In part one of this series we argued that oil prices would rise. The surplus responsible for the collapse in prices began with US shale, and that sector is likely to see dramatically lower output as stretched balance sheets no longer support production.
With output expected to fall by almost two million barrels of oil per day (bopd), sustained higher oil prices are likely to encourage new production. With that expectation, we are on the hunt for Australia’s best oil exposure. It is shockingly difficult to identify.
LNG pricing could change
Debt remains a problem
Price guides restored
Oil and LNG have long been linked but that link is a historical quirk that could soon end.
Spot the market
LNG was once a revolutionary idea that allowed gas to be transported and traded without the use of pipelines. Early LNG markets were characterised by a small number of buyers and sellers who contracted supply for decades at oil linked prices.
Today, the LNG market bears little resemblance to its former self. Traditional buyers such as Japan, Taiwan and Korea which only a decade ago accounted for about 90% of the market, are now competing with China, South America and Europe for LNG cargoes.
The number of countries importing LNG has grown from a few to 30 over the past 15 years, while the number of LNG exporters has doubled to 25. The LNG market is now deeper and more liquid with a bourgeoning spot market.
As more buyers and sellers transact, the spot market will expand and, over time, LNG should trade on its own supply and demand fundamentals rather than piggybacking off oil with which it shares little other than organic chemistry. A growing gap between spot and contract pricing (see Chart 1) heralds a permanent decoupling.
While contracted LNG averages around US$12 per million British thermal units (mmBtu – a unit used to measure gas production), spot prices hover at just over US$5/mmbtu. Japanese and Chinese buyers are already demanding new contract terms, and pressure to lower contracted rates – regardless of what the oil price is doing – will grow. Traditional LNG pricing is under dire threat.
Qatar’s RasGas, one of the largest producers, has already agreed to halve contracted LNG prices for Indian customers.
At the pointy end of these structural changes lie four local gas giants, each dominated by LNG. Oil Search, Santos and Origin have each completed mega LNG projects that have cost more than US$60bn collectively and two of them – Santos and Origin – are among the most expensive LNG suppliers in the world.
Table 1 shows our estimates of the per unit cost of production for LNG projects from all four giants. It is not just a damning indictment on individual projects, it speaks to the exuberance of the industry over the boom years when costs soared and ambition reigned.
|Break even cost||Cost excl. finance|
Woodside appears relatively low cost because it operates legacy projects that were built in a lower-cost environment and are largely depreciated. Debt has also been mostly repaid. PNG LNG still boasts attractive economics but both APLNG and, in particular, GLNG will struggle to generate decent rates of returns.
These projects will increase cash flow (we have detailed our own estimates here for Origin and here for Santos) and, if oil prices reach our expectations, each will make money. Yet debt remains a key problem and means that potential losses are large should we be wrong on oil.
As Table 2 shows, Santos and Origin carry dangerous levels of debt. Although Origin carries more debt in total and in relative terms, it can service the higher load thanks to the high and stable cash flows from its energy retail business. Santos cannot.
|Total, $bn||% of
Santos also operates a relatively stable domestic gas business but it is capital intensive and doesn’t generate enough cash on its own to repay debt. Lower oil prices remain an existential threat and the company relies on rising prices to meet debt repayments.
The balance sheet makes Santos a leveraged play on oil – it will benefit more from higher oil prices – but it also introduces unacceptable levels of risk. The one salvation is that a break-up of Santos will likely yield more value than the market capitalisation today.
Santos’s 13% stake in PNG LNG alone could produce $5-6bn if sold; enough to repay debt entirely. The rest of the business, with a book value of $13bn, is being valued by the market at less than $2bn. At higher oil prices, that is likely to be wildly pessimistic but, at lower oil prices, it could be prophetic. While Santos is cheap, its balance sheet is dangerously stretched. Santos is too risky to buy but it is too leveraged to sell. HOLD.
With more productive gas wells and lower costs, Origin presents a more tempting target. Table 3 outlines our bear case, with a US$50 oil price, and a bull case, at US$90 oil. The numbers suggest that Origin is worth between $4 and $11 per share depending on your view on oil.
