Window On LNG: Santos Shows Off While Woodside Changes Tack

This story features SANTOS LIMITED. For more info SHARE ANALYSIS: STO

– Santos shows off GLNG
– Gas supply remains an issue
– Woodside becomes a gas trader
– No change to dividend expectations

By Greg Peel

Last week analysts and investors were invited by Santos ((STO)) to Queensland for a two-day site tour of the company’s Gladstone LNG development, taking in the Fairview upstream gas operations onshore and the LNG processing facility on Curtis Island. First sales from GLNG draw ever closer but at this stage management is still not being any more specific than to suggest “in 2015”.

Management is guiding to first gas at least arriving on the island for processing by the December quarter this year, leading Deutsche Bank to assume first LNG in “mid-2015”. UBS is being more conservative with a September quarter assumption.

Brokers are in little doubt the achievement of first gas sales will represent a significant milestone that will lead to a re-rating of Santos as the non-believers finally convert. At this stage management insists the timeline remains unchanged as does the current budget. But as to what the true value of Santos stock should be going forward, that’s where things become a little more difficult.

The first issue is one of sufficient gas. Not to fire up the first train, but to justify a second and perhaps third train as is hoped for a facility that has taken years and billions to get to this point. The Fairview well site continues to exceed expectations, analysts note, such that comfort around the size and deliverability of what accounts for almost half of GLNG’s gas resource base is growing. But Macquarie, for one, expects production at Fairview to peak in 2020, and a three-train GLNG is a longer-dated proposition.  

The jury is still out on the nearby Roma and Arcadia resources, and Macquarie suggests up to 30% of GLNG resource will need to be sourced from third party suppliers outside the GLNG joint venture, which includes Petronas, Total and Kogas. Deutsche Bank goes as far as to suggest 50%. To that end, Santos has its eye firmly set on Arrow Energy’s Surat Basin gas but is not alone, and no breakthrough there appears imminent at this stage.

Macquarie is comforted train one development is on time and capex budget, but suggests the growth capex required from 2016-20 to ramp up a second train blows out the budget by 44% to US$26.6bn.

Santos did for the first time provide some guidance on capex from 2016, but as all analysts agree, it is difficult to have any deal of confidence in such numbers at this stage. Not because management is kidding itself, although the long journey to train one gas has been beset with cost overruns, but because there are just too many unknowns out there in future.

Indeed, Credit Suisse notes that if one is to assume a pessimistic bear case on the one hand, and an optimistic bull case on the other, the valuation spread that falls out the back of the model is “large”. Wide as Gladstone Harbour, one would imagine, when one inputs variables for the cost price of source gas, the sales price of seaborne LNG, the currency, construction, equipment and labour, the extent of global LNG demand, the extent of global LNG supply…one could go on. Credit Suisse sums it by despairingly asking “How do we value the residual 2800 picojoules [of gas] needed to run the plant for 20 years?”

It no longer matters what has happened in the past, Credit Suisse suggests, alluding to cost overruns and source gas issues. It is all about what the economic value will ultimately be versus current expectations (ie the current Santos share price). To that end, the analysts still see “meaningful risk of the bear case eventuating” and until the share price is trading at a level which takes such risk into account, which they declare to be something below $12 at this stage, their Underperform rating remains.

By contrast, the UBS analysts have returned from Queensland and upgraded Santos to Buy.

UBS admits it can see a rollercoaster rise ahead, but is heartened by the GLNG start-up clearly getting closer. The main risks to the Buy rating are any leftover construction risks, albeit as time passes these become more manageable, and missing out on gas from Arrow Energy.

Macquarie maintains its own Outperform rating, noting that while the analysts’ projected GLNG internal rate of return of 9.2% suggests Santos will still struggle to return its cost of capital, the projected US$600bn in annual cash flow from 2017, rising to around US$1bn from 2010, means the market should “warm to GLNG over time”.

And let us not forget Santos is also a minor stakeholder in PNG LNG, which is due to deliver first gas at any moment and should see Santos’ free cash flow yield jump to 13% by 2016 – the highest in the large cap energy sector, Macquarie notes, with further upside.

A summary of FNArena database ratings for Santos and the other major listed gas players appears in the table below.
 

Finding sufficient source gas for Australia’s major LNG projects has long been an issue, as Woodside Petroleum ((WPL)) found out the hard way before being forced to be satisfied with only one train at Pluto for the time being, but another significant issue is that of the price at which each of the LNG aspirants can export their liquid product to an energy-hungry Asia.

The big swing factor in this equation which has emerged since the first rocks were being turned on these enormous developments a decade or more ago is that of shale gas. And specifically the US shale gas revolution. By the time the leading Australian LNG projects had reached Final Investment Decision (FID) it was known that new technology in lateral drilling had been developed which would reopen the vast US shale fields long ago abandoned after the last Middle East oil shock ended over three decades ago. What nobody could have guessed at the time is just what an extraordinary and rapid transformation in the US energy outlook this would imply.

As is explained in detail in Can Australia Sell Its Gas At A Decent Price?, investment decisions regarding Australian LNG have always been based on the assumption of oil-indexed pricing, which has been the established contract benchmark since the North West Shelf partners began exporting LNG to Japan in 1989. But US domestic natural gas is now so abundant, the price paid by US consumers is well below that implied by oil-indexed pricing. If US energy companies can also export LNG to Asia, and do so at a much lower price, surely Australia’s long held hopes of gas riches will be dashed upon the rocks of the Pacific coast?

