The spread between BG’s (LSE: BG) share price and Shell’s (LSE: RDSB) bid terms has narrowed to its lowest levels since the merger was initially announced back in April 2015. Shell is offering 383 pence in cash and 0.4454 Shell B shares for each of BG’s shares. At the time of writing, this would mean each BG share would be worth 966 pence if the deal goes ahead, a 5.1% premium to its current traded price.
The spread between the BG’s traded share price and its offer terms have been fluctuating quite a lot since the deal had been announced. It widened to peak at 17% in August, as the extended falls in the oil price raised the market implied likelihood that the merger would fall through, or the offer terms would be changed.
But, as the spread has narrowed again, it could be seen as evidence that investors believe the prospects of the deal reaching completion under the current terms is increasingly likely. This is despite the fact that the shareholders of both companies have yet to vote on the planned merger. In addition, the recently extended falls in the oil price have made the deal seem extremely expensive.
With the benefit of hindsight, Shell made the deal with BG too early and ended up paying too much. Had Shell waited a few more months, it would acquire BG much more cheaply. But this logic assumes another bidder would not have come along and made its own offer for BG.
That said, there are still plenty of acquisition opportunities that Shell could have instead made, with the oil price trading below $30 a barrel. None may have the scale that BG has to offer, but I’m sure a combination of acquisitions with organic capital spending would be just as value-accretive, if not more.
There are few dissenting voices from major shareholders or analysts who disagree with the logic behind the merger. Standard Life is one of the few, though. Its head of equities, David Cumming, said the deal was “value destructive” for Shell’s shareholders and that “a lot [has] changed since the bid was announced”.
However, there are many reasons why the deal is likely to go ahead. Despite Standard Life’s open criticism of the merger, most are likely to vote in favour of the deal. They tend to agree with the longer term rationale of the deal.
The acquisition lowers Shell’s average cost of production, albeit to a level with is still substantially higher than today’s market price. It would also boost its production, oil and gas reserves and benefit from increased scale in the LNG business. BG’s production figures have been faring much better than Shell’s own figures. Between 2014 and 2015, BG’s oil production by 16%, compared to Shell’s mid-single digit decline.
But although BG’s production figures are great, its cash flow position is not. It expects to bring in around $4.3 billion in operating cash flow in 2015, but it has spent around $6.4 billion in capex to grow production (amongst other things). This means the shortfall has to be funded through asset sales and increased debt, and that is before we consider dividend payments. With oil prices having fallen further recently, this free cash flow shortfall is only set to widen.
Shell probably needs the oil price to be well over $60 for the deal to become value-accretive. With the oil price currently trading at less than half of that, I do think Shell is overpaying.