BG – winning back the confidence of investors?

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BG Group CEO Chris Finlayson last month set out a value creation strategy aimed at reassuring investors that the company has not lost its way. Until last autumn BG had been a darling of the stock market for over a decade. Then came a revision of production targets that deeply disappointed shareholders and savaged the company’s share price. The keenly awaited strategy presentation was also an opportunity for Finlayson to stamp his mark on BG – given that his predecessor, Sir Frank Chapman, was always going to be a hard act to follow. So what have Finlayson and his newly reconstituted team come up with? And how likely is the new strategy to win back investor confidence?

by Alex Forbes

If you did not already know, you would hardly guess that – in the words of Andrew Gould, the company’s chairman – BG Group is “the offshoot of a former nationalised utility”. Having emerged amoeba-like from successive divisions of British Gas – the nationalised monopoly that was privatised in 1986 – BG Group, again quoting Gould, “has been transformed into an international energy business focused on exploration and production and LNG”. In the process its market value has quadrupled to $60 billion.

It’s worth spending a moment looking back at the company’s genesis because that helps to explain how it got to where it is today.

The shaping of the company that we today know as BG Group began in 1997, when the privatised British Gas demerged into two companies. The demerger followed a series of high-profile battles with the company’s then regulator Ofgas, and a breakthrough in re-negotiation of troublesome long-term take-or-pay gas supply contracts.

A newly formed holding company called Centrica took on the UK gas and electricity supply business and the Morecambe Bay gas fields, among other assets, while a second company called BG plc took on the international interests, notably exploration and production, and transmission and distribution assets, and the Transco gas pipeline network business in Great Britain. (Oddly, Centrica got the right to use the British Gas name in the UK, while BG plc got the right to use the same name abroad.)

In 2000 BG plc underwent another demerger, which separated it into two companies, Transco and BG International (BGI), under a holding company called BG Group plc. The announcement immediately prompted speculation that a stand-alone BGI, with its tempting portfolio of international projects, would become an obvious target for takeover. In fact, what happened is that Transco was demerged under a holding company called Lattice Group and in 2002 merged with National Grid, owner of Britain’s electricity network, to form National Grid Transco.

“Integrated gas major” By 2003, BG Group was describing itself as an “integrated gas major”, with interests in exploration and production, LNG production and trading, gas transmission and distribution businesses, and electricity generation. In the ensuing years it became clearer and clearer over time that the real performers were the E & P and LNG businesses. BG Group has in recent years therefore been pursuing a strategy of selling off its non-core assets to free up capital.

Construction of BG LNG plant in Queensland Australai

QUEENSLAND CURTIS LNG – The QCLNG project in Australia is expected to deliver BG Group $3.5-4 billion dollars per annum of operating cash flow on plateau. (Photo courtesy of BG Group)

Last year it sold off its stakes in two electricity generation plants in the Philippines and the Brazilian gas distributor Comgas. Just this month it completed the sale of its stake in India’s Gujarat Gas Company.

All this corporate activity has shaped BG Group into what it is today. In the words of CEO Chris Finlayson at last month’s strategy presentation in London:

“This is a fantastic company with great strengths to build on. We have highly distinctive capabilities: our world-class exploration and our unique LNG model. These will remain the core of our strategy. We have an excellent set of growth assets to develop and we are in a period of strong growth in demand for natural gas and particularly LNG. We’re big enough to explore the best frontier acreage, but we’re small enough to be commercially agile. I will ensure we keep these valuable attributes.”

Charismatic performer: There is no question that the company has made an impressive success of its E & P and LNG businesses over the past decade-and-a-half, most of that time under the leadership of former CEO Sir Frank Chapman, who stood down at the end of last year. Under Sir Frank, a charismatic and compelling performer, the company took a series of bold decisions that drove strong growth in its production, its revenues and its share price.

The company also seems to have had more than its share of luck, though probably mostly of the sort that film producer Samuel Goldwyn was referring to when he coined the phrase “the harder I work, the luckier I get”. (Appropriately, in this context, last month’s strategy presentation was held at the British Academy of Film and Television Arts (BAFTA) in Piccadilly, London.)

However, luck seemed to temporarily desert the company last year, when Sir Frank revealed during presentation of the company’s third-quarter results on 31st of October that previously announced production targets would be missed. Because of the shut-down of the Elgin/Franklin field in the UK, less drilling activity in the US because of low prices, deferral of the start-up of the Jasmine field, continuing reservoir decline in Egypt, and other factors, Sir Frank said that production was expected to grow by just 3% in 2012 and to be flat during 2013.

