Winners And Losers

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(This story was written two days ago. It was sent in the form of an email to paying subscribers on that day).

By Rudi Filapek-Vandyck, Editor FNArena

It has taken a while but the Australian share market is (finally) catching up with the fact that future capex intentions will prove to be a lot less than surveys suggest. It's never a bad thing to have mining and energy companies expressing confidence in the future outlook of their industries and promising to spend a whole lot of dollars on expansions, new projects and on building new infrastructure to support their operations, but it's a completely different matter to actually be able to execute these plans.

"All at once" is not a formula that leaves many in a winning position a lot of times. Think a few weeks ago when "all ot once" wanted to get out of the silver market. Similary, capex surveys around the world, particularly in Australia, have indicated the world will soon be confronted with a tsunami of new capital expenditure from companies in the energy and mining sectors. In an ideal world, this would be fantastic news for many. In reality, however, the actual outcome will be strong, but a lot less than what survey data are indicating.

Let's start with the labour market. Australian companies, whether they operate in resources or in other industries, are already scrambling to find sufficient skilled labour. Note that three years ago overseas immigration to Australia peaked at around 315,000 new people per annum and this number has steadily been reduced to 171,000 by the final quarter of 2010. If ever there was one statistic to illustrate the impotency of Canberra during a once-in-a-lifetime opportunity, it would have to be the annual immigration intake. (Note there's no difference between government and opposition on this). To those suffering today from high interest rates: take away the tight labour market and Glenn Stevens and Co might not even be thinking about further rate hikes for the foreseeable future, not to mention the fact that last hike might never have happened.

In the slipstream of the tight labour market, there's the observation that price rises for "everything", from steel to oil, to sugar, to cotton, to grains and latex, is no longer just hurting companies and consumers outside the energy and mining sectors. Large projects undertaken by companies inside energy and mining are now causing headaches and embarrassment because of higher costs and schedule delays. This will increasingly become a prominent feature as starting dates draw nearer for large projects that combined make up the capex tsunami of the coming years.

The past weeks have already supplied several key examples of what is yet to become regular headline material. First up was Woodside Petroleum ((WPL)) which issued yet another increase to forecast costs for its Pluto-1 project, plus another commissioning delay by six months, plus a downward revision in projected output volumes for the year. Investors should note at the now "most likely" outcome of US$14.9bn in costs for the project, the increase since 2007 when the original go ahead was approved by the board is no less than 24%.

Moreover, external calculations now put the internal rate of return at 10% or less, which positions the project at the bottom of Woodside's acceptable project returns guidance of between 10-15%. One more delay or further cost blow-out will push the project below the range. In terms of time, if the current delay proves final, Pluto-1 will have over-run the original time schedule by 14 months, or 33%.

All this triggered the following comments from analysts at Citi: "At the CY10 result, WPL presented a chart using Independent Project Analysis (IPA) criteria to show that Pluto-1 was still defined as a "success". We note Pluto-1 has now breached several of these metrics, and question if the project can still be defined as a success".

I leave the answer to that question for others. It should be clear the risk profile for Woodside overall has increased significantly. Not just because there remains potential for further disappointment at Pluto-1, but because Woodside has more similarly large projects in the pipeline. One can only wonder the risks and potential blow-outs connected to Pluto-2 and Browse.

However, the biggest mistake investors can make is to consider this a company-specific risk or failure. This is not just about Woodside, this is at the very least about the burgeoning LNG industry across Australia.

Specialised industry consultant Wood Mackenzie has pointed out that gas giant Qatar has built 60mtpa in capacity with a peak labour force of 93,000 people. In comparison, the Queensland coal seam methane (CSM) sector is currently targeting 33mtpa with a peak labour force of 20,000. Sure, there will be key differences between the two regions, but at the very least one can see that more than half of Qatar's achievement is being targeted in Queensland with only a third of the labour. Don't take my word for it, but the consultants at Wood Mackenzie have little hesitation in their prediction: delays and cost over-runs are inevitable.

