How Do Australia’s LNG Majors Stack Up?

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This article was first published exclusively for FNArena subscribers on February 28 and is now open for general readership.
 

By Greg Peel

This report follows on from the recent FNArena feature article A Revised Outlook For LNG: The Road To Riches Or A Waste Of Time And Money?

There are three LNG production and export facilities operating in Australia today. North West Shelf has been in operation since 1989 and now boasts a globally impressive five LNG trains. A conglomerate of global Big Oil players holds a one sixth stake in NWS, as well as locals BHP Billiton ((BHP)) and Woodside Petroleum ((WPL)). Foreign-owned Darwin LNG started up in 2006, while Woodside’s first Pluto train began production last year.

There are a plethora of LNG projects under construction or under consideration across the Australian continent from offshore Western Australia to the Queensland coal seam gas (CSG) fields and on to Papua New Guinea. Some are fully foreign-owned, such as Gorgon in WA and Ichthys in Darwin, while others boast locally listed oil & gas companies as equity stakeholders. We can list Woodside, Santos ((STO)), Oil Search ((OSH)) and Origin Energy ((ORG)) as representing Big Gas in Australia (not counting a diversified BHP), with a handful of smaller players also in mix.

Each of these four majors has reported a six-monthly earnings result in the past two weeks and has provided an update on the progress of their significant LNG projects. Woodside has Pluto underway as well as several other projects on the simmer, including a Pluto expansion. Santos holds a 30% stake in the Gladstone LNG project (GLNG) along with co-owners Petronas, Total and KOGAS. Oil Search holds a 34.1% stake in the PNG LNG project with co-owners Santos (17.7%), Exxon, Nippon Oil & Gas and the PNG government. Origin holds a 37.5% stake in the Asia Pacific LNG (APLNG) project with co-owners ConocoPhillips and Sinopec. PNG LNG is a natural gas project while GLNG and APLNG are both Queensland CSG projects.

LNG facilities are very time consuming and very costly to build, and along the way each of the projects has been beset with problems including construction delays, cost overruns, a strong currency, gas shortages, reluctant equity and offtake partners, and a falling gas price. From the beginning of construction to today, the world has lived through a GFC, a European recession, a Japanese nuclear emergency (bringing global nuclear power into question) and a US shale gas “explosion”. Pluto’s first train is now in production, PNG LNG and GLNG are both due to start up in 2014 and APLNG in 2015.

Projections for the global LNG demand-supply balance over the next several years suggest that these four projects, along with other foreign-owned Australian projects nearing production, will be in a position to exploit a window of potentially lucrative earnings opportunity for around four to five years. It will all hinge on being able to secure “first mover status” in this next phase of global LNG production expansion and assumes no show-stopping issues for any project between now and then. The US government is now fast-tracking its LNG export plans with the hope of the first shale LNG exports hitting the oceans in 2015. Whether or not this goal is achieved, the US is still lagging behind Australia in terms of LNG facility development despite its abundance of source shale gas. But by 2020, it is assumed the US will be a major export player and that further global supply (including from China’s own gas reserves) will be competing in an ever crowded global market.

In terms of which of the four Australian Big Gas companies will prove most successful, and thus a valuable investment at this point, the companies’ recent earnings result releases and project updates provide a point of comparison. We will now look at analyst conclusions in light of these disclosures, but before we do so we must note some distinguishing features among the four.

Aside from the vagaries of the government’s petroleum resource rent tax (PRRT), all of Woodside, Santos and Oil Search posted earnings results largely as forecast, albeit Oil Search’s existing production fell a little short of expectation. Origin’s result missed broker forecasts due to weaker than expected earnings from its downstream division. Origin is unique among the four in selling gas at the retail level as well as producing wholesale gas upstream.

Aside from having fingers in both PNG LNG and GLNG, Santos derives significant income from its substantial Cooper Basin conventional gas production. Woodside has long derived income from the North West Shelf and now from Pluto, and boasts the most ambitious growth pipeline of all four. Oil Search, as its name implies, is not in the business of operating or even maintaining long term interest in energy projects. OSH will continue to sell-down its interest in PNG LNG over time and move on to other projects.

Woodside Petroleum

It’s been a long, hard road for Woodside, but the first train at Pluto has ensured the company is currently a cash generating machine. Capital expenditure has peaked, and a gearing level of only 11% supports a very strong balance sheet. The company rewarded its long suffering shareholders by increasing its dividend for the period by 18%, but this only brings distributions into line with management’s previously flagged 51% payout policy. Said shareholders would like to think there are more significant capital management rewards being planned in the near term.

