Is Shell's acquisition of BP meaningful?

European oil giants set their sights on ExxonMobil and Chevron, is a petroleum behemoth about to be born?

For a long time, speculation about a merger between BP and Shell has never ceased, and it is even considered "inevitable." Recently, Bloomberg reported again that Shell is exploring the possibility of acquiring its rival British Petroleum (BP). If this potential super merger is successfully realized, it will create a European oil giant capable of challenging ExxonMobil and Chevron.

According to analysis from UBS Group, the merged company’s daily crude oil and natural gas production would reach nearly 5 million barrels of oil equivalent, an 85% increase from Shell's current daily production of about 2.7 million barrels. This would make the merged entity the largest oil and gas producer in the world, surpassing ExxonMobil's first-quarter production of 4.6 million barrels and Chevron's 3.4 million barrels per day.

Continuing dominance in the natural gas sector, commodity trading business expected to expand

Royal Bank of Canada (RBC) analysis indicates that Shell is already the world's largest liquefied natural gas (LNG) seller, and acquiring BP would propel its business "to new heights," with the merged company's annual LNG sales expected to soar to over 90 million tons, accounting for more than 20% of the current global market.

The analysis also pointed out that acquiring BP's Denver-based U.S. shale oil business (BPX) would compensate for Shell's strategic misstep in 2021 when it sold its Permian Basin assets to ConocoPhillips just before the shale oil boom.

It is reported that BP and Shell are already the world's largest commodity traders, with numerous physical assets such as refineries and pipelines providing them with valuable market insights.

Although these business segments are relatively opaque, both companies have revealed some value clues. Over the past five years, BP's traders have contributed about a 4% increase to the company's capital return on average. Shell's traders have made similar contributions over the past decade, ranging from 2% to 4%.

After the merger, the commodity trading business is expected to expand further. However, RBC noted that it remains unclear whether the merger could enhance these return rates:

"Given that Shell already has its own trading organization, is it willing to pay a premium for BP's trading organization?"

Acquisition deal may face multiple obstacles

One major challenge facing the deal is BP's balance sheet.

According to UBS, as of the end of the first quarter, BP's leverage ratio (including leases and hybrid bonds) was 48%, making it the most heavily indebted company among oil giants. Additionally, BP is burdened with annual compensation payment obligations stemming from the 2010 Gulf of Mexico oil spill, which will continue until 2033.

This means Shell would need to pay a premium to rectify BP's over-leveraged balance sheet. RBC stated:

"We believe that the combination of BP's debt, hybrid bonds, lease commitments, and Macondo liabilities would be toxic for Shell, which has always been a relatively conservative company in terms of its balance sheet."

Another challenge comes from the regulatory perspective.

According to UBS analysis, the merger would expand Shell's fuel retail network by about 48%, adding over 21,000 sites, bringing the total to over 65,000. UBS stated that in certain markets, the combined market share of the two companies could be high enough to raise competition concerns, which could force asset sales. **

If Shell chooses to avoid such concerns by selling BP's entire marketing and retail division, RBC estimates that this part of the asset could be worth between $30 billion and $40 billion.

According to RBC, Shell may find that there are many other parts of BP that are not worth keeping, and the sheer number of potential assets facing sale could itself become an obstacle to the transaction.

“We believe that the non-core portfolio is too large to overcome, as this could prompt Shell to undertake another round of large-scale asset sales.”

“This is not a good image for a company with a history of abandoning value in M&A projects.”

Bank of America: Buying back its own stock is “wiser” than acquiring BP

Bank of America analyst Christopher Kuplent and his team reviewed Shell's acquisition history of BG Group in a recent report, finding that although BG's LNG and Brazil's subsalt oil portfolio brought significant cash flow growth to Shell, the corresponding increase in Shell's stock count was about 20%, taking three years to translate into per-share cash flow growth.

Based on such history and the current situation and outlook of continuously declining international oil prices, the report suggests that for Shell, a cash-rich company that believes its stock is undervalued, large-scale buybacks of its own stock seem to be a wiser choice than acquiring BP.

Shell's Chief Financial Officer Sinead Gorman has stated:

“As oil prices fall, (stocks) actually become cheaper. This is a better way for us to allocate capital.”

Currently, Shell has repurchased stock for 14 consecutive quarters at a scale of $3 billion or more, totaling $42 billion, accounting for more than one-fifth of its current market value. Although the company's stock price has fallen by 15% over the past 12 months, this has not shaken its determination to buy back shares.

In the recent earnings call, Shell CEO Wael Sawan also stated:

“In my view, value investing now means buying back more Shell stock.”

Bank of America pointed out that if Shell wants to avoid per-share cash flow dilution for shareholders while acquiring BP, it needs to achieve over $3 billion in annual synergies.

Moreover, considering BP's current plan to cut capital expenditures by $3 billion to $4 billion over the next three years, the restructuring costs and any gradual implementation of synergies will put pressure on the cash flow of the merged entity, making cash flow growth more difficult to achieve before 2028