The case for selling Woodside

Profits have never been higher. Dividends, production and cash flow have all hit records while capital expenditure and debt has plummeted; These aren't the usual conditions to support the argument to sell the largest independent oil and has business in the land. And yet that's what we're about to do.

The company is in fine financial shape. Profits rose to US$1.75bn in the year to December 2013, while annual production hovers around 87m barrels of oil equivalent (mmboe). Dividends of US$2.49 per share offer an amazing yield of over 5% and appear sustainable. Sometimes derided as a risky business with lumpy cash flows, on the numbers at least, Woodside looks more like a utility or a bank.

Management has committed to pay out 80% of profits for the foreseeable future and won't face a material production decline until 2020, when North West Shelf output peaks. Pluto output will start to decline in 2030, so steady profits and a rich dividend could feature for years.

So why worry? Because oil and gas fields are finite resources that deplete with production and an energy business that pays out 80% of profits risks under-investing in production growth.

Production represents the recycling of one asset – oil and gas – into cash. As production depletes oil reserves, a part of profits must be reinvested to replace and (hopefully) increase oil inventory. Without that, producers risk a slow decline as their assets deplete.

This is the worry with Woodside. It appears to have run out of development projects and will find reserve replacement either difficult or expensive.

There are two ways for Woodside to boost reserves: to increase exploration or buy reserves through acquisitions (Oil Search is often mentioned as a likely candidate). Management, however, doesn't appear keen. 'We can buy volume growth but buying value is harder', says chief executive Peter Coleman. By publicly committing to strict investment hurdles, management has made a takeover unlikely.

Instead, the company has beefed up its exploration team and is spending millions on seismic surveys to peek beneath the oceans in search of oil and gas. It's also scouring the globe looking for new unexplored basins to drill. Exploration is rewarding when it works but expensive when it doesn't. A new reliance on exploration makes Woodside riskier despite its operating stability.

Right now, with the market fixated on yield, there is little pressure to add to reserves but that will change at some point. The loss of Leviathan and a stalemate at Sunrise (in the Timor Sea) means that Woodside has only one development asset of note: Browse.

A giant gas field off the Western Australian coast with reserves of about 15 trillion cubic feet, Browse is four times as big as Pluto. If size is its drawcard there are many drawbacks. Isolated, rich in carbon dioxide and a long way from shore, cost estimates have topped $50bn, effectively shelving the development. Woodside and its partners now plan a Floating LNG (FLNG) platform that could lower costs and ultimately lead to development.

The plan is a bold one. Browse will require three separate FLNG vessels to suck gas from three separate fields within the structure. Doing so would reduce development time and more than halve the cost. The consortium is due to make an investment decision late next year. At the earliest, Browse could be commissioned early next decade.

But even in the best-case scenario, it leaves Woodside facing years of depleting reserves and production stagnation. Far from a sign of strength, the high yield is compensation for decaying value. Today's valuation doesn't appear expensive by historic standards. On a PER basis, on an asset basis and on a reserves basis, Woodside isn't priced for a boom.

Yet it faces a decade marked by stagnating production and dwindling reserves. With much dependent on exploration efforts, Woodside deserves a modest valuation.

This is a decent business we'd happily buy at lower prices but, with fresh opportunities emerging on our buy list, we'd rather have cash invested elsewhere. SELL.