BG Group reported a 39% drop in third-quarter earnings from the same period a year ago despite a greater drop in oil and gas prices during the same period. Production gains during the quarter of 5% over a year ago helped to offset the decline in earnings for the exploration and production segment. However, production fell 2 million barrels of oil equivalent short of the company's targets because of delays in the startup of the Hasdrubal facility in Tunisia. LNG segment earnings fell only 17% year-on-year, thanks to the company's medium-term sales programme.
Despite the miss in the production targets, the quarterly results demonstrated the resilience of BG's earnings in an environment of falling commodity prices. However, management's update on the company's key projects held more interest for us.
Foremost is the development progress of BG's position in the Brazilian pre-salt offshore discoveries. During the quarter, the company announced the Guara discovery holds estimated recoverable volumes of 1.1 billion-2.0 billion barrels oil equivalent. As a result, the partners will prioritise development of the discovery with first production targeted for 2012.
On the Tupi field, the extended well test continues to perform well with a flow rate constrained at 20,000 barrels per day, though management indicated the well could flow up to 30,000 barrels per day unconstrained. Production remains on schedule for 2010 with the needed FPSO vessel almost halfway complete.
Another key project is BG's first foray into a United States gas shale play with EXCO Resources in the Haynesville Shale. Currently the partners are running seven rigs but plan to ramp up drilling activity by adding three more in the fourth quarter and four in the first quarter of 2010.
Fair value estimate: 1,244p ¦ Fair value uncertainty: Medium ¦ Economic moat: Narrow
Thesis
(Last updated 17-04-2009)
BG Group's early entry into liquefied natural gas (LNG) made it a leading global integrated natural gas player. Now with infrastructure and low-cost resources in place, BG looks to capitalise on growing global demand for natural gas.
We think BG will deliver attractive returns as it continues to execute its strategy of connecting its low-cost resource base to high-value markets. BG wisely moved early to acquire natural gas reserves in areas with little or no local demand where the gas would otherwise be worthless. By utilising its own LNG infrastructure, BG gains flexibility and directs the gas to markets that generate maximum profitability. Full integration of the process, from reserve to burner tip, affords the company the ability to drive efficiencies, control costs, and capture value along the entire chain.
Because these projects require long lead times and considerable capital, growth is slow and uneven. Although BG will see limited additional LNG capacity over the next five years, we see long-term supply growth from last year's acquisition of the Queensland Gas. The acquisition not only brings BG a new source of LNG supply, but also marks the company's significant entry into unconventional gas. Already used in the United States and Australia for domestic supply, the newly acquired coal seam gas reserves will feed initially two LNG trains.
Although LNG may allow BG to monetise its reserves, it is exploration and production success which drives the company's profits. Once reliant on the United Kingdom for the majority of its production, BG's main producing areas now include Egypt, India, Trinidad and Tobago, and Kazakhstan. BG's rich portfolio of projects combined with its record of delivering projects on time and within budget should drive substantial production growth during the next decade. In addition to expanding its current fields, BG has immense growth potential from partnering with Petrobras in Brazil's offshore presalt fields, which could deliver up to three billion barrels of reserves for the company. More importantly, with experience in gas injection, deep-water drilling, and now unconventional gas, BG possesses the expertise that appeals to resource owners looking for partners, critical in today's environment of diminishing opportunities.
Even though we like BG Group's positioning, it is not without risk or competition. Integrated oil supermajors, aware of the global trend toward natural gas and in search of additional reserves, have begun to aggressively move into developing stranded gas resources and building LNG infrastructure. Like BG, they have the size, technology, and experience that appeals to governments and the ability to execute on large, capital-intensive LNG projects. BG also faces the prospect of cheap Russian gas invading key markets. Already the primary supplier to Europe, Russia could increase future volumes crowding out LNG. In China, Russia recently signed agreements to build pipelines to supply oil, and natural gas could soon follow.
Potentially more worrisome, though, is the political threat to BG's low-cost resource base. Governments often look to renegotiate existing contracts, modify tax policies, or change terms for outside firms in periods of high energy prices as in the case of Venezuela, Russia, and Libya. BG could find itself in similar circumstances with a rebound in oil and gas prices.
Valuation
Our fair value estimate is 1,244p per share. In our discounted cash-flow
model, our benchmark oil and gas prices are based on NYMEX futures
contracts for 2009 to 2011. For natural gas, we are currently using
$4.38 per thousand cubic feet (mcf) in 2009, $6.28 in 2010, and $6.89 in
2011. For oil, we are currently using $51 per barrel in 2009, $64 in
2010, and $69 in 2011. To arrive at our valuation we consider three
scenarios--base, low, and high--and weigh them 40%, 40%, and 20%,
respectively. In our base scenario, we assume long-run oil prices of $80
per barrel and natural gas prices of $7.50 per mcf. This scenario values
BG at 1,206p. Our low-case scenario assumes long-run oil prices of $50
and $5 for natural gas and values BG at 664p per share. Our high case
assumes long-run oil prices of $150 and $15 for natural gas. This
scenario values BG at 2,481p. Although BG is an integrated company, the
exploration and production segment contributes the majority of income.
