Royal Dutch and Shell

Zachary Stahlsmith
Dr. Asaad
Investments
16, February 2015
Background. Royal Dutch Shell Group is one of the worlds largest oil
corporations and one of the largest companies in Europe. The company was
created as a result of a merge between Netherlands Royal Dutch and UKs
Shell Corporation. The case looks at the issue of price differentials between
several equity listings in different markets from the perspective of investors
seeking an arbitrage opportunity. Royal Dutch trades more actively in the
Netherlands and U.S. markets, whereas Shell trades more actively in the
United States. The result is that the Royal Dutch/Shell relative price moves
positively with the Netherlands and U.S. markets and negatively with the
U.K. market.
Structure. The Royal Dutch and Shell Groups structure has all of its
subsidiary companies controlled by the holding group of the company. These
companies include Shell Petroleum NV located in Netherland, The Shell
Petroleum Company Ltd based in UK, and Shell Petroleum Inc. based in the
United States. These companies are controlled by the two parent companies,
which are Royal Dutch Petroleum and Shell Transport & Trading. The
ownership is divided in terms of 60/40 ratios. The relationship between
these groups of holdings are meant to be 60/40, which means that all the
inflows coming and all the outflows made to shareholders are divided
between the two holdings. This represents that one share of Royal Dutch
and one share of Shell is entitled to the same cash flows. The structure of
the company is different from the equity firms. The main difference is that
the returns of fund management are based on the performance and then
further divided into the fund managers. The manager gets the rewards in
terms of compensation while maximizing the investors investment return.
In this case the Dutch is receiving more than the Shell which means that
whatever the earning would be, Royal Dutch gets the maximum out of that
inflow and Royal would pay more in terms of outflow.
ADRs. An American Depository Receipt is a certificate that can be negotiable
and issued by the banks located and operating in the US. This negotiable
certificate represents as a number of shares in foreign shares that is issued
and traded in the US stock exchange. Companies find it attractive to issue
ADRs because it can help the company reduce its administrative costs while
saving on duty costs. If a company does not issue an ADR, they must pay a
higher duty on each transaction. For each transaction the company would
also have to bear the additional cost for administrating that transaction.
Investors are interested in ADRs because they raise equity capital and
increase the chance to acquire equity at lower costs. This is because ADRs
allow the investors to enter into the large market where equity investors are

Royal Dutch and Shell

easily available to invest in the company. This would also reduce the legal
requirements. Within an ADR, a foreign firm enjoys all the benefits of US
listed firms without losing its original identity. The cost of listing in the US
stock exchange is high but using the ADR it reduces the cost. Many
companies issue ADRs, because it increases the exposures in terms of raising
capital in the global market. It also increases the liquidity of a stock of the
company and develops the trust in local equity investors to invest into the
company. On the other hand, from an investors perspective ADRs increases
its portfolio into global market where an investor invests into diversified
portfolio that ensures the maximum returns of invested capital. It reduces
the risks involved in direct investment into foreign market and investors get
the benefits in investing ADRs as the exchange rates of USD is competitive
against other currencies that generates higher returns.
Price Differentials. Exhibit 3 presents evidence of a disproportion amongst
the ownership of the Royal Dutch and Shell Corp in different markets. The
ownership of Royal Dutch is approximately equally split between the U.S. and
Dutch investors, while Shell Corp. stock is almost exclusively held in the UK.
This could possibly be explained by different tax treatments of the two
companies under different rules. For a private investor there would be no
difference in the tax treatment between the two investment opportunities.
However, pension funds have different tax treatments in each jurisdiction
depending on whether the investor bought Royal Dutch or Shell. In Exhibit 8
of the case study, Royal Dutch was trading for $141.368 in Europe and
$141.375 in New York (a 7 cent differential). Shell was trading for $124.222
in Europe and $126.554 in New York (a $2.332 differential). These price
differences exist due to market inefficiencies; however, these differences are
small. As shown in the last column of Exhibit 11, these calculations render
small estimates of the impact of these discrepancies. The percentage would
be approximately 1% of the company valuation. The impact of these
differences is calculated with the following formula: Avg. dividend for the
group x Difference in tax treatment for the two entities.
Arbitrage. In economics and finance, arbitrage is the practice of taking
advantage of a price difference between two or more markets: striking a
combination of matching deals that capitalize upon the imbalance, the profit
being the difference between the market prices. In this case, there is an
opportunity for arbitrage. One arbitrage transaction that could be utilized
would be a buy / sell transaction. An investor could liquidate his holdings of
Royal Dutch and purchase the equitant stake in Shell. Following the
expected convergence, the investor would sell his shares of Shell and
purchase Royal Dutch. Another option to commit arbitrage would be to enter
the customized swap agreement with the hypothetical Wall Street firm.
Net Payoffs. When considering the sale of an asset, the seller should take
into consideration not just the sale price, but how much he/she will actually

Royal Dutch and Shell

receive at the end of the transaction the net payoff. In the buy / sell
transaction HSGA could sell Royal Dutch in New York and purchase Shell
Corp. in London. The total transaction cost would be 395,088 shares of Royal
Dutch * 25c truncation cost in New York ($98,772) + $50m * 151 bps
transaction cost in London ($755,000) = $853,772. In this buy / sell
example, one would incorporate the FX spread on the Shell portion because
of the need to convert the profits from Royal Dutch shares into pounds
sterling. When examining the swap agreement, there would be no direct
transaction cost, but HSGA would have to pay 4% on the $50 million of Shell
Corp shares. That would be $2 million per agreement with the Wall Street
firm. Overall these arbitrage strategies show that market discipline might
fail if market expectations about price convergences are time bound and
market liquidly is limited.
Suggestions. The first strategy (buy / sell) is open to investors to take
advantage of an arbitrage
opportunity. The profit opportunity might not
be very attractive, but does in fact produce positive returns. In the other
case of the swap strategy, any further divergence of prices would bring
losses to the investors. In conclusion, market makers might be reluctant to
exercise the arbitrage opportunity, subject to convergence expectations.
Under current market expectations as stated in the case, the transaction
would look to be unprofitable, and arbitrageurs would have no reason to
expect the convergence to occur.