Long suffering shareholders are probably going to be disappointed. While brokers support the idea of capital returns (in whatever form), management is clearly not of the same mind. At a time when the big diversified miners are rapidly reining in their major expansion plans, Woodside has listed no less than twenty potential growth options which, if all pursued, would cost more than US$60bn before overruns. Says Macquarie, this “seemingly confirms management’s growth bias over dividends”. Management will not sit on cash if projects are delayed and will offer distributions instead, but Macquarie suggests this would be somewhat of a consolation prize against stalled growth.

Given increased investment guidance, UBS notes 2013 free cashflow will begin to dry up anyway, preventing any distribution bonus. Deutsche Bank “supports” capital management and includes its possibility as a reason for the broker’s Buy rating, while Citi believes Woodside could return cash to shareholders, but only under a certain condition. A somewhat cynical Citi believes the company’s planned James Price Point gas refinery on the pristine Kimberley coast will be deemed uneconomic by mid this year, which would free up some otherwise earmarked cash.

If Woodside is pro-growth and anti-shareholder return, and bearing in mind the long and painful process that was and is Pluto, just how do Woodside’s growth options rate?

The four major growth projects are Pluto (second train) and Browse (both offshore WA), Sunrise in the Timor Sea, and the Leviathan project in Israel. Management’s project update noted a US$225m capex allocation for Leviathan, but nothing for Browse, which puts Browse into perspective. JP Morgan notes, nevertheless, that the sale of a 14.7% stake of Browse to Misubishi-Mitsui last year suggests there is still a market out there. Woodside has not yet secured enough gas to confirm Pluto-2 while Sunrise has met with Timorese ownership arguments and environmental protest. Morgan Stanley suggests, “There are no new projects of any materiality, apart from Browse LNG,” which is expected to be ready for a final investment decision (FID) by mid-year.

As to a strategy of pursuing more and more LNG capacity growth, Macquarie is not as enthusiastic as management seems to be about the longer term prospects for global demand-supply. Say the analysts, “Here we do not share management’s confidence in the outlook – yes LNG demand growth should be significant (particularly in Asia), but the plethora of new entrants and new projects is intensifying supply-side competition – this is a problem given WPL’s unsanctioned projects sit so high on the cost curve”.

So to sum up, Woodside is enjoying a “first mover” advantage in this next phase of global LNG production by adding Pluto income to legacy North West Shelf income and earning lots of cash as a result. But rather than share the spoils with shareholders (beyond an increased payout ratio), Woodside wants to pour all its winnings back into developing ever more LNG projects in an ever crowded marketplace.

At the end of the day, what matters is how value stacks up against share price. Following the result, and after a good share price run up to that point, Citi and Morgan Stanley downgraded Woodside to Hold (or equivalent) to join BA-Merrill Lynch, UBS, Credit Suisse and Goldman Sachs while Macquarie downgraded to Sell. Only Deutsche Bank and JP Morgan remain on Buy in the FNArena database, which shows a consensus target of $40.45.

Santos

In somewhat of a contrast to Woodside, the Santos result/update brought forth one Downgrade to Hold from Credit Suisse. All other FNArena database brokers stuck with Buy. The consensus target stands at $15.57.

The good news is that Santos management announced at the result release that the GLNG development is on time and on budget. No Australian gas project has been spared cost blow-outs in the past few years, and some capex upgrades have been substantial. Delays have also been obligatory. The market was holding its breath at the update, having just learned of a cost blow-out at rival APLNG.

Deutsche Bank noted that “while it is always pleasing to hear major LNG projects remain on-track and on-budget, the Australasian LNG development industry continues to face challenges, with wage pressures and resource constraints showing no signs of abating”.

On the matter of resource constraints, the GLNG update included a cut in contingent resources which reinforces UBS’ view that more third party gas supplies will be needed, and are expected to be needed, in the near term. JP Morgan warns that the headline reserve numbers “do not inspire absolute confidence in the resource base”. On the matter of “on budget”, Macquarie notes the stated GLNG capex budget of US$18.5bn only gets the project to the end of 2015 rather than through the whole development period.

In terms of “on track”, GLNG is now 47% complete which suggests to Macquarie the project has closed the gap on the BG-owned Queensland Curtis LNG project (QCLNG), which is 51% complete, and has extended the lead on Origin’s APLNG at around 30%. Yet APLNG is only expected to take 610 days from FID to the first module, while QCLNG took 660 days and GLNG looks like taking 830 days. This suggests the timing has actually slipped.

That said, PNG LNG, which Santos shares with Oil Search, is 75% complete, and Santos management declared this project to also be on time and on budget. Macquarie is not that concerned over the nitty-gritty but rather sees each step as an erosion of development risk ahead of the 20 plus years of free cashflow the projects will generate. The analysts believe this is what the market will now focus on as the clock ticks down towards completion.

