Why Adnoc's offer to acquire Santos marks big leap for a state energy company

It would be the largest acquisition of an upstream international oil and gas company by a state-owned one.

Adnoc’s $18.7 billion bid for Australia’s Santos, in partnership with private equity giant Carlyle and Abu Dhabi’s holding company ADQ, is a dramatic sign of its ambitions. It tells us important things about Adnoc’s strategy and its role in reshaping the global oil and gas industry.

Adnoc made the offer through its international investment unit XRG, which, in its short life, has already made some big moves. XRG intends to become an $80 billion business focused on gas, chemicals and lower-carbon sectors. And it also aims to become a top-five integrated global gas business, with 20 million to 25 million tonnes of annual liquefied natural gas (LNG) capacity by 2035. The company has already acquired LNG assets and gas purchase contracts in the US and Mozambique, totalling about 4.4 million tonnes, alongside gas projects in Azerbaijan, Turkmenistan and Egypt.

XRG is not afraid of aiming for full control of companies listed on western public markets, an area where Gulf state investors have often been shy. It endured a long negotiation and regulatory process to win control of Germany’s speciality chemicals maker Covestro in a $16.3 billion deal which is now proceeding through European Union checks. In March, XRG reached a complicated agreement with Austria’s OMV to merge cross-holdings in the Borouge and Borealis polymers businesses with Mubadala’s Nova Chemicals.

It is hard to think of a similar international expansion by a major oil-exporting country. Previous deals by Kuwait, Saudi Arabia, Qatar and Venezuela from 1981 onwards were much smaller, involved minority stakes for financial return, or focused on securing downstream outlets for crude oil production in refineries and petrol stations. The big Middle Eastern producers have generally taken the view that it made little sense to invest overseas in competition to themselves, when returns were so much better at home.

XRG’s approach, however, is different. Working with partners reduces its financial exposure while retaining its access to Santos’s strategic benefits. Buying Santos does not compete with Adnoc’s core oil business.

Adnoc’s LNG business depends on the historic Das Island plant and the under-construction Ruwais facility in western Abu Dhabi. But with plenty of other demands on its gas output in the UAE, achieving truly competitive scale and geographic spread requires international expansion.

The Adelaide-headquartered company produces almost entirely gas, from fields in Australia and Papua New Guinea, including stakes in three important LNG projects. It has 7.5 million tonnes of annual LNG capacity, taking XRG almost halfway to its 2035 goal. The Papua LNG project, with an anticipated start date of 2028, will bring a further 1.3 million tonnes net to Santos’s interest.

The addition of Santos and the completion of Ruwais would make Adnoc the world’s fourth-largest LNG producing company, slightly ahead of ExxonMobil and behind Shell. New projects, though, would see others such as fellow Australian Woodside regaining ground in the race.

Beyond this deal, XRG’s easiest route to its 20 million-25 million tonne target would be to acquire more US projects. There are plenty of them, many need finance and transactions are frequent. This contrasts to the rest of the world, where good LNG assets rarely come on the market, and the available greenfield developments bring major technical, commercial and political risks.

Other than Australian compatriot Woodside, which is much bigger and would be a political hot potato, there are few publicly traded LNG specialists. There has been market chatter around various suitors for the UK's troubled BP, which itself has 8.9 million tonnes of annual LNG capacity plus a big and profitable trading portfolio. But Shell would likely compete hard with any bidder for its smaller British rival.

Perhaps even more important than the raw volumes are three other things that Santos brings. First is expertise in developing international LNG projects. That will be useful whether XRG seeks organic opportunities or acquisitions to meet the rest of its 2035 target.

Second is geographic balance. Its focus on Asia-Pacific balances the US-facing elements of XRG’s LNG portfolio. The two major LNG-producing and consuming regions, the Atlantic and Pacific basins, are rather separate, even more so with the current difficulties in transiting through the southern Red Sea.

US, and West and North African LNG primarily serves Europe, while East African, Middle Eastern and Australasian LNG goes to Japan, South Korea, China and south Asia. Because of tariffs, it is commercially impossible to sell American LNG to China at the moment.

Third is pricing balance. US LNG is usually priced against the Henry Hub benchmark in Louisiana, sales in Europe are determined by gas trading hubs in the UK and the Netherlands, while LNG sold in Asia is mostly pegged to the oil price or the Japan-Korea marker. These prices can move a long way out of alignment with each other, particularly at times of crisis such as Russia’s invasion of Ukraine in 2022. This is a chance for smart traders to profit but also involves risks of big losses if a company cannot cover its sales commitments.

Santos’s board has agreed to back XRG’s offer, and L1 Capital, one of its leading shareholders, is also supportive. L1 estimated in 2023 that Santos’s assets should be worth A$10.50 (US$6.80) per share, compared to the current offer of A$8.89.

Still, XRG and its partners will have to overcome some hurdles. Santos’s shares are trading 13 per cent below the offer price, indicating the market sees a significant chance the deal will not be completed, and that there won’t be a higher counter offer. Last February, Santos and Woodside called off merger talks after failing to agree on valuation.

Australia may be concerned about the security of domestic gas supply, for which Santos is a key producer. The state of South Australia will want solid commitments on preserving jobs. While Adnoc will give assurances on these points, the domestic politics around energy acquisitions by foreign companies are often tricky.

Obtaining all approvals could take up to a year. Adnoc’s willingness to brave this process is perhaps another competitive advantage over more cautious Gulf peers.

The oil and industry has consolidated significantly, with the disappearance of major firms such as LNG leader BG, bought by Shell in 2015. European investors are shy of hydrocarbons, North Americans prefer their home markets, and Chinese and Russian buyers are not welcome in the West. This is a great time for someone with deep pockets and tolerance for risk to build a world-scale gas business.