Rudi's View | Jul 12 2012
FNArena Editor Rudi Filapek-Vandyck is still recovering from his spine injury. We hope he'll be able to share his latest market insights in next week's Weekly Insights. In the meantime, we have chosen a recent market update on Australia's LNG projects, written by Greg Peel, for this week's edition.
Greg's story below fits in with Rudi's last Weekly Insights prior to his injury, titled "The Next Revolution Is Already Here" (25 June 2012).
By Greg Peel
I'd like to begin this report by recalling some excerpts from earlier FNArena LNG reports. Let's begin with some forecasting provided by boutique fund manager Alphinity in LNG: Where The Resource Sector Upside Lies (May 2012):
“Australia's LNG production will increase from 20mtpa to 80mpta plus by 2020 based on currently sanctioned projects alone, lifting Australia's global LNG export market share from 9% (fourth place) to 25% (first place). Australia has accounted for 70% of all LNG capacity sanctioned globally in the past five years.”
It all sounds very exciting, and well it might be. Yet while Alphinity is generally bullish Australia's LNG sector, the analysts are also quick to acknowledge that not all Australian LNG hopefuls can be winners in the great global gas race. In LNG And The Great US Gas Glut (February 2012) we learned that the analysts at BA-Merrill Lynch are not quite as positive on Australian LNG as others in the market:
“For the most part, Australian energy stock analysts are keen on what they see as significant long term value in all these gas projects, while also admitting it will be a case of first in, best dressed. The BA-Merrill Lynch analysts, on the other hand, have a different view. On the release of Woodside's ((WPL)) December quarter production and sales report last week, Merrills had this to say:
“'Australian LNG costs are still accelerating at a disturbing rate. Most recently Ichthys set a new record with a $4,000/ton cost estimate. This is not good news for greenfield developments which already suffer from thin economics. With increasing supply side competition from the likes of Canada, Mozambique and the US buyers are not short options and expensive Australian gas may find itself homeless.'”
Here we're talking about West Australian offshore natural gas, but in the February article Merrills revealed a particularly strong view on east coast coal seam methane LNG as well:
“Citi [suggests] that BG's capex blow-out does not thus provide a direct 'read-through' to Santos and Origin, which would thus explain why those two companies were able to claim 'on time and on budget' status at their recent updates. Both companies have built in greater capex contingencies into their original estimates, and Santos, for one, has been praised for its 'best in class' approach to community liaison and regulatory issues.”
On budget?
Last week Santos rather irritated a market already short on patience and belief by announcing an increase of 15.6% to the GLNG initial capital budget, declaring capex needed to be “brought forward” to “STO claims this is a US$2.5bn acceleration of scope to enable faster ramp-up and that late-life capex is lowered [ie 'bringing forward' rather than increasing]. But a faster ramp-up compared to what? STO has not quantified the revised ramp-up expectations and, given the lack of detail around sustaining capex and ramp-up, we are treating this as a blow-out”.
Credit Suisse was asking questions as well. The analysts had been anticipating a capex increase announcement ever since the BG blow-out admission in May, yet “The timing and size of the cost increase has been larger and earlier than anticipated – previously STO had guided the market to expect no capex update until early 2013”.
Credit Suisse suggested the announcement left the market confused. “Confused” is one way of putting it, but judging by the market's response on the day, initial upstream capex by US$900m, noting the deal was signed a full eighteen months after sanction.
“The extra 300 wells required points to lower well productivity in the gas fields,” offers Citi, “most likely Roma in our view”. However Credit Suisse suggests “We suspect the shortfall in GLNG gas supply (despite good well performance) is due to the fact that no deal could be done on APLNG's share of Fairview gas”. And Deutsche Bank adds “We ponder whether today's announcement was necessitated by an additional expected third party deal failing to eventuate”.
All this suspecting and pondering begs the obvious question: what ever happened to disclosure? Macquarie has its own view:
“Given the large amount of infrastructure already in place at Fairview, it appears that at least part of this additional budget is merely cost inflation (similar to that announced recently by BG). Separately, with management making no change to its currency assumptions, it appears that a formal capex overrun announcement is on its way”. [My emphasis]
So shareholders beware, there may yet be more disappointing cost announcements to come from Santos. What could cause those blow-outs? Well UBS is happy to provide a long list of potential factors. They include regulatory approval and land access costs, potential delays stemming from the need for more wells, the move to electrify the GLNG upstream operations and build a micro tunnel for the gas trunkline, and, more generally, increased competition for resources and lower worker productivity.
So with all of Woodside, BG and now Santos having conceded to cost blow-outs in recent months, where would this leave Origin and its further-developed APLNG project, remembering Origin had also claimed “on time and on budget” at its most recent update?
The market knew it would soon find out, given Origin had promised an announcement on a second train at APLNG by “mid-year”. Maybe Credit Suisse is being overly nervous by noting that yesterday's announcement was “a few days late”, but when it comes to these massive LNG projects we can't blame anyone in the market for being nervous at this point. The good news, nevertheless, is that the co-owners of APLNG have reached a final investment decision (FID) on a second train at APLNG.
This is the news everyone was expecting, given it has been assumed for some time that APLNG is at least a two or even more train project. The news was still well-received, but as the announcement hit the screens one could discern a sharp intake of breath across the market. What horrors might otherwise be contained regarding any cost update?
