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Investors Are Underestimating Royal Dutch Shell Plc’s Deal To Buy BG Group plc

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Large-cap FTSE 100 blue chips like Royal Dutch Shell (LSE: RDSB) are considered to be relatively safe investments.

Unfortunately, Shell has been trying to go against this belief over the past year. During the past 12 months Shell has taken on three high-risk projects, all of which could cripple the company if they don’t go to plan. 

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As a result, investors have turned their backs on the oil giant and Shell’s shares have underperformed the FTSE 100 by a staggering 25% over the past year. 

Three big bets 

None of Shell’s three multi-billion dollar bets is without risk. For example, the most controversial of them is Shell’s Artic drilling plan. So far, despite operational and environmental headwinds, Shell has spent $8bn developing wells off the coast of Alaska, but despite the huge expenditure, no oil has been found yet. 

The second bet is Shell’s proposed strategic alliance with Russian energy giant Gazprom. Two joint projects have already been announced, including an expansion of Shell’s LNG export project in the Russian far east.

But the largest, and potentially most costly of the three bets is Shell’s $70bn deal to acquire BG Group (LSE: BG)

Misunderstood

Shell’s deal to buy BG has attracted plenty of criticism. The main concern is the fact that, in order for Shell to benefit from this deal over the long-term, the price of oil needs to head back above $90 per barrel. City analysts believe that the deal does not make sense with oil trading below the key $90/bbl level. 

However, figures released by Shell’s management last week brought the analysts’ figures into question.

Shell now believes that it can achieve up to $4bn in “value synergies” from the merger, in addition to the $1bn of operational cost savings already predicted. Under City takeover rules, Shell can only set out initial operations cost reductions that will be achieved byeliminating clear duplication that accounts are able to independently verify — duplications such as separate office buildings located next door to each other. The projected “value synergies” include benefits that can’t yet be calculated.   

Still, if the estimated $5bn in synergies is really available, the economics of the Shell–BG merger start to make sense, even with oil trading at $60/bbl. 

Indeed, the deal is expected to be cash generative from the start and synergies achieved should only improve cash generation over time. Moreover, Shell is planning to sell $30bn of unwanted assets from its portfolio to fund the deal. These assets are likely to be low-return assets already earmarked for sale. 

So, while Shell may have to take on debt to fund the BG deal in the short-term, over the next few years management will be able to rebuild the balance sheet. 

Project management 

Shell has built a reputation for exemplary project management over the years, and now more than ever, the company needs to show that it can execute. 

The BG deal could transform the company. Cost savings will boost cash flow and after several years Shell’s balance sheet will have been rebuilt. Further, if the price of oil recovers, Shell’s earnings will surge. 

For long-term investors, Shell’s deal to buy BG is a risk worth taking.

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Rupert Hargreaves owns shares of Royal Dutch Shell. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

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