[Ed note: While Greg Canavan is away in Turkey, we thought we’d go back and look at his thoughts on the Australian oil and gas sector, published earlier this year in his newsletter Sound Money. Sound Investments. Please note Greg has since updated this analysis for his paid-up subscribers. ]
Over the past few weeks I’ve spent quite a bit of time looking around for some good quality and good value energy exposures.
The bad news is, there isn’t any.
Below I’m going to show you why Australia’s three largest energy companies are actually risky investments right now. I’ve had a good look at Woodside, Santos and Oil Search.
I also took a look at Karoon Gas, the fourth largest oil and gas company. It’s quite a bit smaller than the others with a market cap of $1.57bn. But it is an explorer and developer and is forecast to lose money for the next few years. Needless to say there is ‘nothing to see here’ for the value investor.
Getting back to the top three, there is a lack of compelling value on offer. Sure, their share prices might continue to rise on the back of stronger oil prices – the big wild card on this front is what is currently happening in the Middle East. But as you’ll see, these companies’ market values are already factoring in some pretty positive outcomes over the next few years.
A characteristic of all three companies is a heavy capital expenditure program over the next few years. They are all investing in big growth projects, mostly LNG for export markets (Liquid Natural Gas).
Now, keep in mind that what determines a company’s value in any industry is the rate of profitability it can generate on newly invested funds. Which is why these companies are more for the speculator than the investor. It is very difficult to determine what return these massive investments will actually achieve.
I’m not saying that you should never consider an investment in the sector, or you need to be absolutely sure of what you’re getting. But without a margin of safety, the risk becomes that much higher. As you’ll see below, there is no margin of safety when it comes to the big three in the oil and gas sector.
Let’s face it, when you ‘invest’ in oil and gas plays you’re really speculating. Speculating on a successful drilling program, a higher oil and gas price, increased productivity from existing wells…whatever.
If you’re going to do it though, you may as well try at the smaller end where you get more bang for your buck. In the next few issues I’ll move down the scale in the oil and gas sector and see whether there are any opportunities.
But for now, I’ll show you why the big end of town is not really all that exciting.
Australia’s largest and probably best oil and gas company is Woodside Petroleum (WPL). It reported full year results (year to December 2010) on Monday. Unfortunately, there wasn’t much to get excited about.
Profit increased 7 per cent on last year, driven mainly by the higher oil price as production volumes were down year on year.
The company might just have to rely on higher oil prices again this year because the outlook for volume growth doesn’t look good.
Production guidance for 2011 is 63–66MMboe (million barrels of oil equivalent) plus 5–9MMboe from the new Pluto LNG project, expected to contribute to production from September. So in total, 2011 production should be 68–75MMboe. This compares to 2010 production of 72.7MMboe.
From 2012 the production story improves as Pluto contributes for a full year. But the share price has already factored some of that upside in.
As you can see from the box above, Woodside is trading on a 2011 PE of 21 times forecast earnings, which falls to around 15 times in 2012.
If I assume Woodside hits consensus forecasts in 2012, and plug this into the valuation model, I get an intrinsic value of just $42.40 (assuming 12 per cent discount rate), which is right around the current share price.
So in fact, by paying the current market price for Woodside you’re already paying for 2012 growth, which is still over a year away. Of course oil prices could skyrocket and you would look like a genius by buying now, but at these prices there is no margin of safety.
Perhaps you might consider the Browse and Sunrise LNG projects as the margin of safety. While it’s true that significant growth will come from these two future projects, they’re still many years and many billions of investment dollars away.
The other wildcard for Woodside is corporate activity. Shell still owns 24 per cent of Woodside but is a seller. Will another strategic investor sit on the register or should you expect a takeover offer? Who knows. But it could see the price pushed around irrespective of intrinsic value.
BHP is often suggested as a buyer of Woodside but there’s no way BHP will pay a premium to the current Woodside price.
Out of the three large-cap oil and gas plays, I think Woodside is the better quality and value play. But it’s certainly not compelling.
Santos (STO) also has a December year end and recently reported full year underlying earnings of $376m. Now if I wanted to be a bit cruel I would point out that the profit number represents an earnings yield of just 3 per cent. This is another way of saying the PE ratio for 2010 was 33.
(To get an earnings yield, just divide 1 by the PE ratio. Based on actual or forecast earnings, it’s meant to tell you what the yield will be on your purchase price.)
No one in their right mind would buy a company on an earnings yield of 3 per cent, so Santos must have some growth options, right? Right. The only question is how long will these projects take to boost earnings?
I’ll try and answer that in a moment.
But first, a quick run down on Santos’ strategy. It has a mix of ‘base’ and ‘growth’ assets. The base assets include oil and gas production in Eastern Australia, WA, Indonesia and Vietnam, while the growth assets mostly relate to some major LNG projects, including the recently announced Gladstone Island project in Queensland and the PNG LNG project.
