Is Woodside heading the wrong way?

Woodside may have to take a few lessons from BHP to reassure income hungry investors.

Summary: In a climate of falling energy prices, massive spending on resources projects will be hard justify. For Woodside, there is an opportunity to substantially increase its dividends as well as for capital returns.
Key take-out: Market nervousness is reflecting the fact that Woodside’s growth momentum is not only under question but also has much higher risk.
Key beneficiaries: General investors. Category: Income.

One of the hardest decisions boards of directors face is to suddenly discover they are in charge of an income-producing company rather than a growth company.

Our institutions are pressing for more dividends and capital returns, so increasingly companies are going to face difficult decisions in deciding forward strategy and where they stand in the growth/income funds allocation game.

BHP is going to swing more towards lower borrowing and greater shareholder returns than its traditional higher debt/ growth strategy, and that was one of reasons for the appointment of Andrew Mackenzie as chief executive. BHP is coming to grips with this new environment. (To read more on BHP, see today’s story from Ian Verrender).

Similarly, earlier this week when Rio Tinto appointed Chris Lynch as its chief financial officer, it was a signal that Rio will adopt a lower-growth profile, and income and lower debt balance sheets will take over.

In contrast to BHP and Rio Tinto, I am not sure that Woodside has fully grasped the significance of the new environment that the group faces. And so this week I want to talk about Australia’s great LNG pioneer, Woodside Petroleum. As Eureka readers will know, I have been alerting people to the dangers that US shale developments pose to the long-term Australian LNG market but this is the first time I have focussed on a single stock.

In simple terms, we are going to see a big rise in the amount of gas and oil energy in the global market during the next five years (and in the decades ahead) as a result of the US shale, oil and gas expansion and the discoveries in the Middle East, particularly in Iraq.

The LNG market has received a fantastic boost because of the collapse of the Japanese uranium industry. The Japanese have stepped up their buying of LNG and pushed up the price. But the advent of bountiful low-cost gas in the US is already making it hard for the Japanese goods to compete against US manufactured goods, which are steadily benefitting from lower US energy prices. The same will soon apply to the Chinese. Accordingly, the rise in oil and gas supply will intensify competitive pressures in the world trade market, which may impact LNG prices.

My guess is that Japan may return to its nuclear ambitions, but that’s not a forecast. The real point is that it is very dangerous to assume continual escalation in LNG and oil prices, and there is a clear possibility that they will be softer than current broker estimates indicate.

In the LNG space a graph came across my desk this week from the Macquarie Group, which showed that they believe the global expansion of LNG facilities to 2025 is going to be much greater than Woodside is anticipating.

I don’t know who is right but, as the Macquarie graph below shows, there is clearly a risk of much greater LNG capacity emerging at a very sensitive time in the world energy market.

(Source: Macquarie Group)

In that environment the high cost of constructing new LNG projects in Australia is simply going to be extremely difficult to justify. Woodside budgeted to spend $12 billion on its Pluto expansion. In the end, the project was a year or two late and the final cost came in at $15 billion – a rise of 25% on the original budget.

Gorgon, which is owned by Chevron, Shell and Mobil, has seen the cost of its $43 billion project escalate by $9 billion to $52 billion. There’s a good chance there is more cost escalation to come. And, of course, over on the east coast in Gladstone they are struggling with higher construction costs and not enough gas. That means that new LNG projects in Australia are not going to be easy to get off the ground.

In its latest presentation Woodside places much emphasis on the Browse and Sunrise projects, which not only are vulnerable to this higher-cost regime but have environmental and political difficulties as well. And then the company has gone off and purchased a major stake in an Israeli gas field – Leviathan. That means the company is looking for growth in high-risk areas, which gives Woodside a totally new risk profile.

Maybe the project in Israel will be fine but there are already suggestions that Israel is looking to take gas from Turkey at a much lower cost than starting up a new project.

So Woodside’s quest for growth at this point of its development indicates that it’s seeking growth at higher risk. At the same time, while Woodside has excellent local reserves, they are falling and it hasn’t replaced them at the required rate.

(Source: Macquarie Group)

Indeed, in the original Pluto plans, there was to be additional trains of gas and, while they may still take place, the company’s discovery of new gas reserves in the Pluto area has been disappointing.

So suddenly you start to look at Woodside from a totally different perspective. And I hasten to add we may have to look at other Australian LNG operators in the same way given Australian costs. Woodside reported that in the 2012 calendar year, its underlining profit was just under $US2.1 billion. And, of course, there were new production records given the commissioning of Pluto. The profit equalled earnings per share of $US2.53, and the company paid a dividend of $US1.30. Is the company likely to earn greater profits than this? It is true that in 2013 it will enjoy a full year’s production from Pluto, but in the next two or three years it is hard to see any further substantial increase in its production.

And so the profit will depend on the movements in the LNG, gas and oil prices, plus the Australian dollar. Because hydrocarbons are priced in American dollars, if the Australian dollar was to fall then profits expressed in Australian dollars would rise, all other things being equal.

The group has reduced its gearing to a mere 11.2%, with total debt at $4.3 billion. So this is a company that is capable of actually paying out much greater dividends if it moves out of the growth phase into an income-producing phase. But, of course, an oil/ gas company is not a bank or industrial company — when reserves start to fall the markets punish oil/gas companies despite income. So oil and gas companies must continue to explore and must try and replace the gas and oil that they are selling if they are to maintain their share price. Accordingly, Woodside has some difficult decisions to make but I suspect that it is going to move towards the higher-income profile despite its difficult problem.

Dividends could be increased substantially as the cash flow comes through, and as assets are depreciated so there will be scope for capital returns as well.

But the Woodside share price has always been geared towards growth. In recent weeks we have seen a fall in Woodside shares from around $39, and although this week we saw some recovery the market nervousness is reflecting the fact that Woodside’s growth momentum is not only under question but also has much higher risk.

So this is a stock to treat with some caution, although I underline that the group is still optimistic about Browse, Sunrise and Leviathan in Israel and understandably doesn’t share my nervousness about the longer-term price of LNG.

Don’t be misled by the fact that Woodside may currently pay a higher yield than BHP. According to Bloomberg, BHP has a net yield of 2.9% - grossed up to include the benefits of franking it becomes 4.1%. Woodside has a net yield of 3.39%, while grossed up it is 4.8%.The point is that BHP is reshaping its returns towards better future income streams for its shareholders.

I think the BHP change of direction will affect many other companies. Woodside will be one of them. But whereas BHP has enormous reserves of all the minerals it produces, Woodside will still have to allocate money to try and maintain its reserve levels because, unless it does that, its share price will be affected.

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