Shell-BG Deal no Harbinger for What Comes Next

There is a widespread assumption that weak commodity prices are likely to spark a wave of merger and acquisition activity as stronger companies seek to buy assets on the cheap.

The $70 billion buyout of BG Plc by larger rival Royal Dutch Shell (RYDAF) is generally viewed by investors and analysts as the first big deal in a likely series of major mergers and acquisitions in the resource sector.

After all, the last time commodity prices fell sharply, around 15 years ago, there was a rash of mega-mergers, such as Exxon with Mobil and Conoco with Phillips in the energy space, and BHP with Billiton and Rio Tinto (RTNTF)'s purchase of Alcan.

Notwithstanding the Shell-BG deal, it appears executives may be more cautious this time around, eschewing mega-mergers in favour of smaller acquisitions and in-house projects to add
shareholder value.

Ryan Lance, the chief executive of ConocoPhillips (COP), was adamant that he didn't expect a "big M&A wave any time soon".

Speaking at the Asia Oil & Gas Conference in Kuala Lumpur on Monday, Lance said the rationale that drove the previous round of major deals doesn't quite apply any more.

Why would a giant international energy or resource company want to go down the M&A route currently?

The normal motivators for such mega-deals are the cost synergies that executives believe can be extracted, the ability to acquire reserves at attractive prices and the addition of assets that fill gaps in existing portfolios.

The Shell-BG deal was most probably motivated by the desire to build on assets in liquefied natural gas (LNGLF) (LNG), particularly in Australia where BG already has an operating coal seam to LNG plant on the east coast, and Shell effectively has stranded gas reserves after it deferred a decision to build its own plant.

It's likely that there will be more of these kinds of deals, but on a smaller scale, as companies attempt to add assets that are complementary to their existing businesses.
            
COST REDUCTION, INTERNAL PROJECTS
But Lance was also clear that while ConocoPhillips looked at deals from time to time, it hadn't seen anything that was as attractive as developing the internal pipeline of projects.

In the energy space, he said that the advent of U.S. shale oil and gas production, and the massive addition of reserves they provided, had made acquisitions for the sake of adding to reserves less likely.

Both large and mid-size companies also had less need to fill in their portfolios with large deals, he said, while the need to merge to drive cost reductions had been less urgent with the work being done to strip out costs within companies.

The cost reduction mantra was one highlighted repeatedly at the conference in the Malaysian capital, but the focus of most speakers was on how to drive efficiencies within existing businesses, and how to deliver greenfield projects without the cost blowouts that typify the resource industry.

What this is likely to mean is a move toward "modularity" in resource projects, meaning the repeated construction of identical units to identical standards in order to cut down on both building and operating costs.

There is no shortage of resource projects being planned around the world, from deepwater oil in Brazil and Africa, to LNG in western Canada.

What has changed is that these projects will now have to be far more rigorously costed than they were before, and companies are more likely to concentrate their efforts in these areas as opposed to seeking to use mega-deals to try and drive shareholder returns in a low commodity price environment.

Perhaps instead of large M&A deals, this time the commodity cycle will deliver more spinoff-type deals, such as BHP Billiton (BHPLF)'s de-merger of its aluminium and energy coal assets into South 32, which started trading on Monday.

South 32 actually reverses much of the BHP merger with Billiton, and Rio Tinto is looking to do something similar, albeit on a smaller scale, with the planned sale of its Pacific Aluminium assets.

Currently, with the industry's focus on cutting costs in order to preserve dividends and thus shareholder value, the valuations of companies that may present as M&A targets are likely still too high.

It will take sustained, lower commodity prices to knock valuations to the level where mega-mergers may make sense again.

It seems that smaller deals and asset disposals are more likely than a deal on the scale of Glencore (GLCNF)'s proposed, and rejected, merger with Rio Tinto.

By Clyde Russell