Is Shell too big to fail?

Of course the answer is obvious. How could anyone be so foolish as to think that a company with earnings of $19bn in 2014, with reserves of 13bn barrels of oil and gas and with daily production of 3m barrels of oil and gas could possibly fail ? How could anyone think of bracketing Royal Dutch Shell with GEC, or ICI or Lehman Brothers — each in their time great companies but now reduced to dust. Perhaps it is impertinent to even ask the question. Surely Shell has survived for a century and more getting through wars, expropriation, an entanglement with Nazi Germany, the horrors of Nigeria and numerous other “crises”?

All true. Shell is undoubtedly one of the world’s great companies — decent, honest, civilised and a world leader in energy technology. But even those attributes do not provide complete protection in a world where the past is no guarantee of the future. Companies can have too much history and too great a sense of their own institutional importance. In a very competitive world no one is ever totally safe.

What brings companies down — first shrinking and then falling victim to break-up and extinction? Every example is different but there are some strong common factors. What matters is not just a mistaken decision — every company makes those. Much more important is the inability to recognise a mistake when it has been made and change course. Many companies that fail simply lack a reverse gear. They just keep going in one direction driven by the combination of necessity and belief in their own correctness. But in a world of dramatic, unexpected change there can be no room for such obduracy.

That is perhaps the best word to describe the mind set of Shell at the moment. The bid for its smaller rival BG Group is the most recent example of this trait but it is not the only one. The misadventure in the Arctic persisted for years beyond the point when the outcome was obvious. Behind both decisions lies Shell’s failure to replace their production with new reserves. In 2014 it replaced only 24 per cent of its oil and gas output. That failure create the necessity to buy reserves whatever the cost.

On January 26 Shell’s shareholders — who have seen the value of their holdings fall by almost 40 per cent over the last 18 months — will be asked to back the bid for BG, which has now cleared its final regulatory hurdles.

When announced, the bid put a premium on BG shares of 52 per cent. Goodness only knows what the BG share price would be today without the bid. The scale of the premium was quite unnecessary — BG’s weakness has been recognised for years and many companies had looked it over and decided against buying. When the bid was made the oil price was $65. Now it is $37. Over the last eight months, various claims have been made about the oil price that were necessary for the bid to add value for Shell shareholders. At first a figure of $90 was mentioned — the mid point of Shell’s long-term planning range at the time. That number has been reduced again and again without any convincing rationale but has still not managed to keep pace with the decline in prices in the real world.

The bid made no provision for any fall in the price of oil or natural gas because Shell is convinced that prices will rise again. That conviction is almost religious in its fervour. On December 18 Ben van Beurden, Shell’s chief executive, was quoted in the FT as saying that oil prices would “average” $65 a barrel over the lifetime of the merger — whatever that means. The word average is important because it tells us that he is expecting prices for part of the period to be substantial higher than $65 to balance their current low levels.

Every man and his dog are entitled to have their views on future prices, but how on earth can a serious chief executive plan the investment strategy of a major company on the assumption of an enduring increase of at least 70 per cent above current prices? Clearly, Shell’s shareholders don’t agree with him, or the value of the company would not have fallen so much. Some may also share the view that planning the future on blind optimism is one sure route to corporate failure.

What should Shell do now ?

Most immediately, it should renegotiate the deal with BG at a price perhaps 50 per cent lower than the current offer. This is tough on BG shareholders, who have also suffered from a surfeit of management optimism over the years. But they have nowhere to go and I imagine institutional shareholders would accept a revised bid. If they don’t, BG will receive a $750m payment for non-completion of the transaction and presumably come up with its own plan B.

Beyond that, the Shell board — which is supposed to represent the interest of shareholders — should demand and impose a $40 strategy. That will challenge the company’s excellent technical staff to come up with different solutions, instead of relying on starry-eyed optimism from head office. If the price does eventually average $65 so much the better.

Shell is not too big to fail but failure should not be allowed to happen. The company represents a significant part of the London market and part of most major institutional portfolios. It is one of the few examples of a genuine European champion capable of working and competing anywhere across the world. Its decline would be a cause of great political and economic concern.

Someone has to blow a whistle of common sense to break out of the currency obduracy. Accepting that you have made a mistake is not dishonourable. If that is impossible all bets are off.

 Nick Butler

Nick Butler is Visiting Professor and Chair of the Kings Policy Institute at Kings College London.