AWE: Interim result 2015

Yet again, AWE has reported awful profits. Production numbers were good – down 14% because of shut downs at the BassGas project – and revenue fell just 8% for the past six months, which isn't bad in the light of slumping oil prices and lower output. Yet add in high operating costs, high depreciation, amortisation and interest charges, and there was no profit left. The business actually lost $14m for the half.

That's not even counting over $90m of impairments due to falling oil prices. Worst of all, consistently poor results aren't expected to improve within the next two years.

We've maintained coverage of, and optimism towards, AWE for one key reason: large volumes of gas that are now sold at tiny margins will be renegotiated in 2017 at much higher prices, potentially repairing the company's chronically poor profitability. 

Gas output accounted for 55% of production but just 25% of revenue while oil accounted for 20% of output but 38% of revenue. AWE is heavily dependent on oil to generate profits but oil output is falling. 

The company had planned new output from an Indonesian oil project, Ande Ande Lamut (AAL), to raise the share of oil and hence profitability but that project has been delayed as operator Santos seeks to conserve cash. For the next couple of years, the business must try to lift profits from gas alone.

From 2017, when AWE's existing contracts start to expire, that should be easy to do. New contracts will reflect vastly higher gas prices – up to three times existing contract prices – which will lift profits. Until that happens, gas projects continue to suck in plenty of cash and spit out too little.

Lower asset values

Lower oil prices have also slashed the asset value of AWE's stake in a Texas shale field, Sugarloaf. That field was valued at about 50 cents per share – about 40% of AWE's current market capitalisation – but will now attract far lower prices. Although it sits in a sweet spot and boasts low operating costs, Sugarloaf consumes huge volumes of cash and, so far, generates no free cash flow. We are bitterly disappointed management didn't sell the asset during the boom. We're going to say it: we told you so, AWE.

That brings us to a key criticism of the business. For years, AWE has generated lousy investment returns for shareholders and yet management has made no recognition of that fact or pledged to do better. The business is too focused on lifting production rather than profits. Management takes some blame but so do we. We've been far too generous about the potential of the business at the expense of actual performance.

We should have sold when prices hit our valuation in AWE downgraded on 5 Jun 14 (Hold – $1.82). What to do now is a trickier decision. We're loathe to show more patience to a buisness that has already taken too much but, with the prospect of higher gas prices closer, now is not the time to be selling. 

We're cutting the prices in our recommendation guide to reflect the lower asset value of AAL, and Sugarloaf. With new contracts and higher prices now two years away, however, we're sticking with HOLD.

Note: Our model Growth Portfolio owns shares in AWE.