With GLNG sucking in all the oxygen of investor attention, it is easy to forget that Santos has a stake in PNG LNG and even easier to forget that the company still produces wholesale gas for sale on the east coast from its legacy Cooper Basin operations. There are no two ways about it – retail gas prices have already doubled or tripled across the country and when wholesale prices are marked against prices determined by demand for LNG exports, they will rise further. This reality puts Santos in the box seat.

Santos has announced strong reserve additions in the Cooper, and at its WA oil and gas operations, suggesting to Goldman Sachs that the company is “exploiting its legacy assets effectively”. And as further technological advancements are made in “tight gas” (meaning CSG, shale) recovery, and they are happening all the time, east coast gas fundamentals are moving “distinctly in Santos’ favour”, Goldman suggests.

Citi goes on further to note that Santos boasts “a promising and highly material exploration program” in 2013 which could provide the next level of growth once GLNG and PNG LNG are up and running.

The bottom line is that Woodside is generating cash but would rather pour that cash into what analysts deem to be marginal growth projects at best, rather than return capital to shareholders. Woodside appears to many to be overvalued. Santos’ growth, on the other hand, is believed to be undervalued by Goldman Sachs, who sums up a general analyst view. Citi suggesst the market is still overly worried about the negatives, such as cost blow-out potential and lack of source gas, and that the stock’s upside is “underappreciated”.

Credit Suisse was the only FNArena database broker to withdraw from a Buy rating on Santos post the result/update, dropping to a Hold for now. CS cites the recent share price run up offset against fairly demanding forward PEs ahead of both LNG projects reaching full production as reason to remain a little cautious.

Oil Search

Santos’ value may be somewhat overly defined by GLNG, but there is no doubting PNG LNG defines the value of Oil Search. Deutsche Bank’s net asset valuation, for one, is 90% represented by this project. Oil Search does keep its cashflow ticking over from earlier projects, but for as many years as anyone much can remember now, OSH has been all about Papua New Guinea.

As noted, PNG LNG is 75% on track to first production. Unlike the case with GLNG, there is no concern as to whether enough source gas can be found. With resource estimates increasing for the Pn’yang field, alongside the promising Hides field, analysts now consider a third LNG train in PNG is all but a given down the track.

GLNG is planned as a two-train facility but clearly a second train is subject to sufficient gas resources being available. It is a similar story for Woodside and Pluto-2, with the company’s lack of exploration success over the past couple of years proving very frustrating. Woodside nevertheless has a cut of the five-train North West Shelf. APLNG has actually moved forward the planned start-up date for its second train, but as we will soon see APLNG has its own problems. At a possible three trains, and further fields under exploration, PNG LNG appears to be the pick of the new bunch.

Credit Suisse is not alone among brokers in suggesting PNG LNG is “the best LNG project among Australian majors”.

PNG LNG has not been spared cost overruns in recent times but in line with the Santos update, Oil Search management has confirmed the project is on track and on revised budget for first production in 2014. Deutsche Bank acknowledges capex risk will always remain given the sheer size and complexity of the development, but the analysts see PNG LNG as relatively low risk given limited exposure to cost inflation pressures currently impacting on Australian LNG developments.

OSH is spending its funds faster than Macquarie expected on the project, and has also increased its exploration budget. Last year the company secured a debt facility and Macquarie suggests OSH will have to dip into it, although the analysts assume something like US$50m will be needed and the facility is for US$500m – so no real issues there. Indeed Macquarie considers the PNG LNG budget to be “seemingly conservative”. Several major infrastructure milestones have now been passed, leading BA-Merrill Lynch to be confident PNG LNG has a lower risk profile than other projects.

As a searcher for oil (and gas), Oil Search still has plenty of other exploration projects on the go and these add to valuation. Citi, Credit Suisse and Merrills all made specific mention of this upside potential in their post-result reports.

It is nevertheless no straightforward task to assign value to as yet uncompleted and risky LNG ventures and the value of as yet undiscovered resources, which is why broker valuations and recommendations can often vary wildly for not just energy stocks but all resource sector stocks in general. In OSH we have an example, given post the result/update Citi downgraded its rating to Hold from Buy, citing fair valuation, while Credit Suisse upgraded to Buy from Hold, noting OSH has “significantly underperformed its Australian peer group” in the past six months.

This leaves Oil Search with six Buy ratings and two Hold ratings (the other being JP Morgan) in the FNArena database. The consensus target is $8.72.