There are two major issues here. Firstly, the US government, unlike the Australian government, is very wary of selling its own natural resources to the likes of China and draining low-priced domestic supply, so restrictions are placed on energy exports. Secondly, Asian importers such as China, Japan and Korea place great stake in their own energy security, which can only be achieved through long-term supply contracts. A shift to competitive global pricing based on the US Henry Hub price would also suggest a shift towards more of an LNG spot market, which is far less secure. Australia’s energy companies have always been confident, therefore, oil-indexed LNG pricing would stay, perhaps with just a little discount thrown in to recognise the potential availability of cheaper short-term supply elsewhere.

Indeed, at its investor presentation in May, Woodside stated the “risk adjusted price gap between US supply and Asia LNG supply is minimal”, and the 2013 annual report went further to suggest “the long term price of US LNG delivered into Asian markets will be comparable to current oil-linked pricing”. In other words, Woodside management convinced themselves that the landed price of US LNG would end up being a lot closer to an oil-based price than it would a Henry Hub-based price after risks were taken into account.

Those “risks” largely reflect the aforementioned enormous time and money it takes to build LNG export facilities and to get that timeline and budget even close to initial forecasting. The US is still very much in the construction phase.

So why would it be that only two months later, Woodside has announced a 20-year agreement with US energy company Cheniere to buy LNG from its Corpus Christi project in South Texas? Woodside will buy 0.85mtpa of LNG from 2019 on Henry Hub-linked pricing.

“Sleeping with the enemy,” says Macquarie, “if you can’t beat them join them”. “From seller to buyer,” says Deutsche Bank. “Market evolution,” declares JP Morgan. Whichever way you look at it, Woodside has changed tack.

It is by now well established that Woodside is an energy company swimming in cash flow but offering little in the way of growth. Pluto has disappointed with only one train commissioned, the North West Shelf is reaching old age, Leviathan was recently abandoned, Sunrise seems but a dream and even the Browse floating LNG project is uncertain at this point. Outside of sudden exploration success (more on that below), Woodside is facing an uncertain future. The company is currently handing out big dividends to shareholders but future big dividends require future production growth.

And so it is Woodside is looking to follow in the footsteps of the likes of global Big Oil majors Shell, BP and Exxon and become not just a producer/supplier but an LNG trader. On current projections the Cheniere purchases will represent around 13% of Woodside’s 2019 volumes, Macquarie calculates. Woodside has marched straight into the enemy camp with white flag aloft.

The shift from seller to buyer is not a complete shock, as Woodside has previously indicated its intention to start dabbling in the gas trading game and has set up offices in Singapore to do so. Woodside’s a bit late to the party in Singapore – Asia’s oil trading hub – but the Cheniere deal will certainly be the talk of Raffles. Most significantly, the deal appears to imply a concession to the threat of Henry Hub pricing.

The bottom line is that while the likes of Woodside have to date remained stubbornly convinced in the robustness of oil-indexed pricing, Asian customers have been sniffing around the US and Canada in early talks about just what sort of deals might be done ahead of North American LNG hitting the waves. Security of supply is as much of an issue as price, as noted above, so by the time the US is ready to ship its first cargoes the global LNG market will probably have settled on some form of oil-linked/Henry Hub-linked hybrid. Lower than today’s prices (assuming a steady oil price), but enough to still provide windfall revenues for the first-mover Australian players.

The Cheniere as yet hinges on the US government granting the company export approval from its three-train development, but the Obama Administration has more recently bowed to Big Oil and increased the number of available licences. Were Australia to have a Free Trade Agreement with the US this would not be an issue, but we don’t as yet, hence we are on the same “approval required” list as China.

UBS has called Woodside’s move to trader status a “natural evolution” and a “logical next step”. JP Morgan speculates that during the course of its preliminary Browse marketing, Woodside received feedback from customers that a hybrid pricing model is favoured by those looking to diversify their geographical exposure and their benchmark exposure. (Note that any spike in the global oil price due to some supply shock, such as an insurgent takeover of Iraq’s oil fields for example, would impact on oil-linked LNG pricing while Henry Hub pricing would remain stable).  

The Cheniere deal implies that in the future, one does not buy Woodside gas from Pluto or the North West Shelf or Browse, one buys from Woodside’s portfolio. Woodside has its own fleet of vessels to ship LNG cargoes, so it enjoys destination flexibility. And, as UBS notes, trading out of Singapore suggests tax advantages as well.

So what does longstanding Woodside cynic Macquarie think of the move?

“It will do nothing to fix the lack of reserves,” says Macquarie, given existing reserves will be waning by the time Cheniere is up and running, “and it will do little to offset the declining production profile or meaningfully add to the dividend”.

Macquarie retains an Underperform rating. A summary of FNArena database ratings and forecasts for Woodside appear in the table above.

With regard to aforementioned exploration, Woodside may have stumbled across something promising at the Toro field in the Exmouth sub-basin off WA. It’s early days, but if Toro proves viable, further drilling at other Exmouth sites may even lead to sufficient gas to keep North West Shelf croaking along for longer or even realise the train two dream at Pluto, UBS suggests.

It’s early days.
 

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

Find out why FNArena subscribers like the service so much: "Your Feedback (Thank You)" – Warning this story contains unashamedly positive feedback on the service provided.

Click to view our Glossary of Financial Terms