Little Arrow resistance

Arrow Energy's response to the $3.5 billion of increased overtures from Shell and PetroChina is pragmatic. From the moment Shell and PetroChina made their ambitions clear, Arrow appears to have focused more on the terms of surrender rather than resistance.

There are several reasons for that, the most significant of which was that to fund its own ambition of developing a single train 1.5 million tonnes per annum coal seam gas-to-LNG plant at Fisherman's Landing in Queensland Arrow needed to raise about $2 billion of new capital (Targeting Arrow, March 8).

That would have been difficult enough, given that its own major shareholder New Hope Coal, which has a 17 per cent shareholding, had made it clear it was a seller rather than a capital provider, but realistically became impossible once Shell and PetroChina moved.

Asking shareholders to contribute about half the group's current market capitalisation when they could instead receive a big lump of cash at a premium would have produced a predictable response.

Arrow, with a market capitalisation of less than $4 billion (and it would have been significantly less had it rebuffed its suitors) is a minnow in the world of LNG. With an over-supply of LNG in the near to medium terms, the development risk and commercialisation risk of going it alone with Fisherman's Landing would have been acute. Coal seam gas-fed LNG is a game for big players.

So, instead of resisting the approach, Arrow immediately engaged with Shell and PetroChina, the obvious buyers of its coal seam gas acreage given Shell's stated ambition of constructing a four-train plant at Curtis Island in Queensland, its relationship with Arrow and PetroChina's status as a strategic customer.

The decision to negotiate rather than reject has produced a $183 million increase in the amount of cash on the table – Shell and PetroChina have upped their original indicative offer of $4.45 a share to $4.70 a share. It has also significantly improved the size and quality of the other dimension of the proposal.

Arrow, apart from its Queensland coal seam gas resource, has interests in northern NSW, shareholdings in several other small players, and an interesting portfolio of international coal seam gas exploration assets. Shell, which owns 10 per cent of Arrow's international business, also has rights to acquire 50 per cent of any production from them in return for contributing half the development cost – an option on anything of real value Arrow finds and develops offshore.

When the Shell/PetroChina approach became public, the international assets were valued by analysts and by Arrow itself at between about 55 cents and 70 cents per share.

Arrow has negotiated a deal with the bidders under which that business, to be renamed Dart Energy and demerged to existing shareholders, will be bulked up with $45 million of cash and a $US25 million loan facility from Shell as well as by the inclusion of the NSW gas assets, the shareholdings in other companies and the removal of Shell's 'back-in' rights (which doubles Dart's interests in any future developments). PetroChina has also agreed to assist Dart develop its interests in China.

The changes to the nature of the residual business is likely to lead to a substantial increase in valuations of Dart, probably to something materially north of $1 a share.

Thus, Arrow has negotiated a deal which will give shareholders a significant amount of cash at a substantial – 35 per cent premium to the pre-approach price – while injecting more value into the continuing vehicle for Arrow management's ambitions.

Arrow's support for the demerger is rational. Woodside is about the only Australian company one can think of which transformed itself from an exploration company into a major stakeholder in a project of global scale and significance.

Arrow, like Queensland Gas (now part of BG Group) before it, has built up an exploration portfolio and proved it up to the point of commercialisation where real capital and technical expertise is required. It can now cash it out and, through Dart, repeat the exercise with its international portfolio.

It has left the door open to a higher offer from a third party but Shell, with its existing relationships, was always the obvious buyer.

The market might have hoped for more cash but, particularly given New Hope's stance, it was always going to be difficult for Arrow to extract the kind of eye-glazing values paid in the entries of BG, Petronas and ConocoPhillips to the sector. Arrow has a lot of acreage but there is still a lot of effort and dollars required to turn it into reserves.

The need for Foreign Investment Review Board approval is a potential issue, given PetroChina's role, but as discussed previously the number of competing coal seam gas-fed LNG projects planned for Queensland and the question mark over demand makes the involvement of a major customer, with suitable safeguards against conflicts, a major attraction of the combination.