Background. Royal Dutch Shell Group is one of the world’s 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 UK’s 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 Group’s 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 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 investor’s 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 ADR’s 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 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.