We’ve weighted the oil price closer to US$70 than US$50 so the fact that the current share price is above our buy price suggests that the market is more comfortable with Origin's debt level or is more sanguine about its future. An alternative is that the market is starting to price in a possible break-up of the business.
Origin chief Grant King recently suggested that splitting the business into an energy retailer and an LNG producer may make sense. That would likely lift the valuation of the total because low interest rates increase the attractions of a stable, potentially high dividend paying utility retailer.
We don’t want to be paying for that speculation although we acknowledge that there is rationality to it. Origin is the most interesting of the big four producers and we would consider upgrading around $4.50. For now, HOLD.
While peers have struggled, Woodside has watched. An operator of two high quality LNG projects, Pluto and the North West Shelf (NWS), Woodside is the elder statesman of local LNG and legacy assets have protected it from the bust. NWS is a fully depreciated cash cow and, although considered dear when built, Pluto enjoys lower costs and higher margins than newer projects.
Despite two splendid assets, Woodside faces well publicised growth problems: the NWS is running out of gas and will need fresh investment within four years; Browse, another potential LNG project, is unlikely to happen; and there are few obvious ways to raise output.
Woodside has bought a stake in the Wheatstone LNG project and its exploration efforts in Myanmar have recently yielded gas but production is years away. With an excellent balance sheet, we are a little disappointed that Woodside hasn’t been more aggressive over the downturn, instead electing to pay dividends at an unprecedented payout ratio of 80%.
That can’t last forever and we expect dividends to be cut as new projects are eventually built.
Without debt concerns or cost burdens, there has been little to worry about and that is reflected in the share price. As Table 4 shows, Woodside is almost spot on our valuation of $27 a share. That number assumes oil prices of US$70 a barrel but is relatively conservative as it omits smaller assets entirely.
Woodside is operating splendidly and is well led. There is little to complain about, but with few problems come few opportunities. The business is fairly priced; we're interested in cheap. HOLD.
Oil Search is the hardest of the big four to value. PNG LNG arguably boasts the best economics of any recent LNG project. Vast onshore gas reserves require few wells and the existing two-train facility can easily be upgraded with one or two additional processing facilities. As good as PNG LNG is, it could get even better.
That prospect is more likely if Oil Search is able to complete a takeover of rival PNG gas producer Interoil, and plug newly discovered gas into its original development. An alternative plan, to build a separate LNG facility in PNG, risks replicating the mistakes made over the course of Queensland’s LNG boom.
With outstanding returns even at today’s oil price and improving economics as the project expands, Oil Search boasts the best financial returns of any energy producer on the ASX.
If the project were located in Queensland or WA, PNG LNG would be worth over US$40bn, implying a valuation for Oil Search of about US$13bn, or A$17bn. That equals about $11 a share and ignores higher output that might come from new gas.
So why is Oil Search stock trading at less than $7 a share? Because the market has factored in a PNG discount.
No one can dispute the value of the LNG project. The squabble with Oil Search is always how much of a country discount to apply. I’ve worked in PNG in the past and seen its dysfunction first hand. My view on the size of the discount? Make it big.
There is a reasonable argument that the current discount is adequate. The Interoil acquisition, should it happen, would be a grand victory for Oil Search, allowing it to lift output at minimal cost and generate exceptional returns without increasing debt. That potential deserves consideration and highlights what has long been hidden: Oil Search chief Peter Botten has been one of the best, least recognised CEOs in corporate Australia.
Country risk will never be conquered but can be controlled by discounting your valuation and using a low portfolio limit. We’re lifting our Buy price to $6.50. Oil Search is within a whisker of being upgraded but remains a HOLD for now.
Despite relatively low oil prices, then, there is little at the big end of the energy sector to excite. Origin and Oil Search are close to upgrades; Woodside sits bang on our valuation price; and Santos is too risky for now.
There are, however, a few other options. In the final part of this sector sweep, we’ll look at the oil futures market, a few ideas in the services sector and uncover the best ASX listed oil exposure.