Baytex bets big on a shale payoff

The $1.84 billion agreed takeover of Aurora Oil and Gas by Canada’s Baytex Energy illustrates some of the complexities around perceptions of the US shale gas sector.

The proposed scheme of arrangement acquisition will also include about $750 million of Aurora’s debt, so the enterprise value implied by the offer is about $2.6 billion. It’s an aggressive deal for Baytex, which has a market capitalisation of $US4.7 billion ($A5.25 billion). Baytex will raise about $1.3 billion of new equity to help fund the acquisition.

Given that the offer represents a premium of more than 50 per cent over Aurora’s pre-announcement share price and a 41 per cent premium over its three-month volume-weighted average price, it isn’t surprising the target company’s directors have unanimously embraced the deal.

The Canadian group has historically been focused on conventional oil production in Canada. The Aurora acquisition represents a significant shift in strategy and a big bet – the biggest in its history – on US shale gas and liquids.

It comes at a time when there is continuing consolidation occurring within the US shale gas sector. This includes the exit of some heavyweights like Shell, which rushed in as the significance of the sector became apparent, but invested too much in the wrong places.

It also coincides with what will probably be a temporary spike in US gas prices above $US5 per Mbtu, which is related to the worst of the US winter.

Henry Hub gas futures, however, are now solidly above $US4Mbtu. This figure is about double what they were two years ago when a plunge in the price below $US2 forced BHP Billiton to write down the value of shale gas assets it acquired in February 2011 by $US2.8 billion.

Since then, BHP Billiton has concentrated its investment and activity on fields containing liquids, leaving the dry gas resources in its US acreage for another day and a higher gas price.

The appeal of Aurora to Baytex is the Australian company’s focus on the Eagle Ford region of Texas, where BHP Billiton has a very large position. Eagle Ford’s resources are liquids-rich, so the deal will add a light crude resource to Baytex’s portfolio.

It is a bold move by Baytex. Apart from the environmental concerns that shale gas exploitation stirs up, it is a highly capital-intensive sector that tends to consume cash. Aurora’s capital expenditures have been running at about $500 million a year, but it generates net profits of only around $100 million.

That cash strain of having to continuously increase drilling to maintain and grow production has been a major factor in the displacement of the smaller companies, which initially developed the sector, by the big energy groups. For instance, BHP Billiton is investing about $US4 billion a year in its shale gas business but doesn’t expect to be generating free cash flows until 2016.

There are, however, quick pay backs and high returns on investment from liquids-rich gas fields and Eagle Ford is regarded as one of the sweet spots in the US industry. The pervasive oil and gas pipeline infrastructure in the US also supports the economics of the sector.

Many people have been cynical of BHP Billiton’s $US20 billion-plus plunge into US shale gas. The valuation of Aurora by Baytex, and the level of both current US domestic gas prices and the forward curve, tends to support BHP’s view of the medium-term prospects of its shale gas position.

It also vindicates the very entrepreneurial decision by Aurora – a tiny company at the time – to enter the then-nascent US shale gas industry just under a decade ago.