Recently Woodside Petroleum (WPL) made an important capital allocation decision which was a microcosm for the growth and risk trade-off facing shareholders.
WPL terminated its memorandum of understanding with the Israel’s Leviathan joint venture because it couldn’t negotiate a commercially acceptable outcome. The Leviathan field has an estimated 19 trillion cubic feet (Tcf) of gas and 700 million barrels of crude oil. WPL had an MOU to acquire 25% of the field at a cost of $US850 million in cash on completion of the transaction, plus further payments once various milestones were met.
The decision to exit demonstrates WPL’s prudent and careful approach to capital management – but also its lack of near-term growth opportunities. CEO Peter Coleman said: “while Woodside’s commitment to growth is strong, even stronger is our commitment to making disciplined investment decisions.” Concerns WPL would buy overpriced assets for the sake of growth have been alleviated by the Leviathan exit. With the balance sheet now boosted by the $1 billion earmarked for Leviathan in 2014, expectations of a capital return have increased. Gearing was already a very low 10% on December 31.
The termination of the deal raises questions about WPL’s growth prospects. While there are some long-dated growth options, a temporary fall in production post-2016 is probable.
WPL will eventually need to invest in new projects to offset the natural decline in production from existing fields. The offshore exploration pipeline includes new acreage in Myanmar, Ireland and New Zealand. The company has been awarded a three-year lease by the Government of British Columbia, Canada, to study the feasibility of developing a liquefied natural gas (LNG) plant at Grassy Point. In Australia, WPL has committed to two drilling rigs for a two-year program off Western Australia and high-potential greenfield exploration wells are planned for the Outer Canning Basin later this year.
This exploration pipeline is positive, and WPL needs to find and develop new reserves to replace the decline of existing assets. But it is a long and expensive road from LNG exploration to production and value delivery for shareholders.
Apart from production and costs, the main earnings drivers for a miner are prices and currency. The price of oil is the main variable and uncertainty when predicting WPL's earnings. Movement in the oil price affects not only the price received for WPL’s oil but also its condensate, liquefied petroleum gas (LPG) and LNG. For 2014, a $US1 movement in the Brent oil price moves net profit after tax (NPAT) by $34 million all else being equal. A one-cent depreciation in the $US/$A exchange rate increases NPAT by $US 4 million.
In FY14, WPL anticipates average realised prices across all its products will increase as a result of LNG price negotiations and oil volumes from the Vincent FPSO coming back online.
Longer term, the growth strategy is underpinned by strong global demand for natural gas and the increasing role of LNG in the global gas supply mix. By 2030, global demand for LNG could be more than double the 2013 level of approximately 240 million tonnes per annum, implying annual growth of 4-5%.
The Asia-Pacific makes up ~70% of global LNG demand and there is significant demand growth across India and South-East Asia. In addition to LNG’s use in power generation and commercial and residential applications, it is increasingly becoming an important transport fuel.
Source: Wood Mackenzie, WPL, StocksInValue
There is increased competition for supply into the Asian market from both traditional and emerging suppliers, and we see some risk of long-term downwards pressure on LNG prices. By 2016 the United States is set to become a global LNG exporter. Two weeks ago Russia's state-owned energy company Gazprom signed a 30-year gas supply deal with the China National Petroleum Company worth more than $US400 billion. By the end of the decade Gazprom will supply ~28 mmtpa (million metric tonnes per annum) to China. In the above chart, this equates to around a third of the expected demand from China/India. At the announcement of the deal, Gazprom CEO Alexei Miller warned “the implications of the deal should not be understated” and the “deal will have an impact on liquefied natural gas projects in east Africa, Australia and west Canada.”
The terms of the deal weren’t disclosed, however it has been reported that a gas price of $US10-11/mmbtu was achieved (about half the current spot price), setting a new benchmark for pricing that may put downward pressure on margins and deter new projects. Potential high-cost LNG projects globally that have not gone ahead may face headwinds in obtaining capital and signing contracts. WPL will need productivity gains to be competitive, as it has become very expensive to develop LNG in Australia. By 2030, demand for LNG from the China/India market is expected to be at least four times Gazprom’s supply, but price pressure in the meantime could dull returns for WPL shareholders.
Production volumes, commodity price and currency risk, coupled with political uncertainty, operational risk and risk of exploration failure make WPL’s earnings difficult to predict. We use an adopted normalised (includes franking credits) return on equity of 18%, marginally below the five-year average of 20% to reflect WPL’s weaker near-term growth profile.
The 12.5% required return reflects the strong balance sheet, large market capitalisation and mostly international earnings. We derive an equity multiple of 1.66x and FY14 valuation of $31.87.
In the absence of near-term opportunities to invest in quality assets, WPL has been returning capital to shareholders and attracting yield investors. The low rate of reinvestment of capital, reflected in the low RI component of 3% in the chart, is why WPL shareholders face slow intrinsic value growth (red oval below) in the near term.
Currently the shares are supported by an attractive dividend yield and a high payout ratio, which may not be sustainable long term if WPL secures suitable growth opportunities. An eventual recovery in interest rates will likely present downside risk to the share price as income seeking investors rotate out of higher-yielding equities into lower-risk fixed income products.
By David Walker, Senior Analyst StocksInValue, with insights from George Whitehouse and Adrian of Clime Asset Management.
David Walker owns shares in WPL.