Share price plummets: The consequences were rapid and dramatic. On the day before the presentation the company’s share price had closed at 1,329.50p; on the 31st the share price closed at 1,147.50p, down 14%, and continued its descent until the 16th of November, when it bottomed out at 1,000.50p, a fall of 25%. Early in 2012 the shares had been trading at over 1,500p.

The shares have since made a partial recovery. Just before last month’s strategy presentation they were trading at around 1,185.50p, a level they were still hovering around at the time of writing, having increased for a while in the wake of the presentation itself.

At the strategy presentation, Finlayson acknowledged that the company had disappointed the market: “As a result of that, people had a loss of trust and faith in us. The only way to re-build that is by showing more disclosure. And that’s exactly what we’re doing. We’re showing very clear short-term, medium-term and long-term milestones, against which people . . . can mark us.”

So what have Finlayson and his team come up with?

At the core of the company’s new strategy is a tight focus on what BG Group has shown itself to be good at: E & P and LNG.

“We will focus on areas where we have distinctive competitive advantage – early stage origination, discovery and development – in upstream oil & gas and in LNG,” said Finlayson. “I have already increased our exploration spend to $1.6 billion dollars for 2013; that’s about a 30% increase on 2012. Over the next three years we will continue to grow this to $1.8 billion per year.

“We will manage our portfolio more actively, monetising assets at different stages in their life-cycle, and bringing in partners to accelerate value delivery. We will create a focused portfolio of 10 to 15 high-quality material assets. We will recycle capital into new, high-return, early-stage growth, and we will return cash to shareholders, and prioritise value over production.

“We will provide transparent milestones and greater asset disclosure. And we will have a simple organisation, with simple processes and clear personal accountabilities.”

To meet its objective of increasing shareholder value, the company plans a two-pronged approach: firstly to achieve strong growth in E & P and LNG volumes, but also for “earnings to grow faster than production”.

E & P: Finlayson confirmed that gas and oil production in 2013 would be within the recently issued guidance levels of 630,000-660,000 barrels of oil equivalent per day (boe/d). By 2015 he expects this to rise to 775,000-825,000 boe/d, excluding any changes to the project portfolio. Of that total 530,000-580,000 boe/d is expected to come from the company’s “base assets” in Bolivia, Egypt, India, Kazakhstan, Norway, Thailand, Trinidad & Tobago, Tunisia, the UK and the US. The rest will come from what the company describes as “growth assets”.

The main growth assets are the company’s new LNG project in Australia, Queensland Curtis LNG (QCLNG), which is due to begin production next year, and BG’s interests in Brazilian oil fields operated by Petrobras: Lula and Iara.

Commenting on progress with the 15 FPSO programme in Brazil, which will form a large part of the company’s production growth, Finlayson said: “Petrobras remains on schedule with our 2011 guidance. This initial programme will deliver 2.6 million boe/d of gross production capacity and some 500,000 boe/d of production net to BG Group by 2020. We are currently assuming an average of 18 months to ramp-up each FPSO. The low unit cost of this development is a result of the excellent reservoir characteristics, which deliver high margins and an economic break-even of less than $40/barrel.”

In addition, the company is currently exploring and appraising five new material basins.

“In Australia we are drilling the Bowen coal seam gas and deep tight gas sands,” said Finlayson. “We have more recently entered the Cooper Basin shale and tight gas sands play with first drilling later this year.

“In Tanzania, which we entered in 2010, after nine successful wells we are continuing to drill and have already built a resource base of around 10 Tcf.

“We entered Kenya in 2011 where a multi-well campaign will start in 2014.

“We won a very competitive bid round in Uruguay in 2012. We have already started our largest ever operated 3D seismic programme, the first phase of which is now 80% complete and we could be drilling our first well as soon as 2016.

“And finally in Honduras we have recently signed a licence to explore some exciting frontier acreage. We expect to commence with a gravity survey ahead of seismic acquisition in 2014 and 2015.”

Chart showing BG growth 2013 to 2018

GROWTH MILESTONES – Growth in the near term will come primarily from the QCLNG project in Australia, third-party LNG volumes from Sabine Pass and oil production in Brazil. Longer term BG is looking at four possible LNG projects and further investment in Brazil (Chart courtesy of BG Group)

LNG: The success of BG’s LNG business is largely based on a strategy of maintaining a diverse portfolio of supply and market positions. Most of the LNG supply is contracted directly to BG Group and most of the market contracts can be supplied from any of the LNG sources. “This means that we are able to continually optimise supply and markets to maximise our margins and ensure reliable supply for our customers,” said Finlayson. He stressed that: “Our LNG business isn’t just a market enabler for our E & P assets, it’s a growing and highly profitable business in its own right.”

BG currently has equity LNG production in Egypt and Trinidad and long-term third-party supply from Nigeria and Equatorial Guinea.

