Breakingviews - Shell-BP merger's key ingredient is time

Reuters

2 days ago

LONDON, June 3 (Reuters Breakingviews) - Wael Sawan must feel like it's Groundhog Day. In recent weeks Shell's (SHEL.L), opens new tab chief executive has been fielding one question over and over again: whether he's considering merging his $198 billion group with struggling UK rival BP (BP.L), opens new tab. Drill down into whether a swoop for the $77 billion oil major makes any sense, and Sawan's lack of enthusiasm is understandable. Yet a year from now, conditions could look more favourable.
Shell-BP would be a seriously big beast. At around 5.4 million of daily barrels of oil equivalent output, it would create a European giant that dwarfs even U.S. peer Exxon Mobil (XOM.N), opens new tab, the biggest Western oil major. The same would apply to its 3.1 million barrels of daily refining capacity, putting it second behind Exxon. Extensive overlap of oil fields, especially in the United States, implies scope for big cost savings.
Even so, the market likes the cost cuts and deleveraging Sawan has managed since joining in January 2023. Shell has outperformed even U.S. giants like Exxon and Chevron (CVX.N), opens new tab, and BP's market capitalisation now lies below 40% of its domestic rival's – the level at which managers internally start to feel it's worth seriously considering a merger, according to a person familiar with the matter. Even so, the M&A math still has to be convincing.
Right now, it isn't. Assume Shell offered a typical 30% premium, valuing BP's equity at $100 billion. Add in BP's $27 billion of net debt, $13 billion of leases and $17 billion of hybrid bonds, and BP's enterprise value would be $157 billion. Going forward, Goldman Sachs analysts expect BP to make less than $17 billion of operating profit in 2026, which factors in expected hits from lower oil prices. Taxed at the 40% tax rate BP guides to, that's a 6% return on invested capital – less than BP's cost of capital of around 8%, as estimated by Morningstar.
That number admittedly doesn't include the synergies. Cost savings of anything between 25% and 50% of the target's distribution and administrative expenses – which include rents and other overheads – are possible on big fossil fuel mergers, according to a person familiar with deals in the industry. Assume that Shell can strip out 25% of BP's $16 billion of such costs in 2024 – roughly in line with synergies from Exxon's landmark Mobil swoop in 1999 and Chevron's 2023 offer to buy Hess – and BP's operating profit would expand to the tune of $4 billion. Even then the overall return would still be less than 8%.
Given the execution and antitrust risks inherent in such a deal, plus chunky one-off transaction costs, that's not a juicy enough return. Sawan is gaining plaudits simply by buying back $3.5 billion of his shares each quarter, and reckons Shell's free cash flow per share will grow 10% or more annually out to 2030. An all-share swoop for BP – which is probably the main option given the sums involved – would inflate Shell's share count by 50% and might imperil this cash gusher.
Even so, by the second half of 2026 things may look different. For one thing, Shell's shares may continue to rise. Bank of America estimates for 2026 suggest the group is trading on a 12% free cash flow yield, way above the 8% European oil sector average – implying the group is undervalued. For another, in a year's time Sawan might be keener on a fresh growth story. While he has already hit 'first sprint' ten-quarter efficiency targets launched in June 2023, and promised further self-help by 2028, mega-M&A that takes 18 months to bed down could provide it.
BP, meanwhile, could look worse. It may take too long to replace a management team and chair that have become associated with previous strategic missteps, or stumble into another crisis. Oil prices upended by excess supply and the shock from U.S. tariffs could also hit BP relatively harder, given 90% of its 2024 operating profit came from exploration and production and it has a more leveraged balance sheet. If oil prices languish at $60 a barrel, BP is expected to cut annual buybacks by 70% in 2026 compared to 2024 levels, per JPMorgan analysts. In contrast, Shell can maintain its dividend and buybacks in such a scenario, Bernstein analysts reckon.
Imagine that Shell's shares rise another 10% from their current level so the company is worth $220 billion, while BP's slump 10% to $69 billion. In a year's time BP's divestment push to cut net debt to between $14 billion and $18 billion by end-2027 should be well underway, given progress in a potential sale of Castrol, which could be valued at $10 billion. If the $18 billion of BP operating profit estimated for 2027 by Goldman transpires, and BP's net debt is trimmed by $10 billion, Shell could achieve a 10% return in that year even if it only extracted the same $4 billion of synergies.
These synergies, meanwhile, are a movable feast. While analysis by McKinsey found, opens new tab that 50% of fossil fuel deals in the exploration and production segment of the sector destroyed value, Exxon's Mobil merger captured $10 billion in synergies within five years, far outpacing the $2.8 billion flagged by the acquirer at the time. Shell itself upgraded its synergy estimate from buying BG Group in 2016 from $2.5 billion to $4.5 billion. If Sawan thought he could strip out 50% of BP's D&A costs, his return would rise to 12%.
Shell's boss may still resist the bother of a major deal. And BP may end up getting a new management team in double quick time, egged on by 5% activist shareholder Elliott Investment Management. That might prompt it to re-rate, messing up the favourable deal math. Still, many of Shell's shareholders are also BP investors. If they start to think BP-Shell is the new Exxon-Mobil, then they will likely make that clear.
Follow Yawen Chen on Bluesky, opens new tab and LinkedIn, opens new tab.