There followed a relieved exhale, given capex guidance for the two trains was reconfirmed at US$20bn. “Reiteration of the base budget seems a clear positive,” says Goldman Sachs, “given that the other two CSG-LNG projects recently experienced material increases”. It doesn't necessarily mean the Goldman analysts will relax, however. “Significant development risk remains in the next 2-3 years, ahead of the T1 [first train] start-up in 2015 and during ramp-up,” the analysts warn. And “visibility on possible contingency erosion is likely still fairly limited at this stage”.
Moreover, there was a little bit of devil in the capex detail.
While the US$20bn capex amount was unchanged, analysts were surprised by Origin's declaration of the equivalent Aussie dollar amount. Origin had only guided in greenbacks up to now but had flagged a switch to Aussie guidance given a lot of the development costs will be paid in Aussie. A forward curve basis had earlier been suggested, but this did not match Origin's declaration yesterday of “slightly lower than”A$23bn. And aside from this figure being higher than expected, many brokers have sensibly decided, given recent experience, to factor in some cost blow-out space into their valuation models. Citi has taken Origin at its word and pencilled in A$22.5bn, but Credit Suisse has decided to play it safe at A$24bn. Merrills has settled on A$25bn and JP Morgan on A$25.5bn.
Deutsche Bank again seems happy to give the project benefit of the doubt, suggesting “While APLNG's capex guidance is 6% below peer projects on a $/tonne basis, we attribute APLNG's affirmation of capex guidance to its superior upstream CSG position”.
Macquarie has attacked the cost situation from a different direction. Origin's current capex guidance equates to a US$35/bbl oil price to cover costs and a net US$50/bbl to return cost of capital. With Brent currently a tad over US$100/bbl these numbers seem very comfortable. However, on an ungeared basis Macquarie is assuming a 20% cost overrun, and this translates into a less comfortable break-even requirement of US$70/bbl.
Then there's the matter of funding going forward. The market had been fearing a likely new equity raising would be announced but was happy when this proved not the case. With FID on the second train being reached, co-owner Sinopec has increased its equity stake in APLNG to 25% from 15%. This leaves 37.5% for Origin, with ConocoPhillips the third partner. Origin and Conoco have jointly announced their intention to sell their stakes down further, with Origin targetting a final 30%. The increased Sinopec stake to date has warned off the ratings agencies but both the majors have moved Origin to negative watch nonetheless. To announce a further sell-down is one thing. To find willing buyers is another. Indeed, says Macquarie:
“Under the unlikely scenario that ORG and COP cannot secure a partner, an equity raising cannot be definitively ruled out”.
With all the uncertainty still inherent in these massive gas projects, with a combination of risk possibilities, time to start-up and cost pressures, one would be forgiven for assuming brokers ratings on Santos and Origin would be mostly of the Hold variety. But while Deutsche indeed has a Hold rating currently on Origin – perhaps surprising given Deutsche seems the most trusting of the bunch – every other broker in the FNArena database has a Buy on Origin and all eight have a Buy on Santos. Credit Suisse had been the lonely Hold rating on Santos up to last week but despite reservations, the 10% sell-down on the day prompted an upgrade.
It seems incongruous, but the simple fact of the matter is all brokers agree the market is ascribing little or no value at all to the companies' CSM-LNG projects. Possible reasons for this supposed mass undervaluation are not that hard to come up with. The projects represent huge investments over a long period of time within an ever changing macroeconomic landscape. Continuous delays and cost blow-outs (including from Woodside) and an apparent lack of sufficient gas are enough to scare investors off, not to mention the historically low price of US natural gas at present.
It would appear the market has said “Show me the money”. In other words, the market will not play ball perhaps until we start to see real LNG and not just a lot of questionable project updates. We recall that Merrills has chosen not to ascribe any value to GLNG either (although the analysts are more confident with APLNG), retaining a Buy on Santos based only on the company's conventional gas potential.
With little value priced in, broker valuations are sitting way above the market. The consensus FNArena database target on Santos is $16.00 with the stock trading at $10.95, and for Origin it's $16.68 with the stock at $12.75. Brokers have little choice but to recommend Buy on those valuation gaps. Woodside, out of interest, boasts six Buy ratings, a Hold and a Sell, with a consensus target of $40.84 against a share price of $31.96.
Some of these Buy ratings have been rusted on for a very, very long time. If, as a longer term investor, you had followed consensus recommendations, how would you be looking?
Well five years ago Origin was trading at around $9.00. It step-jumped on the unsuccessful bid from BG in 2008 and at near $13.00 today has delivered about a 44% net capital return plus a yield of around 4%. Santos was trading at around $15.00 five years ago, has provided a yield under 3%, and is now trading around $11.00. Woodside's numbers are actually far worse.
So why won't the market buy LNG stocks? Sheer frustration, one might assume. Analysts can post Buy ratings till they're blue in the face but no one's listening. Maybe one day they will, but if the LNG train does finally leave the station, a longer term investor can no doubt get on closer to time rather than be stuck with dead money in the interim.
This story was originally written on 5th July, 2012 under the title "LNG: Fear And Loathing" (section: Sell&Buy-ology).