OREANDA-NEWS. Royal Dutch Shell's acquisition of BG Group agreed yesterday could spark a wave of energy deals beyond the opportunistic ones already seen, Fitch Ratings says. The deal signals that Shell has confidence in the sector and is positioning itself for the sector's recovery. Shell's competitors are likely to also look for partners, so they are not at a disadvantage when the cycle turns.

The combination should strengthen Shell's business profile as the largest European oil and gas major, and enhance its position in the LNG market and boost upstream liquids production. The combination would increase Shell's oil and gas reserves by 25% and we estimate production to rise to around 2.9-3.0m barrels a day of oil and oil equivalents in 2015-2017, from 2.27m in 2014 (excluding equity affiliates).

Not many companies have the financial flexibility of Shell but financing deals using equity rather than borrowing, particularly for larger acquisitions, would allow even relatively cash-strapped companies to be able to find a deal. The agreed terms of the Shell-BG transaction assume a total consideration of around USD70bn, mainly share-based, with USD20bn in cash.

The recent fall in oil prices has dragged down the valuations of energy groups, particularly weaker ones, making deals more attractive. Some significant deals have already materialised. Halliburton, the oil services group, agreed in November to buy Baker Hughes in a USD35bn deal.

Smaller companies are typically more vulnerable to low oil prices because of higher leverage, higher production costs and poorer access to external funds. This can make them attractive targets for larger groups with better access to funding and technology, and that have been struggling to increase their reserve base for several years. There remains the potential for larger companies to use the current downturn to enter or consolidate their positions in US shale oil. While some have been burned by shale before, a longer track record of shale oil development combined with weaker valuations and potentially distressed companies may make these tempting targets.

The largely share-based deal limits the credit impact on Shell, which has substantial financial flexibility. Nevertheless, we have placed its 'AA' rating on Rating Watch Negative to reflect that moderate deterioration in its financial profile after the acquisition is possible. The enhancement of Shell's business profile may not fully offset any deterioration of credit metrics.

The Rating Watch Position on BG reflects our view that the acquisition by Shell, if successful, would be a significant credit enhancement to BG's existing business and materially reduce the risk of default for BG's outstanding debt.