Shell shocked: Why bid for BG is unlikely to herald oil prices ‘bottoming out’

Oil majors have a mixed record of timing the bottom in oil prices. That’s the message from the last 35 years of oil price and merger and acquisition (M&A) activity in the sector. While much of the attention in recent days has focused on acquisitions by BP, Exxon, Total and Repsol in the late 1990’s (as Brent crude prices bottomed out close to $10 per barrel), there was also a flurry of M&A activity in the mid-1980’s, just before oil prices slumped by almost 70%.

Brent crude prices and key oil mergers/takeovers
$ per barrel

M&A activity doesn’t just happen because of the pressure of low commodity prices. Many take place because of strategic factors, like gaining a stronger position in another energy type, region or to acquire other assets (i.e. horizontal or vertical integration). And after spending enormous sums on expensive production many oil majors are ill-equipped to deal with low oil prices and need to improve the quality of their portfolios.

Shell’s bid for BG Group allows it to expand into the rapidly expanding gas markets, but it is still very much predicated on the basis of higher oil prices. In line with industry consensus the oil major assumes Brent at $67 per barrel in 2016, rising to $75 per barrel in 2017 and then $90 per barrel through to 2020.

Shell and other oil majors might well think that now is a good time to snap up assets in the belief that in a few years time it will look like a smart move. So does Shell’s bid represent the deals of the 90’s or the 80’s? While oil may look cheap compared with where it has been over the past four years oil bear markets tend to be protracted, lasting between 11 and 28 years. In comparison the current bear market is less than 3 years old (based on Brent peaking around $127 per barrel in early 2012).

In one sense Shell’s bid, if it kick starts more M&A activity could be seen as a sign of capitulation in the face of the shale revolution and low oil prices. In the words of The Economist magazine;

Contrary to some expectations, the oil-price fall has not derailed the American shale boom. The small, flexible and innovative companies which specialise in horizontal drilling and hydraulic fracturing are proving better at cutting costs, raising productivity and adapting to market fluctuations than the lumbering giants who have long dominated the industry. Dinosaurs may mate, to ensure the survival of their species, but this is an age of mammals.

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China iron ore subsidy could extend price rout

China, the world’s largest buyer of seaborne iron ore, may introduce a nationwide subsidy for local producers as early as mid-April according to reports.

The major low cost iron ore producers like Rio Tinto and BHP have been brought on vast amounts of extra iron ore supply with a strategy of forcing the higher cost, primarily Chinese mines to close.

This strategy was already looking doubtful with only minimal closures seen in China. Now with the prospect of a formal subsidy being introduced the strategy looks even weaker. Iron ore prices are now below $50 per tonne, a ten year low.

The subsidies, if implemented, will sustain domestic production, increase the global supply of iron ore and could result in prices slumping further.

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Q&A: What does Iran framework agreement mean for oil markets?

What has actually been agreed?

Its not exactly clear, differing reports from Iran and the United States in the wake of the negotiations show that there are many details yet to be agreed upon.  What appears to be clear though is that the U.S. and its partners were able to secure important nuclear commitments from Iran that will make getting a final deal possible.

So is that the end of it?

No, the final agreement has not been written and the details required to successfully complete the negotiations still likely to prove controversial. It is likely that June 30th will arrive with still no clarity as to whether a final deal will be achieved or not. There is still much that can go wrong that could scupper a deal, namely hard liners in the US and Iran.

When will Iran oil related sanctions be removed?

It has not been determined which sanctions will be lifted, by how much and in what order.

The 5+1 will likely stipulate as part of the deal, Iran’s compliance with the restrictions on its nuclear program, i.e. the US and its allies will want to make sure Tehran is satisfactorily holding up its end of the bargain before starting to eliminate any of the sanctions.

No one knows exactly how long that could take. Consider the fact that modifying nuclear equipment, tearing down over 10,000 centrifuges and carrying out highly-detailed inspections can take months under normal circumstances.

Even under the most optimistic scenarios it is thought unlikely that relief of oil sanctions will start until 2016 at the earliest.

So this is going to make the crude glut much bigger?

Despite fears that lifting sanctions will flood the market, the reality is likely to be quite different.

The Iranian authorities assert that the country could increase production from around 2.8 million b/d to around 4 million b/d while doubling exports.

However, turning the oil taps back on ignores the technical realities involved after oil wells have been switched off for some time. Given current market conditions, only limited international investment will likely be available to help restart its production. For one thing, Iran is not thought to have offered particularly attractive terms to investors and at today’s oil prices, oil companies are cutting back everywhere.

It appears highly unlikely that Iran will be able to increase production until sometime in 2016 with Deutsche Bank forecasting an additional 400,000 b/d by mid-2016.

The one supply of crude that Iran could tap immediately are the 30 millions barrels of crude they have in storage. Energy Aspects estimate that tapping storage could add an additional 100,000 b/d or so to current exports of 1.3 million b/d.

Won’t this make OPEC’s job even more difficult to achieve?

Any rebound in exports is also likely to lead to further internal pressure within OPEC to cut production so its another uncertainty for them to manage. But OPEC have been here before in managing Iraq’s return to higher levels of oil production and exports.

Any rebound in crude exports needs to be seen in the context of production outages elsewhere. Despite the prospect of exports increasing from Iran, escalating unrest in Libya and problems in Iraq has resulted in production being cut in these key OPEC producers.


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What about oil prices?

A successful lifting of sanctions is bearish for oil prices. But as we note this is a long way off. Once the realisation dawns that Iranian crude is not going to flood the market any time soon prices could rebound. It could be a case of sell the story, buy the fact.

What are the broader risks?

If Iran is perceived as having an insufficiently limited nuclear program then there is a risk of a wider nuclear arms race in the Middle East. Last week Saudi Arabia refused to rule out the acquisition of its own nuclear weapons capability. The conflict in Yemen (thought to be supported by Iran) and now Saudi Arabia and other regional states involvement on the other side have raised fears of a wider conflict between Saudi Arabia and Iran. Any move in this direction would put oil production and major crude shipping routes at risk, significantly increasing the risk premium to crude prices.

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