Australia | Jul 27 2010
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By Greg Peel
A funny thing happened on the release of Woodside Petroleum's June quarter production report on Friday. Analysts pouring over the report could find no mention of the company's plans to have its second LNG train at the Pluto project at Financial Investment Decision (FID) stage by year-end. As far as the Macquarie analysts can recall, it is the first time a Pluto-2 update has not been provided since the initiation of the Front-End Engineering & Design (FEED) process.
Must we assume no news is bad news?
To reach FID, Woodside (or any LNG company with a train planned) must be able to justify the high cost of building the train. An LNG train is simply a processing plant for liquefying natural gas for ocean-going transport. A train can only be considered financially viable in the Pacific Basin if long-term gas offtake agreements can be signed with the likes of veteran buyers Japan, Korea or Taiwan (JKT) or with new players China or India. With the security of such a contract, money can then be justifiably spent.
But potential Asian customers are not going to rush to sign unless they can be sure there is enough gas on location to feed the train. When you're talking potentially twenty-year offtake deals, you want to be sure the supplier can actually deliver. A buyer can't afford to have the gas run out in between. And nor can a buyer run around signing twenty-year deals willy-nilly in order to cover their back. They might all come good.
Pluto-2 is not exactly a company making or breaking project for Woodside. Woodside is Australia's most experienced gas project owner and operator, dating back to the 1970s and the early days of the massive North West Shelf project, of which Woodside is a stake-holder. The North West Shelf now boasts five LNG trains, and was in its day Australia's largest ever construction project. But NWS is now a mature asset, and while there may yet be more trains built one day it is not the target of Woodside's plans for expansion into the future. NWS is still happily supplying legacy JKT customers.
Where Woodside sees its growth potential is in other offshore gas projects and prospects which stretch from the West Australian Coast at Karratha in the Carnarvon Basin all the way to East Timorese sovereign waters. Within the area lie Pluto, Browse and Sunrise, along with many other projects owned by others such as the well publicised Gorgon. All three Woodside projects are at some stage of development, with Pluto being the most advanced. The first train at Pluto is now 91% complete.
While LNG is a long-term investment game, the clock is somewhat ticking. With the likes of China and India entering the market it is accepted by the industry and analysts that the period 2013-15 will see an LNG supply shortfall. This is the impetus to get offtake agreements on board. Because thereafter, the number of global gas projects underway now will mean post-2015 that supply squeeze will be over.
So Problem One is that there is a distinct window of opportunity that needs to be exploited as soon as possible, but that means signing long term contracts right now.
Problem Two is that there is a race on. Aside from the plethora of offshore WA LNG projects owned by various global Big Oil players there is a burgeoning coal seam methane industry over on Australia's east coast. Queensland CSM players are in the same race, and in some cases more advanced. Then there's the big project in Papua New Guinea which is further down the track than either Queensland CSM or new WA projects. And while North Sea Gas might be on the wane (one reason for the upcoming shortfall) there is also a shale gas industry being rapidly developed in the US. Russia, among others, has plenty of gas, and if it so desired, Qatar could supply all of the world's gas needs by itself for decades to come.
Indeed, while other sources tend to supply only the Atlantic Basin market, Qatar is a swing factor and supplies the Pacific Basin as well. The only thing stopping Qatar from completely destroying the Pacific Basin (including Australian) market, as far as anyone can tell, is a preference to not “kill” the gas price.
So while there might be a shortfall coming up in 2013-15, were all the projects currently racing toward FID to get up, the interim years would see a glut. This is thus Problem Three – companies which do not sign offtake agreements very soon will find themselves missing out. And because of the upcoming potential glut, the ball is currently in the gas buyer's court. With the wide selection of projects to choose from, buyers can afford to tread carefully and pick the most reliable. And that means sufficient proven reserves of gas on hand to feed LNG trains.
Woodside's immediate future as a growth company is thus dependent on completing Pluto-1 and reaching FID for Pluto-2 before moving on to a planned Pluto-3 as well as trains at Browse and Sunrise. At stake is a vast amount of capital expenditure. While capex for Pluto-1 has actually come in under targets to date, it's only because industrial disputes with site workers have caused delays. Otherwise, Woodside has been forced to raise its expected capex requirements for latter projects.