The base assets, plus the existing LNG plant in Darwin, contributed all of Santos’ production in 2010, which came in at 49.9MMboe. Like Woodside, Santos will be hoping for higher oil prices to assist profit growth in 2011 because production growth will be flat on 2010.
2011 is a big year for capital investments though, with around $3bn earmarked including $2bn on LNG projects.
Which brings us to Santos’ growth trajectory. What exactly are you paying for and when are you likely to get it?
As you can see in the box, Santos is trading on hefty growth multiples of 30.7x and 22.5x 2011 and 2012 forecast earnings, respectively. Obviously the market is prepared to pay up for some far distant growth.
These forecasts are for ‘underlying’ earnings and do not take into account one-off profits from asset sales. But even including these profits, Santos’ profitability is ordinary.
In 2010 ROE was just 8.3 per cent. In 2011, that should rise to around 11 per cent. Without further asset sales ROE will probably drop back under 10 per cent in 2012. This is hardly anything to get excited about.
But the market is excited, especially about Santos’ LNG growth options. The main one is the Gladstone LNG project, (GLNG) in which Santos holds a 30 per cent stake. In January the partners announced a final investment decision on the $16bn project (Santos’ share $4.8bn).
It will include the construction of two LNG trains (processing facilities) and at completion produce 7.8 million tonnes per annum (mtpa) of export LNG. However, the gas will come from coal seams. The transformation of coal seam gas to LNG is untried and while I don’t expect major problems, it does add an element of risk above conventional LNG plants.
Completion is expected in 2015 but these things hardly ever go to schedule. Meanwhile, investors are happy to wait.
The other project that investors are happy to wait for is the PNG LNG project, in which Santos has a 13.5 per cent stake along with Exxon Mobil and Oil Search, among others. I’ll discuss that below in the Oil Search analysis. But briefly, first LNG is not expected until 2014.
From a valuation perspective, a strict earnings-based valuation model (which is what I use) will underestimate Santos’ intrinsic value. This is because there is a lot of capital and shareholder equity tied up in development projects not yet generating returns.
But how much do you want to pay for assets that won’t start delivering until 2014 and 2015? As little as you can. The market is currently valuing Santos assuming a sustainable ROE of 17 per cent.
Again, there is no margin of safety here. Value investors should be quite conservative. I struggle to come up with a value greater than $10 using a 12 per cent discount rate. The market is either happy to accept a much lower return for investing in LNG growth, or is betting that these projects will turn out to be much more profitable than expected.
Oil Search (OSH) is a company that has done very well despite earnings having gone backwards over the past few years. This week, it announced 2010 profit of US$185m, up strongly on 2009 due to an increase in the oil price, but well down on prior years.
Oil Search’s share price doesn’t really respond to its current earnings or production though. This is because it has successfully commercialised its massive gas resources in PNG in the form of the PNG LNG project, a 6.6mtpa, two-train project.
Headed by Exxon Mobil with a 33.2 per cent stake, the project cost is estimated at US$15bn. Oil Search has a 29 per cent interest. As mentioned, Santos is also involved with a 13.5 per cent stake.
The first train should begin producing in 2014. Until then, Oil Search’s production profile will remain flat at best and its profits will depend on oil price movements.
This is why the company’s forward PE ratios are in the 60s for the next two years. The market is ignoring current earnings and is focusing on 2014. Which sort of makes sense, assuming you know what the world will look like in 2014.
I don’t though, so I’m not even going to attempt an earnings-based valuation. Whatever I come up with will be wrong. I’ll leave that to smarter/dumber/more confident people than me.
One way to assess the valuation is to look at Oil Search’s current market capitalisation, which at $9.1bn, is around 3.3x book value. The project will be highly geared (due to its 20–30 year life and reliable locked-in revenue stream) so ROE should be quite robust.
So at 3.3x book Oil Search would look reasonable if it was going into production next year. But we’re still three years away and as I said, who knows what the world will look like then? Paying up for what looks good ‘conceptually’ is not a sound strategy.
When I first profiled Oil Search last year in Issue 07 10, I said it was OTF (One to Follow). I still think that to be the case but at these prices, there is no margin of safety. If I owned it, I would be reducing or selling out and looking to buy back in at a lower price. If Mr Market doesn’t provide the opportunity to buy in at lower prices, so be it.
There is nothing for the value investor amongst Australia’s major oil and gas companies. Woodside is the pick of the bunch, but only by default. If you must have exposure for diversification purposes, I would suggest Woodside. Hence the HOLD recommendation.
For both Santos and Oil Search, if you own either company I suggest selling or at least reducing your exposure at these prices. Although the smarter thing to do in the short term is hold and see how this Middle East situation plays out.
If things spread to Saudi Arabia then US$150 oil won’t be far away. But that’s a speculation. From an investment perspective, these two companies are priced too highly to deliver suitable, risk-adjusted returns.
For Markets and Money Australia