Window On LNG: Enticing Capital Returns Approaching

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– Australian LNG project investments approaching "first gas" milestones
– Leveraged LNG stocks to transform into dividend plays
– Australia to enjoy first mover advantage

 

By Greg Peel

One of the biggest risks involved with the long and expensive process of building and ramping up Australasia’s new suite of LNG projects has been that of costs. Energy companies initially set their assumptions too low, leaving analysts sceptical. The concurrent mining expansion boom in Australia helped to push the prices of all resource sector equipment, services and labour to highly inflated levels. And the previously unforeseen boom in US shale projects further inflated prices of often imported inputs.

Such scepticism, and the sheer scale of the projects being undertaken on the Western Australian coast and in the Queensland coal fields, was passed down to investor perception. Sure enough, Australian energy companies have been forced to continually upgrade their capital expenditure assumptions over the past years, although in more recent reports it appears capex growth has at least levelled off and projections can be more reliably accepted. The end of the mining expansion boom has helped ease the cost pressure to some extent, although not so much for energy sector-specific inputs.

Many of those analysts quite sceptical in the early days have now become more confident as “first gas” approaches for the PNG and Queensland CSG projects. And after a lot of difficulty along the way, Woodside Petroleum’s ((WPL)) Pluto project is up and running, albeit with less ambition for more than one LNG train to be justified. The time has come for analysts to really start looking at just what sort of cash flow Australia’s energy companies can look forward to, and just how much of that can be returned to long suffering shareholders.

There is still the matter of potentially elevated operational expenditure. Opex will take over from capex as projects head towards production (notwithstanding a fixed cost level of sustained capex) and will very much influence earnings. Morgan Stanley notes Australian oilfield costs continue to be “robust” due to the intensive construction phase that is still underway across the country (first gas is expected at various projects from 2014 through to at least 2017 and then beyond for those projects still to be constructed), and due to the global demand for personnel, rigs and other specialised equipment.

Morgan Stanley noted following the most recent reporting season that opex increased at the majority of companies, and those experiencing falls on a per production basis increased existing production. There is some evidence of a possible global peak in cost growth having been reached, but the broker sees little in the way of cost deflation for the suite of Australian projects until “first gas” milestones start to be ticked off.

As Australia’s LNG major projects were being sanctioned back in the period 2007-2011, it seemed like a no brainer. Sure, extensive time and capital investment would be required, implying equity farm-outs, joint ventures and pre-signed customer offtake agreements, but the simple equation of rapidly growing emerging market (particularly Asia) gas demand balanced against limited global supply growth meant such risks would clearly be worth in the long run. At that stage no one really anticipated that newly developed technology would re-open the North American shale fields and portend an eventual swing from energy importer to energy exporter for the continent, nor that East Africa might also rise as an LNG export competitor. While such projects are well behind Australian projects in the first mover race, their development has provided a lot of the unexpected cost inflation Australian projects have been forced to deal with.

On that basis, Deutsche Bank does not believe any further onshore, greenfield LNG projects will be sanctioned before 2020 in Australia. So the advantage lies with those projects now approaching “first gas” (see table below).

Given increased global supply-side competition and industry-wide cost escalation, Deutsche believes a focus on local project returns is “more paramount than ever”. The return on equity on capex already now sunk is now “academic”, the broker suggests, so the focus turns to the ability of energy companies to create value from future growth projects, being brownfield expansions and near-field exploration.

Of the majors, Deutsche’s top pick on this basis is Oil Search ((OSH)), given the standout opportunities on offer in PNG, and among the emerging energy companies the broker likes Drillsearch ((DLS)) for its Cooper basin oil and wet gas upside.

Woodside, as noted, has Pluto underway (as well as the company’s legacy North West Shelf stake) so as at 2014 Woodside offers the leading sector return on equity (ROE) at 15% and an operating cash flow yield (OCF) of 12%, Deutsche calculates. However Oil Search should see first gas from its first PNG train this year and from a second train in 2015, at which point production will plateau ahead of further project expansion. Oil Search’s ROE will reach 17% in 2015, on Deutsche’s numbers, and OCF will rise to 15% in 2017.

Then there’s Santos ((STO)), which has a major stake in GLNG and a minor stake in PNG LNG, which should see OCF reaching 20% by 2017. On these numbers, Deutsche suggests lingering scepticism surrounding GLNG timeline and capex risk is “severely overplayed”, meaning recent share price weakness is offering up an attractive entry point in the broker’s view.

That said, Deutsche’s top pick remains Oil Search, which boasts superior medium term growth potential in OCF with at least one more train likely to start up later in the decade, on the broker’s prediction.

In the longer term, JP Morgan believes PNG LNG could push to a fourth train and beyond. Interestingly, while Deutsche has a Buy rating on Oil Search, JP Morgan’s rating is Underweight. The comparison is nevertheless not quite apples-to-apples given Deutsche is rating against the broad market and JPM is rating against the sector only. JPM believes Oil Search’s assets are of high quality but given the stock price is currently trading at a premium to the broker’s 12-month target price, Underweight is presently appropriate.

JP Morgan also makes note that “first gas” does not mean first big dividend jump for shareholders. As is the case with Australia’s major diversified miners, Australia’s major energy companies will need to strike a considered balance between directing new cash flows to shareholders and retaining funds for future growth. The broker notes PNG cash is only scheduled to be released after Practical Completion, which the broker assumes means six or more months after the second train begins producing in early 2015. Hence no cash is expected to flow from the project to joint venture partner Oil Search (and thus Santos for that matter) until late 2015, despite first gas being due around the middle of this year.

In other words, shareholders should not start salivating just yet.

Then it becomes a case of how much to keep and how much to hand out. The good news is that by 2015 Oil Search’s credit ratios will be “robust”, JP Morgan suggests, and the oil price would need to fall to around US$55/bbl before the project goes into “cash flow lock-up”. (Note: Seaborne LNG prices are indexed to the oil price and Brent crude is currently trading around the US$107/bbl mark.)

The bad news is JP Morgan believes 43% of project cash flow will initially go towards servicing debt, of which around two-thirds will represent principal repayments. But once the project is up and running and has proven its worth, there is a potential to refinance. Such refinancing could then be used to fund expansion trains and lift project value. In the medium term, JP Morgan thinks the market may actually be underestimating the cash available from PNG.

On that basis, Oil Search is currently undertaking a strategic review which will include reinvestment criteria and capital management. JP Morgan calculates that if both Oil Search and Santos were to adopt, from 2016, the same 80% earnings payout ratio as Woodside (bearing in mind the first step depends on a decision over how much the project managers elect to distribute to the stakeholders), then relative dividend yields would be 6.6% from Woodside, 10.1% from Santos and 7.4% from Oil Search. If the broker grosses these yields up for franking, bearing in mind Woodside operates mostly in Australia (pre-Leviathan), Oil Search in PNG and Santos in both, then the comparison becomes Woodside 9.4%, Santos 14.4% and Oil Search 7.4%.

The FNArena database currently shows one Buy (or equivalent) rating for Woodside, two Hold and three Sell. The ratio for Santos is 2/2/1 and for Oil Search is 5/0/1.
 

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