Recent anxiety about a debt crisis has roiled European equities while concerns over a weakening global economic growth have taken a toll on shares of energy companies. We believe the combined effect of these two issues has created a buying opportunity in BG Group (BG.), one of our favourite, if often overlooked, international oil and gas companies. Given a proven business model, favourable market conditions, and unrivalled growth, BG is significantly undervalued in our opinion.
Differentiated Business Model
Investors may have overlooked BG in the past given its differentiated business model. Without any directly comparable peers in the marketplace or a listing on the NYSE or Nasdaq, BG may not appear on many U.S. investors' radar. In our opinion, that would be a mistake. Though many international oil and gas companies are investing in liquefied natural gas projects, none make it the central focus of the company like BG has done. As an early mover into LNG, BG secured stranded, low-cost sources of natural gas in regions with little domestic demand to use as feedstock for exported LNG. As a result, the company has gradually built up a global portfolio of liquefaction and gasification assets, as well as secured contracted volumes, which it is able to leverage and trade against to ensure cargos reach the highest value markets at any given time.
Additionally, we do not think investors should be overly concerned with the U.S. pink sheet listing considering BG is not a speculative play with a market cap of $66 billion. Also, we think there is likely ample liquidity in the ADR shares for retail investors. Meanwhile, we find the company's financial disclosures to be on par with other international firms listed on the major exchanges. The company also complies with SEC reporting standards for oil and gas firms, including the reporting of reserves.
Though we like BG's model and believe it will continue to deliver excess returns as it has done in the past, we also see two other key factors that we believe the market is not adequately crediting BG for, resulting in the current discount to our fair value estimate.
Favourable LNG Market Dynamics
Given that BG specialises in LNG and is an active market participant it has a keen insight into market conditions. In anticipation of a soft LNG spot market in 2011 and 2012 given the startup of global projects, the company decided to lock in LNG operating profits for 2011 and 2012 at $1.9 billion-$2.2 billion. The secured volumes comprise a significant portion of our estimated operating profit for 2011 and 2012 of $8.7 billion and $9.9 billion, respectively, and offer some protection in today's uncertain market environment. However, beyond 2012, favourable market conditions should result in higher profitability for BG.
After completing the commissioning phases, projects that started up in 2011 and 2012 should begin to deliver to customers as part of their long-term contracts. As a result, significant cargo should be removed from the spot market creating tight market conditions. At the same time, historical exporters such as Indonesia and Malaysia will likely see LNG volumes decline and may even need to rely on imports. Meanwhile, a host of other Asian countries including Pakistan, Bangladesh, Thailand, and Vietnam will be increasing LNG imports as new regasification capacity comes on line. These countries will offer incremental demand in addition to China and India, which should see the greatest growth of LNG imports.
China is currently constructing a number of LNG import facilities to accommodate volumes from recently signed long-term supply contracts for LNG volumes. However, additional terminals are under construction or planned to handle spot market purchases as contracted volumes are unlikely to meet demand. Government actions to encourage natural gas consumption as a way to reduce carbon emissions should provide further support of LNG import volumes. In India, natural gas demand for power generation and industrial users is increasing, while lack of pipeline infrastructure in the country dictates the need for waterborne LNG imports. As a result of the anticipated supply/demand imbalance, BG should be able to capture higher profits from its own LNG production as well as trading of its contracted volumes in the coming years.
Attractive Production Growth
In addition to the improvement in market condition we anticipate over the next few years, we also forecast a period of robust production growth beginning in 2012. While we expect to see volume growth from several current key producing regions such as the U.K., Kazakhstan, and Egypt, three other regions--Brazil, Australia, and the U.S.--will likely contribute the bulk of growth over the next 5-10 years for BG. The combination of these projects should lead to compound annual growth of almost 14% over the next five years.
Of the three, Brazil is likely the most transformative. Thanks to early entry into concessions in the Santos Basin and subsequent exploration success, BG now has a source of prolific oil growth for the next decade. Additionally, as the development progresses, BG and investors are gaining a better understanding of the potential value of the resource. Most recently, BG doubled its estimate of recoverable reserves to 6 billion boe from 3 billion boe as the resource proved to be more prolific than originally thought. More importantly, BG expects to develop the additional barrels with little additional capital, greatly increasing their value. Also, given the quality of the resource, BG expects to achieve plateau production sooner and maintain that level longer. Most recent guidance was for production from Brazil of 550 mboe/d by 2020; we now expect BG to exceed those levels.
In Australia, BG expects to add production of about 200 mboe/d by 2014-15 thanks to the addition of two LNG trains. Once again BG is tapping low-cost stranded resources--coal seam gas in this case--with little domestic demand. Similarly to Brazil, BG has increased the size of this project by increasing the size of the trains as additional resources were discovered and long-term supply contracts were secured. Additionally, we expect BG will approve a third train within the next few years given the size of the resource. We also see the startup of the Australian project as fortuitous, given that it will coincide with the tightening of the LNG market we previously discussed. Even without a significant improvement in LNG market conditions at the time, BG should still see LNG profit jump as the Australian projects will increase its LNG supply volumes by over 50%.
In the U.S., BG will realise volume growth through its joint venture with EXCO Resources (XCO), an independent shale gas E&P. BG anticipates production from the joint venture to grow to almost 200 mboe/d by 2015 from about 30 mboe/d in 2010, with volumes primarily coming from the Haynesville. Additional volumes will also come from the Marcellus Shale. While the growth is impressive, we think the value may not come for a few more years until gas prices rebound. BG has advised that its core Haynesville properties are break-even at $3.20/mmcf; however many areas of the Haynesville are likely uneconomical at anything below $4.50. We like its position in the Marcellus better given its status as the most economical shale gas play. Also the bulk of BG and EXCO's acreage is in the more prolific southwest part of the state. Over the longer term, U.S. shale gas production fits with BG's global natural gas portfolio. Though concrete plans remain years away, BG could also eventually use shale gas as feedstock for LNG exports out of the U.S.
Compelling Valuation
At about 1,250p BG trades well below our fair value estimate and provides a compelling risk/reward proposition, in our opinion. We do not think today's share prices accurately reflect BG's growth potential or the positive industry tailwinds of the coming years. While we admit BG is a bit of a long-term story, we also believe that our thesis could play out as early as next year when the company is expected to deliver double-digit production growth. As a result, the recent sell-off provides long-term investors with an attractive entry point to build a position in a name we feel could rise substantially over the next few years. Please see our Analyst Report for further analysis and valuation detail.
