A Bad Deal For BHP?

Array
(
    [0] => Array
        (
            [0] => ((RIO))
        )

    [1] => Array
        (
            [0] => RIO
        )

)

This story features RIO TINTO LIMITED.
For more info SHARE ANALYSIS: RIO
The company is included in ASX20, ASX50, ASX100, ASX200, ASX300 and ALL-ORDS

– BHP has considerably upped its shale gas play
– A big premium belies a consistent acreage value
– Analysts note gas prices have to rise to make the deal viable

By Greg Peel

Last year it was potash – the fertiliser, not the company – that was targeted by BHP Billiton ((BHP)) as an opportunity in which to exploit its iron ore, coal and oil cash and provide a new, diversified earnings stream for the mega-conglomerate. Fertiliser may not be a mineral, but it is mined from the deeps and that's where BHP saw its operating expertise as being applicable.

So BHP took a swing at Potash – the company, not the fertiliser – with the intention of acquiring a tier one existing operation to compliment substantial greenfield assets already secured in Potash's home base of Saskatchewan. But BHP was caught out by a surge in fertiliser prices just as it was preparing the deal, resulting in the premium offered being a bit light on. Nor was the Canadian government too keen from a national interest perspective, and BHP gave up.

No one ever expected Marius Kloppers to brood for too long however, nor to decide there were just no more possibilities. The company commenced buying back its shares in order to turn excess cash into increased shareholder value, but this was really just a time-biding measure. Analysts suggested that if diversification was too hard, perhaps BHP would simply expand its Gulf of Mexico oil operations.

Well, they were wrong and they were right. They were wrong in assuming expansion of existing assets as a fallback, but right in assuming the energy sector offered the most straightforward opportunities. Instead of Gulf oil, BHP began a foray into the hottest new thing in the US energy space – shale.

BHP's subsequent acquisition of the substantial Fayetteville shale assets of Chesapeake Energy was seen by the analysts at JP Morgan, for one, as a low-risk “toe in the water” of a new expansion opportunity. The company could build expertise without risking much in shareholder value. But BHP's latest move is a different kettle of fish.

BHP's US$12bn offer for shale operator Petrohawk Energy has been unanimously accepted by the Petrohawk board and will more than double BHP's shale gas assets. The assets lie in Fayetteville's neighbouring regions of Haynesville and Eagle Ford in the shale-rich Arizona-Texas-Louisiana intersection area – also including the greenfield prospects of the Permian Basin. Petrohawk satisfies BHP's tier one aspirations, UBS suggests, “as it is a large resource, has operatorship, access to the world's largest gas market [the US], is in production with significant expansion potential and is in a stable operating environment”.

While shale gas, which is different but similar to coal seam methane, is the main objective, shale liquids are also on offer, particularly in the Permian Basin. De-risking the potentially liquids-rich Permian assets, suggests Citi, offers the greatest upside in the deal.

That's all well and good, but are shareholders happy? Not really. Shareholders have long been concerned Kloppers' expansion aspirations would result in an ill-conceived “deal too far” one day, such that all that lovely cash generation might end up tied up in a dud. There were plenty of nerves on display when BHP previously attempted a swing at Rio Tinto ((RIO)) for example, and no one was keen for BHP to secure its Potash bid with an increase in price. In the meantime, share buybacks are a safe and solid way for shareholder value to be enhanced.

The problem is no one ever becomes a CEO legend, or gets the big bonuses, by buying back shares. Stock analysts also pressure boards into constant expansion by critising lazy balance sheets, and then cry foul if such pressure results in a poor acquisition decision. In the case of Petrohawk, one particular number stands out. The rule of thumb is that if one company wants to assume control of another, it must offer at least a 30% control premium. BHP has offered a 62% premium over the previous closing price and about a 50% premium over three-month VWAP (volume-weighted average price).

No wonder the Petrohawk board took seconds to say yes.

The immediate shareholder reaction was obvious – that seems like way too much. However, stock analysts disagree, suggesting shale gas's relative infancy and expansion potential mean an assessment of earnings accretion is not the most relevant indicator. So if one ignores the premium over the share price, and considers a price to asset value measure on a per acre basis, the price BHP is paying stacks up pretty well. It's in line with recent transactions in the area including BHP's own Fayetteville purchase at a time when prices in the area are on the move. The rush is on among oil majors to secure stakes in “unconventional” energy supply at a time of dwindling accessible crude reserves and carbon pricing pressure, and shale is hot.

So on that basis, we might assume all BHP analysts consider this a pretty exciting deal. Unfortunately they don't. The problem is rather one of a Catch-22.

Analysts agree that the value in this long term project relies on an assumption of rising gas demand and thus rising gas prices. But unlike crude oil, global gas supplies in their various incarnations are quite abundant. No one expects all of Queensland's CSM LNG projects to prove commercially viable, for example, nor the offshore natural gas aspirations of the likes of Woodside ((WPL)) for the simple reason that outside of a brief timing lag window, global supply should more than satisfy global demand in the next decade or so. Beyond that – well, that's just a bit too crystal ball. So while gas demand from China et al is expected to rise considerably over time, so is global gas supply.

Thus while BHP might be muscling in on the new energy bonanza, the more shale gas production is increased the less likely gas prices are to rise. And that's just shale. There may be greater opportunity from US gas export as opposed to domestic consumption, but that's where all the other gas projects in the world operate or intend to operate.

RBS Australia notes Marius Kloppers' attempt at shareholder appeasement in suggesting the US$12bn Petrohawk acquisition will create more shareholder value than a share buyback of equivalent size. However, “For this to be the case,” says RBS, “we believe gas prices need to improve significantly”.

Citi suggests that if BHP can deliver production growth, fully extract the resource, and the gas price recovers, then the deal stacks up, as is the case with Fayetteville. Incidentally, UBS believes Petrohawk offers no real synergies with Fayetteville as might be an assumption.

JP Morgan believes BHP is acquiring a high quality asset in the context of the shale gas market which will generate “substantial” margins. But from the outset, the deal will only be very marginally accretive, representing the use of cash and debt for payment, and will struggle to deliver much more than a cost of capital return in the long term, the analysts suggest. By contrast, iron ore returns around 20%.

So on the whole, analysts are not convinced. What the deal will mean, most likely, is that the much anticipated BHP takeover offer for Woodside (which analysts never really saw as likely anyway) won't eventuate, and it will also impact on the current share buyback plans. BHP will no doubt announce at its upcoming full-year result that either the buyback is now off or, as analysts suggest is most likely, it will be scaled back in pace and extended out into time.

At the end of the day, BHP is still BHP and the shale gas thing is still only part of an enormous resource empire. BHP's share price has not gone anywhere much of late, but six out of eight FNArena database brokers are still calling BHP a Buy with the other two on Hold. No changes have been made post the Petrohawk announcement, although some stockbrokers want more time to model the numbers.

The consensus target of $54.10 suggests 26.7% upside.
 

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms