Santos or Woodside?

PORTFOLIO POINT: Long the energy investors’ favourite, Woodside has a rival. So how does Santos stack up?

Energy investments are back on the agenda, and top of the list for retail investors are oil and gas stocks. With oil prices continuing to rise, despite a slowing global economy, brokers are re-focusing on the two oil majors on the ASX: Santos and Woodside. (To read more on investor appetite for energy stocks, see Alan Kohler’s feature Buy energy, buy oil).

For most investors over many years, buying oil stocks meant buying Woodside. But the surge in demand for LNG from our Asian neighbours has made Santos an increasingly effective entry into the sector. So if you had to choose just one energy stock, which would you choose?

Capitalised at $30 billion, Woodside is by far the largest of the two stocks. Operated by well regarded team of chief executive Don Volte and chairman Michael Chaney (ex-Wesfarmers CEO) the Perth-based company has quality assets including a stake in the $15 billion North-West Shelf mega-project and the emerging LNG project Pluto. For a long time now, Woodside has been viewed as an expensive but low-risk oil play.

Meanwhile, many investors perceive Adelaide-based Santos to be a higher-risk operator. A declining field in its Cooper-Eromanga Basin, the Indonesian mud volcano disaster where the company had to pay more than $23 million to rid itself of interests in the project, and a $17.8 million golden parachute deal paid to former chief executive John Ellice-Flint were regularly cited as reasons to give Santos a miss. But thanks to a $2.1 billion deal to sell 40% of its coal seam gas project in Gladstone, Queensland, to Malaysian-based Petronas in May 2008, that view of Santos as the poor relation is fading fast.

nHead to head
	Santos	Woodside
Price	$14.25	$42.50
Yield	2.9	3.2
Market Cap	$10.6 billion	$30.2 billion
EPS	$2.73	$2.61
P/E	5.2	16.2

At a time when debt markets are presenting many difficulties, Santos has managed to rise above the muck. Adrian Wood, a senior oil and gas analyst with Macquarie Equities, says: “Given the capital management plan in place, Santos actually has enough money to fund both Gladstone and its stake in the Papua New Guinea LNG project [led by ExxonMobil].”

What's more, Wood argues that a $3 billion capital raising at Santos has made these plans possible while a pullback in the share price has presented investors with a neat entry point (the 2-for-5 retail offer priced at $12.50 closes on June 5).

Wood explains his enthusiasm for the stock: “Our overall net asset value inclusive of the new shares is $15.55 and of that Gladstone contributes $2.60. If it gets off the ground it could grow to about $5.60. There are big uncertainties in this project but on balance it is more likely to go ahead than not.” (Santos is trading today, May 27, at $14.49.)

The recent deals at Santos may have thrown traditional signals of value – such as price/earnings (P/E) multiples – out the window. Most Australian oil companies trade on P/Es in the mid teens, but Santos is on a P/E of 5.2. That may look low, but adjusted for the recent capital initiatives it rises to 17 times; moreover, it is expected to accelerate tremendously in the years ahead.

nMedian consensus forecasts
	Santos	Woodside
2008	17.6	13.4
2009	63.2	28.3
2010	43.2	23.5
2011	36.5	11.2

In fact, far from presenting a problem, the Santos headline P/E – explained by the huge amounts of money being invested in Gladstone and a production date several years away – is not a problem for analysts. On the other hand, Woodside’s valuation is a concern, many analysts believe the Woodside current P/E of about 14 (and about 29 times for the financial year to December 31) is excessive when compared with a global average P/E of 9 among oil companies of a similar size and similar outlook.

UBS analyst Gordon Ramsay, asked to compare Woodside with Santos, says: “The simple answer is that Woodside has built and operated LNG plants and Santos hasn’t, but I don’t know if that makes Santos riskier; they really are quite different companies. I think there are big resources in coal seam gas and over time they will be developed.”

Meanwhile, Woodside, which has been openly derisive of CSG and its potential, has staked its reputation on developing the Pluto gas field adjacent to the North-West Shelf development. Analysts have run the numbers on the first Pluto LNG train and are satisfied with the results. It’s when there’s talk of a second train that things get interesting. (To read more on the CSG market, see Coal seam believer.)

Gordon Ramsay explains: “For Woodside, Pluto 1 works. The return on investment is fine. For Pluto 2 to work it needs to work out where it’s going to get gas from and there are various alternatives. The first is exploration, the second is accelerating production from existing fields and the third is doing deals with other parties.”

Who will those “other parties” be? At an oil conference last week in Texas (where else?), the $US23 billion NYSE-listed Apache Corporation jumped the gun when it announced that it expected to sell its gas exclusively through Woodside’s second facility at Pluto. Woodside put out a clarifying statement saying that it had a non-binding agreement with Apache and was discussing its options with a number of other parties.

These options were extensively canvassed in a supportive note from Goldman Sachs JBWere energy analyst Aidan Bradley. Ticking off potential match-ups, he lists Chevron, Hess and BHP alongside Apache as the kind of partner Woodside might wish to court.

The note also explains that the market has failed to take into account potential success of Pluto 2, Browse and Sunrise. While there are admittedly numerous obstacles in the paths of each project, Bradley goes on to say: “If Woodside is able to deliver on even one of these opportunities, there is a significant value case in Woodside from current levels.”

Gordon Ramsay cautiously agrees: “Arguably there is some upside in the share price based on these projects, but I’m a little concerned about the oil price outlook. I like Woodside but it’s a little close to my share price target right now.” (UBS has a 12-month price target of $44.56 on Woodside, which is currently trading about $42.87.)

Macquarie’s Adrian Wood is not convinced: “With the possible exception of Pluto, those projects all have a lot more risk than something like Gladstone going ahead. We’ve got an Underperform on Woodside and an Outperform on Santos.”

The breakneck recovery of the oil price has been one of the standout stories of the past month. As equity markets moved sideways, oil has gone from strength to strength, putting on another 38% from its recent lows – it reached $US63 a barrel earlier this week. Over time, the share prices of both Woodside and Santos broadly track the oil price but as yet, neither has been able to take advantage of the recovery. Over time, they both should.

The emergence of coal seam gas as rival energy source to oil still has many years to play out and yet it seems that a changing of the guard is already taking place with a landmark deal struck earlier this month (May 13) when the China National Offshore Corporation bought half the output of BG's coal seam gas project for $US45 billion.

While oil remains an essential commodity and there are many functions that LNG cannot perform, a growing number of analysts believe the outlook for Woodside beyond Pluto 1 is not as bright as the outlook at Santos, thanks to the expected project life of Gladstone.

For the record, the broking community seems evenly split on the merits of each stock. Among the top 10 brokers in Australia, five have a Hold on Santos and five have it as a Buy; with Woodside the position is identical.

Whichever way you choose to swing, you are gaining exposure to a producer of a commodity with high barriers to entry that is growing in scarcity and essential to everyday life. Or course, the appeal of such companies is rarely limited to just investors like you and I, hence the persistent takeover rumours we hear about each company on a regular basis that only make things all the more interesting (see All eyes on cashed-up BHP).