Analysts at stockbrokerages never were 100% in line with guidance provided by companies in Australia's LNG sector, as delays, labour and equipment restrictions and cost over-runs were regarded as "logical". Regardless, the recent weeks have seen analysts making further adjustments to their assumptions. The downward revisions have placed energy companies and miners at the forefront of the latest round of cuts to earnings forecasts. And yes, Woodside has been the "leader" of the pack in the week past.

The Woodside announcement has once again highlighted tomorrow's outlook for growing gas demand is not simply a license to print money in Australia, no matter the level of hype and/or optimism. There will be winners and there will be losers. Right now, it seems, companies such as Santos ((STO)) and Oil Search ((OSH)) are loosely regarded most likely as winners amongst Australian peers. Others, including Woodside and Origin ((ORG)), are under stress to avoid being labeled losers.

Analysts at Macquarie see much wider consequences for the sector in Australia as a whole. Predicts Macquarie: "Notwithstanding the short-term Fukushima effects and a near-term tightening in global LNG markets, longer term movements look set to expose Australia’s higher cost base at a time when demand is expected to trend towards more price sensitive markets. As a result, we see growing pressure on local operators to exploit the current market window by sanctioning greenfield projects quickly so that as the market gets more competitive."

As a result, it is widely expected the industry is approaching the point where disciplined boards and management teams will walk away from projects that do not warrant ongoing expenditure. Others might be forced by shareholders or by the market to abandon sub-par investments.

Note that analysts at Macquarie have decided to lower forecasts and price targets for all LNG players under coverage post the Woodside announcement, including for their sector favourite Oil Search. While all targets remain well above current share prices, it seems rather unlikely investors will try pushing these share prices to the maximum anytime soon while such big question marks remain.

Only days after the Woodside news, BHP Billiton ((BHP)) followed up with the announcement the expansion at the Worsley alumina refinery in Western Australia would cost a lot more (58%) than initially budgeted for. While some analysts have been quick in pointing out this news represents only a minor set-back for the company in the bigger scheme of things, this does not take away the fact the company's risk profile has made a significant jump for the worse. This not in the least because the board has allowed for US$80bn in capital expenditure in the years ahead and US$10bn of this is dedicated to potash, which is relatively new to the Big Australian.

The news about Worsley has already generated a few stand-out comments. Probably the most expensive alumina refinery expansion – ever, suggest analysts at Macquarie and Citi. But also: doubts whether the board would have given the greenlight for the expenditure if it had known the ultimate costs would be so much higher. Probably not. On current metrics, the Worsley operation will require 25 years of uninterrupted operation to pay back its costs. And that's not taking into account alumina prices disappointing at some point over that period, or a further increase in costs.

No doubt, some investors are experiencing flashbacks about BHP's chequered legacy with new technologies that end up costing shareholders a lot more than initially anticipated: Beenup in mineral sands, Hartley platinum, two HBI plants and Ravensthorpe nickel.

In between both announcements, China's Sinosteel effectively placed a big question mark over the Oakajee Port and Rail project in WA by ceasing its $2bn Weld project, leaving the other foundation partners in the port project, including Murchison Metals ((MMX)) scrambling for a quick Plan B solution.

Iron ore stocks have experienced their own "winners and losers" contests these past few weeks. Note that experts seem united in the view that prices will hold up for another two years, but will then likely come down by stealth. Which is why any junior with immature financing or a project time-line past 2014 has now received the label of "loser".

The same process is taking place inside the most popular among popular sectors since October last year; the "pick and shovel" service providers to the energy and mining sectors. Widely anticipated to reap a lot of contracts and revenues from the capex tsunami in the years ahead, stocks such as Monadelphous ((MND)), Walter Diversified ((WDS)), WorleyParsons ((WOR)) and Lycopodium ((LYL)) have enjoyed only rising share prices in what has briefly seemed like a race with only winners. The market is now coming to grips with the fact that this sector, too, will have some winners but likely many more losers.

(This story was originally written on Monday, 27th June 2011. It was published that same day in the form of an email to paying subscribers).

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