Resource Sector Losing Oxygen?

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

– Brokers do not buy into rumours of a WPL takeover by BHP
– Progress lost to wet weather makes WPL's Pluto 1 timing ambitious
– Lack of gas or customers throws doubt over Pluto 2 timing
– Santos and BHP have both received ratings downgrades

By Greg Peel

Not one broker in the FNArena database ascribes any credence to the persistent rumours of a possible takeover of Woodside Petroleum ((WPL)) by BHP Billiton ((BHP)) and BHP has denied ever contemplating such folly. Yet analysts note there is still an apparent takeover premium of sorts being built into Woodside's share price.

Ironically, assuming no takeover is in the offing then assessment of Woodside's value flips back to concerns over the overhanging 24% Shell stake which is escrowed until December. Yet here, too, brokers are at odds with a market which fears an indiscriminate dumping by the Dutch-Anglo energy giant. Analysts are convinced the Shell stake will either be sold as a parcel to a “strategic” buyer who has been spurred into action by the Fukushima implications of higher global LNG demand, or rather Woodside itself will orchestrate a buyback in exchange for offering stake-holdings in the various expansion projects the company is struggling to fund.

Either way, Woodside shares saw a 15% surge in March and they are largely hanging on to new levels in April. One must nevertheless acknowledge that the oil price is also hanging on to its higher levels no matter which regional delivery contract one chooses. Analysts have all now moved away from using West Texas Intermediate crude as their benchmark in valuation models and switched to a more realistic Brent price instead. Woodside is also assuming Brent prices, but when WTI is at US$108/bbl, Brent at US$121 and Tapis at US$129 it makes forecasting a little less clear.

The higher oil price actually came to Woodside's rescue to some extent with regards to first quarter production. With the West Australian coast battered by cyclones, gas production was impacted but plans to shut down for maintenance at the North West Shelf were also delayed. The upshot is that Woodside's oil/gas production ratio was higher than expected, and at higher oil prices this was a little bonus in an otherwise frustratingly wet and windy period of lost production and lost progress.

Final construction of the first train at Pluto has effectively been set back one month. Management has not altered its planned first production timing of September but admits the lost time will be difficult to make up. Analysts are thus playing the conservative side. The bulk of Woodside's valuation upside lies in its expansion projects – initially Pluto 2, then Browse, and, somewhere down the track, Sunrise. Analysts are a little more conservative than management here, too.

The global LNG market is forecast by analysts to suffer a supply shortage window around 2014-15. Analysts look to ongoing growth in Asian gas demand coupled with the delay period for new projects to reach production as justification for this forecast. Australia's LNG projects, from offshore drilling in WA to CSM aspirations in Queensland, are the big swing factor in global supply to the Pacific market.

On that basis, analysts fear Woodside is starting from the window and working backwards on its timing schedule for Pluto 2. Management has set a target of reaching final investment decision (FID) status by mid this year and plans to start ordering the first bits of infrastructure ready for the long lead time construction phase. As far as analysts are concerned, there are two glaring problems with this schedule: (1) Woodside has not yet confirmed enough gas reserves for a second train, leading to (2) Woodside has not signed up any customers.

The recent Martin gas discovery gave a boost to P2 hopes, and management seems to feel prospects at Xeres (and perhaps Kelp) are enough to push on with equipment orders, but analysts are applying risk discounts to such speculation. Talks are nevertheless continuing with potential third party gas providers, so it seems Woodside is not likely to wait around to ensure its own gas reserves lest the aforementioned window slams shut before P2 is ready.

Citi notes that management did not actually reiterate its mid-2011 FID target in this production update, and feels a more realistic time frame would actually be mid-2012. Macquarie notes little new news on P2 gas supply, and worries that Woodside is appearing rather hasty now on the schedules for both trains. BA-Merrill Lynch has added six months to the back-end (ie first P2 production timing) in its valuation while JP Morgan quite simply would rather back the more likely winners – those LNG aspirants with customer contracted rather than uncontracted projects.

The bottom line is that if Woodside can pull off everything it would like to pull off, there is tremendous upside potential. The problem is a lot more hope and lot less conservative reality is creeping into schedules. Aside from Pluto, prospects at Browse have been bolstered by hopes for the Omar discovery, but again confirmation is required. As far as Pluto 2 is concerned, Merrill Lynch, for one, suggests “expansion along these lines remains fundamental to our Buy case”.

Another two of the eight brokers in the FNArena database share Merrills' faith, being Deutsche Bank and UBS also with Buy ratings for Woodside. Macquarie, Credit Suisse and RBS all have Hold ratings based on too much uncertainty, while less faith, along with the unjustifiable takeover-driven share price rally see Citi and JP Morgan posting Sell ratings.

If we now cross the continent through South Australia and onto Queensland's coal seam methane fields, we find Santos ((STO)) shares have risen 20% since KOGAS signed an offtake agreement for Gladstone LNG. Analysts had also been surprised when Santos moved to FID on GLNG ahead of securing sufficient contracts (seems to be the new trend), but KOGAS went some way to alleviating concerns. Santos has outperformed the energy index by 15% and the ASX 200 by 18% in the time frame.

Santos has also lost development time to wet weather, but by ordering in more drill rigs the company hopes to catch up the lost couple of months. This means increased costs, but Citi has this morning applauded Santos' move to fixed price contracting on the cost side. Fixed contracts may not end up delivering lower costs but they do deliver cost predictability, and that's a lot more comforting in this risky and expensive business of LNG.

Nevertheless, Citi has a formulaic ratings system and share price outperformance sees its Santos rating downgraded to Hold.

BHP Billiton ((BHP)) spent a long time with a perfect eight out of eight brokers on Buy until late last month JP Morgan baulked and dropped to Hold. Today Merrill Lynch has done the same.

Management has finally reset its oil production forecasts, Merrills notes, after waiting to see just how long the Gulf of Mexico moratorium (yesterday was the first anniversary of the Gulf spill disaster's beginnings) would last and the numbers have been eased. Merrills feels the oil price rally is now running out of steam. Persistent wet weather in Queensland means a return to full coal production is now expected to take several quarters, and copper production at Escondida is expected to be “very weak”, Merrills notes, until a recovery in FY13.

Throw in the “synthetic” share price boost from the share buyback, which will shortly normalise, and all of the above adds up to justification for a downgrade.

To summarise, the FNArena database currently has Woodside on a Buy/Hold/Sell ratio of 3/3/2 with an 8% upside to consensus target. Santos is on 5/2/1 and 13%, and BHP is on 6/2/0 and 14%.

In downgrading BHP, Merrills notes its preference for Rio Tinto ((RIO)), and in that the analysts are not alone. Rio remains on a perfect 8/0/0 with 32% upside to target.

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