A Tale Of Two LNG Hopefuls

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By Greg Peel

Australian oil & gas majors and LNG hopefuls Oil Search ((OSH)) and Woodside Petroleum ((WPL)) both reported interim earnings this week. While both results were largely in line with expectations, it was the contrast in outlooks which stood out.

Consider this summary of Oil Search's prospects from Macquarie:

“We estimate OSH's 29% stake in PNG LNG was worth $3.08/sh at FID [final investment decision], is worth $5.42/sh today and will be worth $7.53/sh on the day of project start-up.
Indeed, assuming a timely project delivery, our NAV [net asset value] would rise from its current $10.51/sh to $12.62/sh by first cargoes. However if a 3rd train is sanctioned, this jumps to $13.85/sh and if the offshore acreage is able to underwrite a more speculative 4th train then we could be looking at over $16.50/sh. Add to this possible upside from MENA [Middle East and North Africa] exploration and there appears a lot to look forward to.”

Now consider this conclusion regarding Woodside's prospects from RBS Australia:

“We always thought that management would be able to appraise up enough gas and reach FID on a second train at Pluto even if the most probable outcome would be a joint venture agreement with third party gas. This, however, has proved not so. Shell appears to have put on hold its plans to sell its 24% stake; however, there are no guarantees that they won’t dump it on the market at any time. In our view, this lack of clarity, coupled with the temporary lack of solid growth opportunity caps near-term upside. We don’t believe there is much optimism from investors towards the company’s project pipeline at this time.”

What we see here is one LNG company bursting with growth upside potential and another languishing with very little. Oil Search is looking at a possible fourth train in PNG but Woodside's chances of a second train at Pluto have diminished. That's not to say Woodside's game is over – far from it – but we certainly have a tale of two different prospects here. Then it all comes down to valuation, which I will get to shortly.

Oil Search published its result on Tuesday. For all of the LNG majors, which includes Santos ((STO)) and Origin Energy ((ORG)), production results over the period are one thing but the real value lies in LNG export upside, and that is long-term game. Many readers would have been in short pants when explorer Oil Search first decided PNG looked like a good prospect. Year in, year out, the OSH story has been all about PNG progress. Management's commentary at this result once again informed that PNG was “on time and budget”.

PNG is now about 60% through the development period and 70% of the capex has been invested, meaning the project is “over the hump” as Macquarie suggests. Santos is, of course, a joint venture partner in PNG, as is operator Exxon Mobil. The production outlook appears consistent with a July 2014 start-up, which is a little earlier than some analysts had previously assumed. Operating costs have risen but capex expectations – the bane of the Queensland CSG players – have not. PNG has not missed out on inevitable delays nevertheless, with the Hides gas water contact well now being pushed out to 2013, or two years past original guidance. However this has not upset any analyst given the benefit of OSH's growing list of other gas feed options.

Current drilling at Hides and Trapia is expected to provide enough gas for a third LNG train. However, management believes the P'nyang JV with Exxon will also offer sufficient gas. Citi thus believes discussions will now commence on moving the third train to FID status, with the analysts targeting late 2014, irrespective of the Hides or Trapia appraisals. AS UBS notes: P'nynag has already delivered success; Trapia is now drilling; Hides drilling has potential material upside; drilling will commence in the Gulf of Papua from 2013; and Taza-1 is also drilling in Kurdistan.

PNG is one thing, but RBS suggests Taza is the “well to watch”. Citi nevertheless believes the Gulf of Papua might provide for two trains, but that's a risky, long-dated proposition at this stage.

The only difficult issue BA-Merrill Lynch sees is the fact Santos has no interest in P'nyang, undermining the possibility of all three JV partners agreeing as to where the gas can come from. However Merrills believes P'nyang offers the fastest path to proven gas (as opposed to probable and possible) and Exxon is only interested in proven gas. It would thus be in the interest of all three partners, the analysts suggest, to integrate the discovery into the project even if Hides ends up supplying the gas for the third train.

Either way, Deutsche Bank sums up analyst views in suggesting “we continue to see a third train expansion as a case of when and not if”.

Just to add another teaspoon of sugar, Oil Search is currently in negotiations with a “highly credentialed global LNG operator” as a Gulf of Papua farm-out partner and an announcement is expected soon.

As Oil Search plugged away consistently on its big project, Woodside also had high hopes for its Pluto LNG project in WA, sourced from offshore gas. At one stage there were murmurs of perhaps a third train, let alone a second, but it would all come down to further exploration. Pluto has been hit by delays and capex overruns, but in the meantime it has drilled and drilled and drilled. Unfortunately, Woodside has drilled without success. Ananke was the last great great hope, and it, too, has come up a “duster”. As a result, Woodside has now put its exploration program on hold pending a reappraisal.

So at this stage if there is to be a second train at Pluto, it is unlikely to be fed by Woodside's own gas. At least not in the near term. There is, nevertheless, the option of buying in gas from neighbouring projects including those belonging to Hess and Exxon-BHP Billiton ((BHP)). Yet herein lies the potential for a stalemate.

Given Woodside's exploration failures in the offshore basin, the neighbours are not going to let their precious gas go for anything but a good price. Either way it appears discussions between the parties will now run into 2013 which represents another delay, as Citi notes. The fact it seems hard to complete a deal suggests to Citi the offers must be “quite marginal”. Credit Suisse does not expect Woodside to settle for simply collecting a tolling fee for running the Pluto facility.