For this segment, we modeled production at a 7% compound annual growth
rate through 2013. LNG segment profits for the next five years should be
relatively flat as additional capacity comes on line beyond 2013. Also,
considering BG's substantial position in Brazil's offshore presalt
fields, we derived an additional valuation for these properties based on
potential reserve additions and oil prices. Production from these
properties is still many years away, however, and faces significant
challenges.
Risk
BG faces the geopolitical risk normally associated with operating in
politically unstable countries where damage to assets or renegotiation
of contract terms may harm profitability. As an oil and gas producer,
BG's main risks include falling prices. Although oil prices are somewhat
protected by OPEC, there is no similar influence in the regional gas
markets on which BG relies more. Weakening global economies and a glut
of gas from domestic resources or other LNG providers could destroy
margins. Also with resources becoming scarcer, BG must deal with
reinvestment risk.
Strategy
BG aims to replicate what major oil integrated players have done
previously, by connecting stranded resources with high-value markets. BG
attempts to control the entire gas chain from production to burner tip
by investing not only in reserves but LNG infrastructure, transmission
and distribution, and gas-powered electricity generation. BG plans to
capture higher returns by remaining flexible as to which markets it
supplies.
Management & Stewardship
BG is led by chairman Sir Robert Wilson and chief executive Frank
Chapman. As is common corporate governance practice in the UK, the
chairman and chief executive roles are kept separate. Wilson joined BG
in 2002 as a nonexecutive director and ascended to chairman in 2004.
Previously he was with Rio
Tinto where he served as chairman and chief executive. Chapman rose
to CEO in 2000, having been with the company since 1996. He previously
held roles at both BP
and Shell.
The company gets credit for an emphasis on variable compensation and
performance-related incentives based on both short- and long-term
performance. Performance measures for last year consisted of return on
average capital employed, earnings per share, and a health, safety, and
environment scorecard. Long-term performance rewards come in the form of
performance share awards which vest over time based on total shareholder
return versus a group of peers. We like this last part of compensation
as it clearly aligns management and shareholders and keeps the focus on
return beyond the current year.
Profile
BG is an integrated energy company primarily engaged in the exploration
and production of natural gas in Egypt, the UK, Trinidad and Tobago, and
Kazakhstan. The firm specialises in utilising LNG to monetise its
stranded gas resources for delivery to high-value markets in the US,
Europe, and Asia. BG ended 2008 with production of 619,000 barrels of
oil equivalent a day, 69% of which was natural gas, and reserves of 2.45
billion barrels of which 72% are natural gas.
Growth
Growth for BG has come from robust production growth and expansion of
its LNG network. Production growth for the next five years should
average a healthy 6%-8% per year. Long-term success will come from
projects in Brazil and Australia. High costs delayed some LNG projects,
which should result in slower growth of that segment.
Profitability
High oil and gas prices combined with BG's low-cost resources and
flexible delivery to produce strong operating margins and profits. Going
forward lower prices will result in reduced margins, but BG has locked
in the majority of LNG margins for the next two years and will likely
direct remaining supplies to the highest-priced markets.
Financial Health
BG ended 2008 with $3.2 billion in debt for a debt/capital ratio of only
15%. The low debt level leaves plenty of room for future financing needs
to fund the capital plan or make acquisitions.
Bulls Say
1. BG's partnership with Petrobras in Brazil's Santos Basin presalt
fields could result in an additional 3 billion barrels of reserves.
2. BG's acquisition of Queensland Gas in Australia added substantial reserves and expertise in unconventional gas to the company.
3. BG's ability to deliver projects on time and technological expertise make it a valuable partner in developing difficult exploration projects.
4. Natural gas is likely to be a preferred energy source as governments begin to enact legislation to curb carbon levels.
5. Recent tumult with Russian gas supplies to Europe has caused concern and increased the value of providers of LNG, such as BG, to the continent.
Bears Say
1. The global recession combined with a glut of gas from LNG and
unconventional sources could depress prices and crimp margins.
2. BG's low-cost resources could be compromised if host countries attempt to renegotiate contracts or change tax terms on producing companies.
3. Competition for resources to convert to LNG is increasing. BG previously lost a bid for Origin energy to ConocoPhillips and could see oil supermajors pushing further into its space.
4. Although BG's resources in Brazil hold great potential, to achieve significant production will require overcoming certain technical challenges and large amounts of capital.
5. BG is investing in production and LNG facilities in Nigeria, which has seen more than its share of violence and political disruption. BG could be in store for project delays, higher costs, and shut in production as a result.
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