Thursday, July 25th, 2019
Recently, we initiated a position in Woodside Petroleum (WPL) within the Clime Direct Model Portfolio. We managed to acquire a share in the business below our FY19 equity multiple valuation – this value can vary quite widely with the USD/AUD exchange rate given WPL reports in USD.
WPL operates the North West Shelf venture, which includes five LNG trains, and the Pluto LNG train. WPL also owns 13% of the Wheatstone LNG project and numerous oil and gas fields in varying stages of development and production. Scarborough is the priority growth project and part of a broader vision to develop the Burrup LNG hub. WPL is Australia’s largest natural gas producer and supplies 6% of global LNG.
Figure 1. WPL’s strategic vision
Investment Thesis – Key Points
- We are structurally positive on oil after the lack of investment in new supply capacity since the oil price fall of 2014-15, constraints on Iranian oil output due to US sanctions, and because OPEC recently moved to support prices by restricting supply. Oil demand grows annually and replacing the world’s fuel-driven vehicle fleet with electric vehicles will take longer rather than happen sooner.
- WPL’s operational performance has generally been reliable and consistent over many years, resulting in the firm being trusted as the operating partner in joint ventures like the NWS and Scarborough. This improves the stock’s investment quality by reducing earnings volatility.
- World demand for gas as a fuel for power generation will grow as the world transitions away from coal. Chinese demand is growing strongly.
Figure 2. Forecast growth in LNG demand
- WPL’s April 2019 heads of agreement (HOA) with Chinese energy utility ENN, to sell 1mtpa of Scarborough’s gas for 10 years, derisks the project by securing a likely anchor customer – and the first customer is always the hardest. This should add momentum to the project in buyers’ eyes and help bring more buyers on board.
- A board decision to develop Scarborough, known as FID (Final Investment Decision), would increase valuations by removing the risk discount typically found in valuations for the uncertainty Scarborough will not go ahead.
- Positive catalysts possible over 2019-20 which would drive the share price towards our valuation include oil price strength, progress on Scarborough from FEED (Front End Engineering and Design) to FID, more HOAs with buyers of Scarborough’s gas, a selldown(s) of Scarborough with an offtake agreement(s) and a related selldown of the planned second Pluto train, further outperformance by the Wheatstone LNG train, first oil from the Greater Enfield project, FID on the Senegal oil project, FID on the interconnector between the NWS and Pluto trains, and progress at extending the NWS’s life. At the FY18 result, WPL said all growth projects were on schedule.
- The 5.6% fully franked dividend yield (at a $36 share price) is at an historic premium to bond yields.
Figure 3. Potential positive catalysts
- WPL’s return on equity averaged only 7.5% over the last five years. This would be less than the company’s cost of equity capital. The low ROE and high payout ratio reduce scope to add shareholder value.
- WPL’s realised LNG prices link to oil prices with a lag. Oil prices are volatile and unpredictable. Caps and collars in WPL’s contracts reduce the volatility somewhat. Asian LNG prices are currently subdued by excessive supply, which could weigh on 2H19 earnings.
- Natural gas deposits abound in the world and the Chinese demand growth story makes development attractive.
- LNG joint venture agreements and projects are highly complex and delays are normal. It is always difficult to align the interests of the partners in LNG joint ventures. WPL’s rush to develop Scarborough is probably running ahead of BHP’s (25% partner) appetite.
- Although gearing was very low at 13% on 31/12/18, WPL could have to raise equity if it is unable to sell down its interest in Scarborough and chooses to fund development of the field itself. This would depress the share price.
- WPL’s dividend payout ratio target of 80% is high for a firm operating in volatile commodity markets and mainly reflects shareholder demand for franking credits and a higher dividend. It is less clear how strategic capital allocation planning influences the target. WPL was free cashflow-positive in FY18 but still had to fund its debt repayment and dividends from the US$1.9bn equity raising in February last year. The high payout ratio makes equity raisings to fund acquisitions and development more likely. On the other hand, the once-off 100% payout ratio for 2H18 could signal the board’s confidence it can fund WPL’s growth without new equity.
- Development and contractor costs are past the bottom caused by the 2014-15 fall in oil prices, so cost and capex estimates for WPL’s growth projects and maintenance are more likely to rise than fall. Already WPL has guided to the lower end of Scarborough’s 7-9mtpa production range, probably because costs are rising.
- 90% of 2019 LNG volumes are contracted but this falls in coming years, exposing WPL to any protracted weakness in Asian LNG prices.
- Burning LNG to generate electricity releases less CO2 than coal does but extracting LNG is extremely CO2-intensive. Western Australia’s Environment Protection Authority has proposed requiring projects which emit > 100ktpa of CO2 to avoid, reduce and offset these. While not law, the proposals highlight what is likely to be an increasing problem for LNG companies and investors.
- WPL has a poor record at reserve replacement by exploration, with three-year rolling 2P reserve replacement of nil to the end of FY18. This increases the pressure to develop Scarborough and other acquired resources.
- Increases in taxation of oil and gas projects.
Clime Group owns shares in WPL.