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Is Shell/BG merger a catalyst event or natural market evolution?

The £47bn merger of Royal Dutch Shell with BG Group could be one of the biggest of the past 10 years, with the resulting company having a value of more than £200bn. 

If the deal goes through, the combined company would be worth 9 per cent of the FTSE 100 and around 7.5 per cent of the FTSE All Share. And this behemouth size has implications.

According to market experts, the move may present a big challenge for some pension funds and closet trackers, which manage their portfolios in line with the benchmark index.  

Hargreaves Lansdown senior analyst Laith Khalaf points out current regulations prohibit active funds from holding more than 10 per cent of their portfolio in one company. Consequently, he says the deal makes it ”extremely difficult” for any managers to take a particularly positive view on Shell.

“A pretty high position for a manager to have in a stock is 7 or 8 per cent. So to have a stock which is 10 per cent is really out of bounce for most managers. This means that looking forward managers will be underweight Shell.”

Fund manager Eric Moore of the Miton Income Fund agrees, saying a 10 per cent exposure would be “uncomfortable” for managers.

”[The merger will be] quite a bad day for the average UK equity fund, both income and oil companies sector specialists. Most funds will not benefit from the takeout.”

However, the rulers do not apply to passives, which are allowed to hold up to 20 per cent of their portfolio in any one company. This has a knock-on effect for investors in trackers, says Khalaf.

“Investors maybe need to take a step back and think about whether by investing in those trackers they have a bit too much exposure to one stock. If they do decide that’s the case maybe they might need to diversify into another fund or two,” he says.

As an alternative he would opt for overseas trackers or active funds where there is no index positioning in Shell.

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Taking aside the weighting to it, does Shell still represent a good stock in which to invest? Particularly when oil prices have hit record lows.

”Shell is still a reasonable investment for individual investors as the yield on offer is 6 per cent. With the 10 year gilt yielding around 1.6 per cent, that still looks like a healthy premium,” says Khalaf.

The giant oil company has a large balance sheet and a robust framework to provide dividends to investors, so “there is no suggestion that Shell is not going to be around in five years time,” Khalaf adds.

Despite that, only 4 per cent of active managers are currently overweight the stock, according to Hargreaves Lansdown. The rest are underweight Shell, with six out of ten active managers not having any position at all. 

Baring Asset Management investment manager Duncan Goodwin, who manages the Baring Global Resources Fund, says the merger is not going to change whether a manager should be overweight or underweight energy.

He says: “We are underweight BG and that group of companies overall. We want to be positioned in companies with good growth and attractive valuations and strong cash generation. We are not going to suddenly buy overvalued cashflows because of what’s happened.”

Goodwin says investors need to identify solid asset companies and that is the same as it was before the deal announcement.

“Maybe the equity markets need to pay attention to those undervalued assets because others in the industry are clearly paying attention to them and taking action.”

Goodwin does not believe the merger is a catalyst for future similar deals but is the result of a possible ongoing structural change in the industry. 

“In the current, potentially lower, price environment the market might experience a portfolio restructuring among the larger caps and major integrated oil and gas companies,” he says. These companies are trying to increase their exposure further down the cost curve including “going to some of the lower cost regions” such as Brazil and the US onshore crude sector. 

”This is not the first or the last repositioning among those integrated oil and gas groups. We could see more coming potentially,” Goodwin adds.

Moore thinks that whether this deal is going to be a good one or not comes down to the oil price. 

He says: “If you look at the cashflows of the combined group I think they are only in the position to pay dividends if oil gets back to $90 a barrel, and that is a long way up from the $55 today.”

”Shell clearly thought BG was undervalued. If you see other companies taking that view than this is telling you where the valuations are in the energy sector.”

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