Returning to the Woodside production report released on Friday, Macquarie noted that while there was no mention of Pluto-2 within there was quite explicit mention of the Browse project. But FID is not expected on Browse until mid-2012, whereas Pluto-2 FID is planned for end-2010. Where has it gone?
The reality is that Woodside has been hoping it can supply all of the gas for its trains from its own reserves, which in industry parlance is known as “equity gas”. But the supply at Pluto has not yet been proven up sufficiently to supply more than the one train. The company is currently pin-holing the area with test drilling as part of a twenty well program. Two of the wells drilled in the June quarter have come up empty.
There has been a lot of faith placed by analysts in Woodside's exploration program at Pluto, and fingers are still crossed. BA-Merrill Lynch notes the program has had a success rate to date of four out of seven wells drilled. But with the last two coming up dry, that year-end target is looking a lot harder to reach.
There are other options, but none that are as palatable to Woodside or its shareholders. Quite simply, if Woodside can't find enough gas in time it can buy in feedstock from nearby.
The obvious contender as a supplier is Chevron's Wheatstone project, but Woodside and Chevron fell out over that project a while back. Deutsche Bank notes that a project owned by Hess is close by, but it is dubious given lack of appraisal work and reserve details. Further away but still in contention is the Scarborough project, which joint owners BHP Billiton ((BHP)) and Exxon-Mobil have been sitting on since 1979.
Deutsche suggests it would likely be more appealing to BHP-Exxon to develop Scarborough as a “brownfield” project, delivering to Woodside's Pluto-2 and 3, than to begin from scratch as a “greenfield” project in this increasingly crowded market. It also sounds potentially cosy, but the problem is one does not just buy in gas from a neighbour for an agreed price. That neighbour has to become an equity partner in the deal to make it viable.
Deutsche suggests such an outcome would be worthwhile for both parties, but the fact remains Woodside would be looking at a positive but diluted return on investment were it forced to sell a stake in Pluto. Woodside simply needs to find more gas and find it fast.
Amidst all the rushed test drilling, Woodside cannot afford any more industrial disputes, particularly with Pluto-1 at the critical stage of near completion. Not only do such disputes cause delays and potentially blow out costs, they sully the international reputation of Australia as a reliable gas supplier.
In light of the June quarter production report, gas sector analysts are now increasingly pessimistic. Production was down on expectation but sales were up, but that's all academic in the context of whether or not Woodside can offer real growth value from its new projects or simply remain a benign legacy player. Woodside's current stock market valuation is building in a lot of hope, such that it represents a premium to the likes of Santos ((STO)) which is in a better position with its own company-advancing project – Gladstone CSM LNG. Pluto-2 is critical to Woodside, and critical at a time when Credit Suisse notes the big LNG players of Woodside, Santos and Oil Search ((OSH)) are all facing an onerous rise in debt funding costs.
With no mention of Pluto-2 in the report, Macquarie suggests “Pluto-2 is unlikely to be sanctioned this year”.
A lot of hope is being directed towards current drilling at a site called Larsen Deep. If Larsen comes up dry, Merrills suggests the Pluto-2 FID will be “at considerable risk”.
Citi, however, suggests that even if drilling at the four exploration wells planned for the September quarter is successful, “we think it highly unlikely FID will be reached on Pluto-2 by end-2010”.
Deutsche Bank offers that such success would still “not be sufficient to underpin expansion at Pluto-2”.
UBS simply says “We think Pluto-2 is increasingly unlikely to meet its proposed FID target date”.
JP Morgan is trying to be optimistic, noting that Pluto-2 FID would be a significant share price catalyst, and would likely lead the market to incorporate more value for Browse, Sunrise and Pluto-3. However, the caveat is that the analysts “are hesitant to rely on the drill bit to underpin a share price recommendation”. This is particularly the case, notes JPM, when there is an alternative sector player (Santos) no longer relying on exploration success.
That only leaves Credit Suisse, who “remains confident on the delivery of a Pluto-2 option”. But even CS acknowledges it all depends on exploration success and more gas certainty.
Of nine brokers covering Woodside in the FNArena database, four are sitting on Hold ratings. Citi only upgraded from Sell this week given recent share price underperformance. That leaves five Buy ratings, but as the above quotes suggest, those Buy ratings may be subject to change.
The average Woodside target in the database is $49.05, compared to a share price today around $42. That's 16% potential upside, but there is a figurative train about to leave the station. Will Woodside be on it?
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