management would also be keen on the deal as they are running out of other ideas. The Arctic exploration programme literally hit the rocks after the Kulluk rig ran aground in 2012 and couldn’t be repaired. Shell decided to slash its spending on exploration in 2014 and it looks set to fall going into 2015 as well.
Another sign that management have nothing better to do with the cash is that they are increasing returns to investors. Share buyback schemes are now in place and the dividend is well supported, and while investors might like this in the short term they would prefer Shell was investing in the business at a decent rate of return rather than just paying out cash.
In a glimpse of how supportive investors might be if a deal was announced Shell shares jumped 1.6pc higher when the rumour about BP was doing the rounds.
Can Shell afford to buy BP? It looks like Shell is certainly close enough to make the deal doable. BP had 18.24bn shares in issue trading at 433.8p giving the company a market value of £79.1bn or ($125bn). The magic number for a deal would probably be around 500p, a 16pc premium to today’s price, valuing BP at £91.2bn ($146bn).
Shell reported $19bn in cash in its most recent results and had unused borrowing facilities of about $42.5bn at the end of 2013. Assuming it cancels the share buyback that would free up another $4bn a year in cash. The combined group would also be able to support more debt which could be paid down with the strong cash generation, so we could add another $20bn as an estimate. That leaves $60.5bn, or £37.8bn, which means asking Shell investors for a roughly one-in-four rights issue to create the largest UK oil company.
The timing for Shell is also important, the shares are still worth about £22 and it would be better to complete a deal now while Shell paper is close to record highs of £24 and before lower oil prices really bite next year.
In January, Shell issued a shock quarterly profit warning and weeks later posted a 33pc fall in annual pre-tax income from $50.5bn the year before to $33.6bn in 2013. In April, BP followed suit, reporting a similar drop in profits for 2013 and the first quarter of 2014.
Don’t underestimate other factors moving behind the scenes. This would be one of the biggest deals in UK corporate history, enriching the bankers and advisors working on both sides. In a climate where deals are becoming few and far between the City not only wants this deal, it needs it as well.
There would undoubtedly be regulatory hurdles of creating such a large UK-listed global oil major and it seems almost certain to attract the attention of competition authorities. But selling BP to Shell is preferable to it being sold to Qatar or another foreign sovereign wealth fund. The enlarged company would still only account for around 6pc of global oil production, and be less than half the size of US giant Exxon Mobil. Regulatory hurdles can be managed through selling off assets and working with governments to protect jobs.
It is rare that all the stars align with two corporates as big and with such history as BP and Shell, founded in 1908 and 1907 respectively, but it looks as though one of these groups is dangerously close to becoming just another chapter in the history of big oil.
By John Donovan