Yet the government will not allow any new LNG hubs in the vicinity, which does provide Woodside with an advantage. But while discussions drag on management's plan is to switch from exploration, which has failed, to acquisition. The problem is that Woodside cannot afford to buy any majors, which leaves the prospect of making investments in smaller and riskier opportunities. A long lead time must still be expected, so this is no quick-fix solution either, all of which puts greater negotiating power in the hands of any third parties looking to process gas using Woodside's infrastructure, JP Morgan suggests.

But let us not despair, Woodside boasts two other potentially lucrative growth projects in Browse and Sunrise.

With significant capex looming large, Woodside has been forced to farm out stakes in Browse. This week partner Chevron announced it had concluded an asset swap deal with Shell, with Shell acquiring the Browse stake. Analysts are at odds over whether this is a good thing or a bad thing.

Merrills had previously assumed Woodside's commercialisation of the Browse field would come as a result of becoming a gas supplier to the longstanding North West Shelf project, of which Chevron is one of the six owners. With Chevron exiting Browse, that option appears now to be lost. However in gaining Shell, Woodside gains floating LNG expertise which may prove a big benefit to Browse.

The problem is, Woodside has commitments in place with both the federal and state governments that it will focus on an onshore LNG facility at James Price Point at least until the expected mid-2013 “FID-ready” date. Deutsche sees the Shell tie-up as a much better option for Browse, notwithstanding the very long timelines. Merrills is not so sure, and points out the elephant in the room. Shell now has considerable direct interest in Australian LNG via Gorgon, Arrow, Prelude, Sunrise and now an increased stake in Browse. How will Shell fund them all? Well there is a small matter of Shell's 24% equity stake in Woodside.

As for Sunrise, it appears to be locked in a political stalemate with the East Timorese.

Macquarie sees five years of exploration disappointment, little hope of an imminent breakthrough in third party discussions, a slower timeline for Browse if there's a switch to FLNG, and a deadlock for Sunrise. “As a result,” says Macquarie, “given our view that growing supply-side competition on global LNG markets is conspiring against Australia's higher cost projects, the lack of progress across WPL's growth portfolio may come at a heavy price if the market window has simply been missed”.

So on that depressing note, is there anything good we can say about Woodside? 

Well yes. The first and perhaps only train at Pluto is up an running and producing bucket loads of cash. With the exploration program now on Hold, Browse having been farmed down and other growth options stalled, Woodside has to do something with that cash. And it has. At this week's result, management announced a 65c dividend when 55c was expected and flagged a general policy of returning 50% of profit. “It seems WPL is taking the 'middle path',” says JP Morgan, “of signaling its new financial strength post Pluto completion, yet conserving firepower for the future”.

Which leads us to the matter of valuation. The above sounds somewhat like rags and riches story, with Woodside providing the rags and Oil Search the riches. Yet as to whether investors should consider either stock at this level, or considering exiting either stock, comes down to what value the market is already ascribing.

JP Morgan's view:

“WPL’s strong 1H12 cash generation underscores the dilemma facing Australia’s largest listed oil [producer]. WPL finds itself amid a market that craves conservatism yet demands investment in growth optionality. Now it is delivering Pluto cash flows, the dogs are barking regarding the slow progress on its current suite of growth options and the seeming dearth of new growth avenues. As we would prefer to be long cash flow rather than long growth in this current environment we retain our Overweight recommendation on WPL”.

Macquarie (Outperform) heads down the same path:

“The market is understandably fearful of projects facing huge cost pressures being funded through equity raisings and [dividend reinvestment plans] (albeit with the prospect of growth). That said, somewhat surprisingly it appears there is no obvious preference for WPL's alternative proposition – namely low development risk, high cash flow, high yield but limited longer-term growth”.

Citi (Buy) sums up the other way of looking at Woodside, as far as the rest of the five Buy-raters in the FNArena database are concerned:

“The timing of Browse, Sunrise and Pluto-2 appears long dated, but there is value in WPL's Browse/Sunrise resources, demonstrated by recent transactions”.

That leaves two brokers on Hold, including RBS (who provided the downbeat opening quote). Merrills is just not a fan of high-cost, high-risk LNG projects, and continues to maintain an Underperform rating on Woodside.

A current consensus target of $40.36 suggests 14.5% upside from today's price.

It's a slightly different story for Oil Search. JP Morgan rates OSH a Hold, but only because the analysts prefer Santos (as well as Woodside) and JP Morgan uses a sector-relative approach. Beyond that, every other broker in the database rates OSH as a Buy or equivalent.

RBS Australia sums up the positive view in suggesting the market is attributing minimal value to any exploration upside, and a likely third train is being valued at very little at all. OSH is in the unique position, notes RBS, of offering both longer term growth through PNG LNG and shorter-term catalysts in the form of the Gulf farm-out, further highlands exploration and the wildcats of Tunisia and Kurdistan. 

A consensus target of $8.77 offers 19.8% upside, but for Oil Search one can imagine there's a level of PNG fatigue. This has been a long, long, long story and it's not over yet, and in the meantime has provided, year in, year out, a set 4c dividend. At the moment that represents a yield of 0.5%.

Analysts now have a forecast FY13 yield for Woodside of 3.6%, with expectations the absolute level will grow ahead.  

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