“Looking out to 2015, our total contractual off-take from Trinidad and Tobago, and Nigeria and Equatorial Guinea is 9.2 mtpa,” said Finlayson, “although individual years will show some variation. Off-take from Egypt “will depend on reservoir performance, investment levels beyond current commitments, and the government not exceeding its domestic off-take agreements”, he added. “If these remain on plan then 2013-15 average LNG off-take from our existing long-term supply sources will be in the range 10.5-12 mtpa. Any volumes from short-term contracts will depend on prevailing market conditions.”

As for new LNG supply sources, BG has two that will come into effect in the next couple of years. The company’s QCLNG project in Australia, currently under construction, will come on stream next year and ramp up to full production of 8 mtpa by 2016. “QCLNG turns strongly cash positive from 2015,” said Finlayson. “This is high-margin production that will deliver BG Group $3.5-4 billion dollars per annum of operating cash flow on plateau.”

From 2015 BG will start to receive third-party LNG supply from Sabine Pass, the first US LNG export project in the Lower 48 states, from which BG has contracted a total of 5.5 mtpa spread across four trains.

“BG Group’s main LNG markets are in Asia,” said Finlayson. “As Asia will need to secure far more new LNG supply than the US is likely to export, we believe Asian LNG prices will remain at levels required to launch more traditional projects. With some of the lowest cost US export supply we expect to remain competitive in the Asian market across a range of Henry Hub and Asian LNG prices.”

All told, by 2015 Finlayson expects BG Group’s LNG off-take to be in the range 17-20 mtpa, excluding short-term volumes.

New projects: Looking further into the future, BG is currently pursuing four new potential LNG production projects: Prince Rupert in Canada (around 14 mtpa, with sanction unlikely before 2016); Lake Charles in the US (15 mtpa, with a complete FERC application expected at the end of this year); Tanzania (around 10 mtpa, with project sanction probable in 3 to 4 years); and a third train at QCLNG (following a 2-3 year exploration and appraisal programme to identify the best options).

Asked by Gastech News about the possibility that shale gas development outside North American and new pipeline supply might undermine bullish LNG demand projections, Finlayson replied:

“We do recognise that there are other potential game-changers out there . . . but we believe that the demand for gas in the Asian markets, and particularly in China, is potentially so great that it can easily absorb all of these [supply sources]. My favourite statistic in this – given what air quality is like in Chinese cities – is that if China changed its fuel mix 10% from coal towards gas that would be the equivalent of the full current seaborne LNG trade world-wide.”

Chart showing predicted increase in cash margin for BG productionFINANCIAL OUTLOOK – The proportion of the group’s production with cash margins of over $50/boe is expected to triple over the coming five years. (Chart courtesy of BG Group)

Financials: So what does Finlayson expect the strategy to deliver in financial terms? A key driver will be the emphasis on growing earnings faster than production. As the chart above shows, the proportion of the group’s production with cash margins of over $50/boe is expected to triple over the coming five years to more than two-thirds of production, thanks to high margins in Brazil and Australia.

Moreover, despite an increasing spend on exploration, capital expenditure is expected to fall from around £12 billion in 2013 and 2014 to $8-10 billion in 2015 and 2016, as the Australian LNG project and the FPSOs in Brazil come on stream.

“As a result,” said Finlayson, “we expect the group’s return on capital to increase over this period; partly driven by the growth in earnings but also by the rising proportion of capital that will be in production as the growth projects in Australia and Brazil come on stream.”

Chart showing BG Cash Flow strategy for next decade

CASH FLOW – BG expects its new strategy to create strong free cash flow later in the decade, allowing the company to pay down debt, invest in growth and return cash to shareholders. (Chart courtesy of BG Group)
That in turn will have a big impact on cash flow. During the current period of high investment, net cash flow is expected to be negative. “However,” continued Finlayson, “over the period 2015-17 our cash flow position will improve significantly. We’ll have strong cash flows from Brazil, Australia and Sabine Pass and lower capex. To this we are likely to add proceeds from further portfolio management. This will create strong free cash flow allowing us to pay down debt, maintain a strong flexible balance sheet, invest in further organic growth and high levels of exploration activity, and return cash to shareholders.”

Over-reaction? It is hard to escape a sense that the market response last October to Sir Frank’s comments about missed production targets was something of an over-reaction. The subsequent partial bounce-back in the share price tends to support this view.

BG Group’s new strategy inevitably carries some risks. In particular, LNG volumes in Australia will depend on reservoir performance, while in Brazil BG will be depending to a large extent on the performance of operator Petrobras. It will take time to fully win back the confidence of investors, while they wait to see how well BG’s aspirations are transformed into reality, and as Finlayson shows his mettle.

What is not in doubt is that BG has a strong set of opportunities and an impressive track record of successful exploration and development.