Playing Coal And Gas Upside

This story features ENERGY RESOURCES OF AUSTRALIA LIMITED.
For more info SHARE ANALYSIS: ERA

By Greg Peel

Centennial Coal ((CEY)) has been in the pink of late, enjoying share price run that has hardly faltered while all about have been crumbling (adjusting for the capital return). With coal now the new black on the commodities front, so well might Centennial be enjoying such revaluation. It’s a lot to do with momentum as far as some brokers are concerned, but others are not so convinced.

It’s a common theme. It seems, for now at least, that commodities have shaken off their recession concerns, particularly as stoppages in China, South Africa and potentially Chile, and floods in Australia, have exposed systemic problems which threaten to encumber supply for a long time yet. When the super cycle began, resource analysts made the mistake of expecting commodities prices would soon revert to mean as supply increased to match higher prices – just like they had always done in the past. But analysts were left in the dust as demand from the developing world skyrocketed, exposing long term neglect in the mining industry. The rush to increase supply was fraught with constant delays and stoppages.

Thus commodity prices rocketed, eventually stalling when supply did belated begin to catch up. Talk of a US recession then added to weakness, and soon the market was wondering whether the great commodities boom was indeed over. But now analysts are beginning to realise that despite increased investment in supply, there will still likely be constraints. Apart from incapable port and rail infrastructure, and misbehaved weather, power supply, or lack thereof particularly in developing countries, could force commodity prices higher again. And there is little sign of abating demand from China, India et al.

Analysts tend to be behind the price curve at all times, if for no other reason than conservatism and a reluctance to keep moving forecasts around every day. But they are also behind cost and currency curves. Mining costs around the world and in Australia in particular have been a big wake-up call, while currency headwinds are only now being pre-forecast. But analysts do know from experience that mining production is always beset with problems and delays, and that exploration is still only as good as one’s divining rod, even if surveys look spectacular. What this all adds up to is analysts tend to believe the market runs ahead of itself on exuberance in commodity bull runs. Often they are right. At other times, analysts are forced to keep shuffling up commodity price forecasts just to keep up.

Centennial is a case in point. Four out of seven brokers in the FNArena database call Centennial a Hold, with one – Citi – having downgraded to Hold post yesterday’s result. It’s not that difficult to see why – Centennial has rallied about 30% in 2008 alone, when the ASX 200 is down about 13%.

A lot of that has to do with coal prices. All the aforementioned stoppages, including severe flooding in Queensland’s coal producing region, have affected a doubling to trebling of spot coal prices. Now domestic and seaborne coal trade work on longer term contracts – not spot – so analysts are tending to err on the conservative side in predicting where the next coal contracts will settle. However, it’s hard to find an analyst who doesn’t think 100% increases are possible. The great advantage Centennial has is it’s a NSW producer, with so far unfettered access to Port Kembla (Newcastle, on the other hand, is more problematic) and no flooding problems to date.

What an exuberant market may not have taken into consideration however, is that only 20% of Centennial’s export contracts are currently up for negotiation and that domestic contracts (CEY supplies 47% of coal for NSW power) are not up for any more than CPI adjustment until 2012. There are shades of Energy Resources ((ERA)) and uranium here. And analysts expect that by about 2010, infrastructure improvements will have been completed in Australia that will allow more export throughput (at the expense of price).

Moreover, Centennial is suffering the same cost increases as everyone else, the same depreciation increases as everyone else, and the same currency headwinds. What is there to be excited about?

Well there must be something, for three out of seven brokers call the stock a Buy at this level.

The good news stemming from the Centennial result was not the profit number itself – indeed, it was down for the half – but the fact the company has provided a lot more clarity on its plans to move from an 80/20 domestic/export mix to 50/50 by 2013. It has also now sold off discontinued assets, and all grand plans are predicated on organic growth alone. All analysts agreed this is positive news.

Deutsche Bank believes Centennial provides a “low-risk exposure to a commodity sector” with “robust price upside potential”, and hence retains a Buy at this level. Macquarie sees a deal of upside to global coal prices, and is happy with Outperform. GSJB Were suggests Centennial is no longer “good value”, but that hasn’t stopped the analysts retaining Buy. Again it comes down to coal price upside, CEY’s move to 50/50, and the eventual potential to reprice domestic contracts. “It’s all momentum!” says Weres.

Whether or not all are convinced, the average target in the FNArena database has moved from $3.91 to $4.38 this morning (last trade $4.43) on a range from $3.07 (JP Morgan – the perennial conservative) to $5.18 (Weres – often the most bullish). Should Centennial be considered on a short term valuation overrun? Or a bigger picture play?

The same question can be asked of Woodside Petroleum ((WPL)). As an oil producer, and with oil at US$100/bbl, it’s a bit hard to see how Woodside could not make exceptional profits. However it has been a somewhat more rocky road for Woodside’s share price since the world began talking of recession and the oil price was expected to fall. Woodside had a bit of exuberance to wipe off. But the share price is pushing back up again as the oil price does the same, which leaves us at a bit of a cusp. Where to from here?

Seven out of nine brokers in the FNArena database call Woodside a Hold. Once again, a lot of it has to do with the recent run up in price. Yesterday’s result was roughly in line with expectation. UBS downgraded to Hold this morning, given the share price. That leaves one Buy (Deutsche Bank) and one Sell (Credit Suisse). CS has had a valuation-based Underperform in place since September.

One highlight of the Woodside report was the company’s plan for liquid natural gas. LNG is rapidly becoming the new oil.  Management yesterday outlined some very aggressive target dates for various LNG projects to come on line between 2008 and 2010. For more than one broker, these targets appeared overly ambitious, not allowing for inevitable delays, political problems, and competition for resources. Clearly this belief only adds to a general feeling of overvaluation among most analysts.

Deutsche Bank, on the other hand, shrugged off the aggression of the LNG targets. For Deutsche’s analysts the result indicated a turnaround from previous years, such that there is now upside risk to production guidance given acquisitions, new production ahead of schedule, and better than expected production from existing assets. But the analysts are even more excited about the bigger picture:

“We continue to advocate Woodside as the best exposure and leverage to the global megatrend of LNG supported by a positive macro environment”.

So once again, does an investor look at short term valuation in this case or longer term potential? Despite the lack of Buy ratings on Woodside, its average target did increase this morning – a tad – to $53.22 (last trade $54.23) on a range from $46.90 (Citi) to $65.40 (Deutsche).

Click to view our Glossary of Financial Terms