Woodside US LNG Purchase Stirs Heated Debate

This story features WOODSIDE ENERGY GROUP LIMITED. For more info SHARE ANALYSIS: WDS

Woodside Energy’s planned acquisition of a downstream US LNG processing project is a shift in direction for the long-standing upstream developer. Analysts are split on whether this is a good deal or a bad one.

-Woodside Energy intends to acquire Driftwood LNG project in Louisiana
-Driftwood has no gas reserves of its own
-Woodside will thus be exposed to volatile input/output spreads
-Most analysts yet to be convinced of the benefits

By Greg Peel

Woodside Energy’s ((WDS)) June quarter update revealed a minor fall in production in the quarter and a small rise in revenues due to higher prices largely offsetting each other. Otherwise, the key takeaway was a further 4% increase in the estimated cost of the now 67% completed Scarborough gas project off the Pilbara coast of Western Australia.

But the bombshell announcement involved the acquisition of US-based LNG infrastructure developer Tellurian Inc, which boasts the key asset of the proposed (but fully permitted) Driftwood LNG project on the Gulf coast of Louisiana.

The announcement raised many eyebrows, and set off quite a debate among oil & gas analysts locally.

A Pivot in Approach

Woodside has traditionally explored for, found and developed gas reserves, before building the infrastructure (processing “trains”) to convert natural gas to liquid natural gas. The upfront costs are large, but once up and running, the operating costs are very low. At that point, the developer is simply exposed to the fluctuating price of LNG.

Driftwood LNG does not have its own gas reserves, it is simply an LNG processing facility. This means Woodside would need to buy in the gas, which would be subject to the US domestic Henry Hub price. Whereas developing and processing its own gas reserves leaves Woodside exposed only to LNG prices, Driftwood leaves the company exposed to both input (Henry Hub) and output (LNG) prices, and the spread between both.

It is a pivot for Woodside. As Jarden puts it, this “proposed transaction differs materially from Woodside’s historical LNG involvement”.

At US$1.00 per share, Woodside is paying a 72% premium to Tellurian’s pre-offer share price to acquire Driftwood. But as Morgans notes, the offer still sits some -42% below Tellurian’s share price one year ago, hence it is “a timely move on a friendly deal”.

The deal remains subject to Tellurian shareholder approval.

Driftwood

The project has a Phase 1 capacity of 11mtpa LNG volume and is targeting final investment decision readiness by the March quarter 2025. Driftwood could eventually be expanded to 27.6 mtpa capacity.

Cost estimates of -US$900-960/t imply Phase 1 gross capex of -US$9.9-10.6bn. Woodside plans to sell down equity and retain a 50% interest in the project, though it has not stated how much LNG exposure it would retain. The company says the transaction creates an “LNG powerhouse”.

Jarden estimates Woodside’s LNG sales volumes will increase from a minimum of 11.5mtpa in 2030 to 16.8mtpa – a significant increase, but still less than 3% of forecast 2030 LNG market share (some 600mtpa).

Management said its proposed investment in Driftwood is consistent with its capital allocation framework of 12% internal rate of return (IRR), and payback within seven years of start-up. If approved, Woodside intends to fund the acquisition and Driftwood capex via debt. The company’s gearing was 13% as at June, according to management.

The Doubters

Jarden (Neutral rating) has modelled the impact of the Tellurian acquisition and Driftwood LNG Phase 1 on Woodside’s free cash flows, gearing, earnings per share and dividends assuming the company retains a 50% interest. Phase 1 capex of US$10.6bn reduces Woodside’s forecast cumulative free cash flow to US$7.1bn from US$14.5bn over the five-year period between 2024 and 2028.

Gearing peaks at over 20% on Jarden’s forecasts, which may have implications for Woodside’s willingness to maintain an 80% dividend payout ratio. The broker models an ungeared 11.5% IRR for the project, which, while attractive as a midstream infrastructure play, is marginally below Woodside’s investment hurdle of 12%.

Both Scarborough and the proposed Driftwood development sustain a heavy capex profile for Woodside to 2028, notes UBS (Neutral), weighing on medium term free cash flow estimates. This broker’s analysis of US LNG infrastructure unit costs under development indicates that Driftwood LNG is in the bottom quartile of US unit plant costs, and bottom third when comparing only greenfield projects.

Given Driftwood currently screens as a higher relative cost plant, producing into an oversupplied LNG market in 2029 and beyond, UBS remains cautious on Woodside achieving its targeted returns of 12% post-tax asset IRR.

There is some value attraction to Woodside, says Ord Minnett (Hold), but execution risks for large projects, and the likelihood of fresh capex on the Driftwood project hindering improved shareholder returns for some years, prevents this broker from being more constructive on the stock.

Citi (Neutral) believes Driftwood earns an infrastructure-like IRR of 9% at current market prices. This can rise to a 12% IRR with a US$0.80-1.20/mmbtu portfolio benefit by capturing market dislocations. However, Citi finds historical levels of volatility would have seen Woodside out of the money in most years.

Before Citi goes into further detail, we’ll need a quick lesson in statistics.

When normally distributed data is plotted on a graph, it generally takes the form of a bell curve. The plotted data that are farthest form the mean of the data usually from the tails on right and left of the curve. “Kurtosis” indicates how much data resides in the tails.

With that now understood:

The right-tail LNG price outcomes of the 2011 Fukushima nuclear disaster and the 2022 Russian invasion of Ukraine earned very good spreads, Citi notes, meaning the 15-year mean spread if extrapolated to the future could earn Driftwood close to a 12% IRR. But shocks can go the other way too, such as recessions.

Woodside is becoming the global marginal producer, so negative shocks will see the company trading at its short-run marginal cost, well below its long-run marginal cost at a 9% IRR, let alone the 12% hurdle, Citi warns. Investors need to ask whether right-tail kurtosis is predominant to left-tail to achieve the 12% IRR.

“We are sceptical,” says Citi.

The Champions

Woodside has entered “the right kind of deal”, says Morgans, acquiring a large LNG project for which the vast majority of investment will go into development capex rather than acquisition premium.

“It is clear that market pundits are unwilling to lend any imagination to the Tellurian acquisition, with Woodside’s non-US model approach to a US infrastructure project”.

Morgans is “very willing” to give some leeway on small differences in estimated IRR in exchange for removing subsurface risk (ie developing gas reserves) when the player is as formidable an operator as Woodside with such deep marketing ties.

“Believing the market will gradually discover it is biting into cheese and not chalk on Tellurian as it gains understanding and confidence,” an indignant Morgans retains its Add rating.

Given legacy free cash flow declines, Macquarie (Outperform) believes Driftwood LNG is an attractive opportunity for Woodside to pursue (at the appropriate equity level) to grow its LNG marketing and trading business. This is an attractive segment, the broker suggests, and Woodside is uniquely placed to capture this growth.

Morgan Stanley (Overweight) sees the proposal as consistent with Woodside’s competencies in engineering and LNG trading, albeit a step away from its historical vertically integrated model.

The Wash-Up

The six brokers monitored daily by FNArena covering Woodside Energy are split 3/3 on Buy/Hold or equivalent ratings. The consensus target price is $31.08, ranging from $28 (Citi) to $35 (Morgans).

Not monitored daily, Jarden is Neutral with a $29.15 target.

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