Origin Energy

The value of Australian coal seam gas did not come to light until UK energy giant BG made an out of the blue bid for Origin back in 2008. Twice Origin knocked BG back, and ultimately BG moved on to acquire the Queensland Gas Company instead and thus put its stake in QCLNG rather than APLNG. BG’s courting nevertheless served to spark sudden and substantial re-ratings for Australian oil & gas companies, CSG or otherwise.

The irony is that five years later, Origin is trying to sell-down its holding in ALNG to below 37.5% and with the project some 30% complete, it cannot find any buyers. Macquarie suggests this “will do little to support the market’s already dwindling confidence in the CSG-LNG value proposition”. Origin is thus forced to carry on, at least for the time being, and dip into its debt facilities along with cashflows for further funding. The company has just been cut to BBB credit rating but management is not particularly worried. Management has ruled out a capital raising, but Macquarie believes “things will be tight” if Origin is forced to stay at 37.5%.

For UBS, hanging in there with a 37.5% stake is a risky strategy, but one that will “pay off” if APLNG does come in on time and on new budget. It is the “new budget” that has analysts most concerned.

As noted, Origin is unique among the four LNG majors in being both an upstream producer of gas and a downstream retail distributor. Origin’s result fell short of broker expectations due to volatile Queensland retail gas prices. But once again, Origin’s value is defined by its LNG project. The good news is that while APLNG is only 30% towards first production, management has announced the second train could be delivered up to three months early.

The bad news – that which “completely overshadowed the second train announcement” as far as JP Morgan is concerned – is an announced 7% capex budget increase, coming on top of Origin’s failure to find a buyer for the project.

The Australian listed energy sector, which is dominated by the gas majors, underperformed the broad market in 2012 by some 7%. It was not about gas prices but much to do with LNG project cost blow-outs. It is these, including a recent, significant budget increase for the formidable, foreign-owned Gorgon project in WA, which leads Macquarie to highlight the aforementioned “dwindling confidence in the CSG-LNG value proposition”. (Gorgon sources natural gas but the song remains the same.)

It is for this reason investors breathed a big sigh of relief when none of Woodside’s, Santos’ or Oil Search’s project updates featured capex overruns, Origin is out on its own. Mind you, all three know exactly how Origin feels, having been down this path themselves. Furthermore, the unexpected drop in Origin’s retail revenues led management to downgrade FY13 profit guidance for the second time this year. A share price recovery from here, suggests JP Morgan, is “now heavily dependent on an FY14 rebound”.

The picture looks rather gloomy, yet with six Buy ratings and two Holds in the FNArena database Origin matches Oil Search, and both are just behind Santos with seven and one.  It’s tough times for Origin, says Macquarie, but the company is well-managed and trading on an “attractive valuation with the best utility business in Australia and the best CSG-LNG project”.

The consensus price target for Origin is $14.26.

A Last Word: Beach Energy

Beach Energy does not rank as an Australian gas major but no doubt would one day like to. Beach produces oil in the Cooper Basin in waving distance from Santos’ longstanding operations but just as the majors are being defined, rightly or wrongly, by their big LNG projects, Beach is now being valued by the market with respect to its significant shale gas reserves.

Development of these reserves to the production stage is very much a long-way-off proposition, and in the interim the US is set to dominate the global shale scene. Analysts appreciate what Beach is sitting on but struggle to ascribe too much value at this early stage, and it has not gone unnoticed that while Santos does have an operating shale gas well in the area, the company has never shown much interest in its neighbour’s extensive reserves.

But last week US energy giant Chevron rather shocked the analyst community by taking a stake in Beach’s shale. The move rather intrigued JP Morgan, given Chevron is big in WA and has no current east coast LNG strategy but has just bailed out of its stake in Woodside’s offshore WA Browse project and jumped into the Cooper. JP Morgan can only assume Chevron is taking an option on a longer term potential gas source rather than even thinking of how to commercialise at this stage.

It was a good deal for Beach, Citi believes, but then Citi continues to view Cooper shale as “long-dated and cost-challenged”. Merrills suggests that now that Chevron has made its move, “most of the optionality is drained from this [Beach] stock”.

Macquarie notes the inevitable – that shale will continue to draw the limelight away from Beach’s actual operational results at least for the remainder of the year. Macquarie is the only broker in the FNArena database with a Buy rating on Beach (out of five covering the stock), with four Sell ratings and one Hold the balance.

The consensus target price is $1.46.
 

Recent FNArena LNG feature articles:

A Revised Outlook For LNG: The Road To Riches Or A Waste Of Time And Money?
BHP's Write-Down And The Global Gas Outlook
A Tale Of Two LNG Hopefuls
LNG: Fear And Loathing
LNG: Where The Resource Sector Upside Lies

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