Woodside's yield-growth challenge

Growth, and the prospect of future profits, is why most investors buy resource stocks and why they are back on the radar screens of professionals.

But in the case of Woodside Petroleum, the game is being played in reverse, with yield today and growth tomorrow … perhaps.

Yield hunters love Woodside’s plan to pay out 80% of underlying profit as dividends. That’s why its current dividend yield of 3.8% is much higher than that of its major rival, Santos, which is yielding 2.5%, or the smaller Beach Energy at 2%.

Investors seeking growth are not so sure about the wisdom of returning so much cash to investors. They also worry about whether a recent decision by the government of Israel restricting gas exports will cause another growth-hope to fall over, with the Leviathan project joining the Browse and Sunrise projects in the too-hard basket.

In effect, Australia’s biggest independent oil and gas producer is in the curious category of short-term buy for yield, and longer-term hold, until management decides how to overcome multiple setbacks in its new projects division.

The yield appeal was triggered in April when Woodside’s chairman, Michael Chaney, announced a special (one-off) payout of US63c a share, thanks to the rapid accumulation of cash from the Pluto LNG project and the sale of a stake in the stalled Browse project to Japanese interests.

Along with the cash in the hand came the new policy of returning 80% of underlying profits as dividends, a ratio which Chaney said was “expected to be maintained for several years”.

The generous dividend policy had the immediate effect of lifting Woodside’s share price by more than 10%, but since that April boost the stock has slipped back to where it was, trading at around $34.

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Current roadblocks

Global economic uncertainties, particularly China’s rate of growth and the prospect of the world flipping from an oil shortage to a gas glut, is weighing on Woodside investors and management, which has struggled to commercialise the company’s gas reserves and, in the case of Pluto, failed to find (or buy) additional gas for its expansion.

Sunrise, a project in waters between Australia and East Timor, is in limbo because the governments of both countries cannot agree on a tax-sharing regime, or even where the offshore gas should be landed.

Browse, which is in Australian waters, has been returned to the drawing board because Woodside and its partners became concerned about its $45 billion price tag and because of the advent of new, lower-cost, floating LNG technology.

Leviathan, the third possible LNG project on Woodside’s books, is also in the unresolved category because the Israeli government plans to enforce a gas reservation policy to ensure its needs are met first, effectively limiting the amount of gas which can be converted to LNG for export.

Exactly how much gas in the Leviathan field will be available to export is unknown, with estimates ranging from 40%, a level which could jeopardise the LNG phase of development, to 50%, a level which could see Woodside commit to its biggest ever overseas investment. A spokesman for the company says it is studying the detail of the decision.

For long-term followers of Woodside, the Leviathan issue is just the latest in a series of project setbacks which have dogged the company for decades. It might have oodles of gas in the ground, but it always has trouble getting it out.

Technical mistakes

It would be unfair to describe Woodside as accident prone, but management has developed a reputation for believing too strongly in its own capacity to deliver, shrugging off repeated technical mistakes as the price investors have to pay for high-risk projects.

Historic errors, that cost hundreds of millions of dollars to fix, include bending the subsea piles on the original North Rankin platform, driving the piles too deep in the Goodwyn platform, and poor design of the flare stack on the Pluto project, which added months to its start-up date.

To those mechanical mistakes can be added the diplomatic bloopers in dealing with East Timor over the Sunrise project, the overly ambitious plans for Browse, and the possibility that Leviathan will be added to the miscalculations.

Cash in the form of a generous dividend policy is washing away the problem of finding Woodside’s next big growth project, though a point will be reached when the cash flowing from current operations will start to slow.

It’s this “cash now, growth maybe” approach that worries investment bank analysts, if not debt-rating agencies such as Standard & Poor’s which this week upgraded Woodside’s BBB credit rating from stable to positive – with the next step-up likely to be an A- rating.

Analyst views

What S&P likes – the cash flow to service debt – is what Macquarie, UBS, BA-Merrill Lynch and Goldman Sachs are not so sure about. Those four big investment banks are rating Woodside as neutral, with JP Morgan one of the few to recommend the stock as a buy, or overweight, to use its expression.

All of the analysts with neutral views of Woodside question how long the 80% dividend policy can be maintained, and whether there is a big new growth project to drive future earnings.

Macquarie noted that the Israeli domestic-gas reservation policy meant that “potential returns on Leviathan are now falling, and the political risks are rising”. Despite that note of caution, Macquarie believes Woodside will find it tough to walk away.

UBS welcomes the fact that the Israeli government has at least made a decision on gas reservation, which will enable Woodside to decide about whether to proceed – because the situation with Leviathan is “just beginning, not ending”.

BA-Merrill Lynch notes that the possible loss of Leviathan means Woodside will struggle to sustain dividend payments.

Goldman Sachs argued in a comparison written last month that Woodside’s dividend strategy was different to its resource peers, and not as attractive. It might mean a higher return over the next few years, but after 2016 Woodside “loses relative yield support”.

Projects pipeline

For Woodside management the challenge is to nail down a big new project, and while Leviathan is the development most likely to proceed (if political and commercial risks can be tamed) it might not be long before there is a return to Browse.

Two clues which add to a belief that Browse is not dead, despite environmental objections to the original gas processing site at James Price Point, can be found in strong Chinese interest in the project and the personal backing for floating LNG technology by Chaney.

Earlier this month, PetroChina, the company which paid $US1.6 billion to buy BHP Billiton’s stake in Browse, described the gas project as being of “key strategic significance” for its oil and gas plans in the Asia-Pacific region.

At roughly the same time Chaney told a conference in Perth that he was attracted to floating LNG technology, which obviates the need for an onshore processing site.

While not committing to the use of floating LNG, which essentially involves parking a massive barge over the gasfield, liquefying gas, and then feeding it to a fleet of special tankers, Chaney made it clear that it was very much an option for Browse.

Rejecting union-led criticism that floating LNG meant few local jobs, Chaney said it was possible that Woodside’s home town of Perth could become the global centre for the technology.

“This is fantastic, exciting new technology which is really high-tech and certainly in Woodside’s case if we proceed with that, with Browse, we’ll be insisting that the technology is located here, in terms of design and so on,” Chaney said.

A key factor in using floating LNG at Browse is that Woodside’s long-term technology ally (and still major shareholder) Royal Dutch Shell is the leader in floating LNG and is well-advanced on installing the world’s first system on its Prelude gasfield close to Browse.

For investors, the challenge is assessing the time it will take for floating LNG to be proved, and for Shell and Woodside to apply the technology to Browse. Planning might be underway but a decision to proceed is unlikely inside the next two years, and a floating system is unlikely to be on site within the next seven years.

Conclusion

So, as at today, Woodside is a yield play spinning off generous cash dividends, with an option to participate in Israel’s Leviathan development, an option to expand Pluto if it can source (or discover) additional gas reserves, and longer-term options on undeveloped gas in the Browse and Sunrise gasfields.

That boils down to buy now for the cash and yield, but keep a close eye on growth plans and trim your holding if not convinced that management can deliver.