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In the middle of the first decade of the 21st century investors in the United States began to receive advisory letters pumping something called the Bakken Shale centered in the state of North Dakota.  Many ignored the promotions as little more than Wall Street hype promoting obscure oil companies with some strange scheme for extracting oil. Today, if the state of North Dakota was able to join OPEC it would be its 10th leading oil producer. For the first time since 1949, the United States exports more oil and oil related products than it imports. The hydraulic fracturing technology that made this possible has also led to a natural gas revolution in that country.

Based on the share price performance of late with Australia’s leading players in what many experts are calling the coming of the golden age of gas, one wonders if investors here in Australia also view this as little more than speculative hype. 

In the late nineteenth century British physicist Michael Faraday discovered how to transform natural gas into a liquid state via a cooling process. It has taken more than a century, but the commercial viability of LNG is here and could lead Australia into a new resources boom centered on natural gas.

This is more than hype.  It is real and there are ample investment opportunities with LNG if you know where and how to look. The world’s energy producing giants are here – Exxon, Chevron, Royal Dutch Shell, Total, and others – and there are four Australian companies in the hunt for LNG prominence. The two leaders are Woodside Petroleum (WPL) and Santos (STO). Here is a one year share price movement chart showing how keen investors are in these two stocks:

Santos and Woodside have majority stakes in their respective LNG projects.  Santos has the Gladstone LNG project which is expected to begin shipping in 2015 and Woodside’s Pluto project is the first Australian majority owned and operated LNG facility to go online.Woodside has two other projects in the pipeline, Browse and Sunrise.

The other players, Origin Energy (ORG) and Oil Search Limited (OSH) have minority interest in the Asia Pacific Project (ORG in partnership with Conoco) and in the Papua New Guinea project (OSH in partnership with Exxon). Here is how these two players have fared in the share market over the last year:

If there really is a golden age of gas in the offing, these companies could be dirt cheap at this point.  Of course, with more daily doses of macroeconomic dirt dumped on the share market, they could get a whole lot cheaper.  To evaluate the probability of a natural gas resource boom here, let’s look at three factors:

The Potential

The Problems

The Players

The Potential

Currently there are three operational LNG facilities in Australia – Woodside’s Pluto; Conoco Philips Darwin LNG plant; and the Northwest Shelf LNG plant, with equal shares owned by Royal Dutch Shell, BG Group, Chevron, BHP, and Woodside.

One of the many bits of investing wisdom you have probably heard is to follow the smart money.  Considering the pedigree of the international companies involved in stgeloping LNG in Australia, they certainly qualify as smart money.  Here is where they are going.  From international energy consulting firm Woods Mackenzie the following generic map lists LNG projects in Australia in operation, under construction, or in the planning stages:

The smart money sees enough potential here to justify major capital expenditures on 18 projects, with only three currently operating.  Five more are in stgelopment (Front End Engineering Design) and another 10 in the planning stages. 

Where is all this gas going?  The International Energy Agency sees as projected growth in demand for natural gas through 2035:

There are 34 member nations of the Organisation for Economic Co-operation and Development (OECD) – all stgeloped nations.  The non-OECD countries represent the emerging markets of the world where the growth in natural gas consumption is expected to far outstrip that of the stgeloped nations.  Despite its reputation as the global growth engine, China is still a non-OECD country and these numbers do not reflect a game-changing event for natural gas consumption – the Japanese Fukushima nuclear disaster. 

On 04 May 2012 the last remaining of Japan’s 54 nuclear plants was shut down.  While two reactors are scheduled to go back online to meet summer demand, public opposition to nuclear power is growing.  The resultant increase in Japanese demand for an alternative source of supply has driven up the price of LNG imports and Australia is already benefiting as the loss of nuclear power will lead to a 10% increase in Japanese LNG imports in 2012.

Both Japan and South Korea, another major importer of LNG, are scouring the globe seeking investment opportunities in LNG projects to ensure their badly needed sources of supply.

Pollution concerns throughout industrialised countries are shifting focus to natural gas as a cleaner alternative source of energy.  The United States International Energy Agency (IEA) predicts natural gas will surpass oil as the world’s number one source of energy beginning in 2035.

So while the smart investing money may be shying away from our LNG opportunities, the smart money from the world’s major producers is bullish to the tune of over $200 Billion invested in LNG projects in Australia.  They witness the growing demand and pinpoint us as a major source of supply. Analyst for research analysis firm EnergyQuest, Graeme Bethune, expects Australia to supply 10 percent of China’s gas needs, 20 percent of Japan’s and 30 percent of South Korea’s when our existing LNG projects go into production.

The Problems

Although the potential is huge, there are real problems giving investors reason to pause and ponder.

The first is capital expenditures.  Capex requirements for an LNG facility are enormous.  Woodside has suffered due to cost overruns and construction delays in its now operational Pluto LNG plant.  LNG production requires extensive port facilities for the LNG processing plants and the transport tankers at both ends.  Exporters are spending billions to build liquefaction facilities and in some projects on infrastructure requirements to get natural gas to the facility.  When the LNG tankers arrive at their destination, another processing facility is needed to turn the gas back into its gaseous state as well as the infrastructure needed to get the gas to markets. Linked to the cost concern is the possibility of tightening credit markets making it tougher for the big players to continue with LNG projects yet to move from the drawing boards to the stgelopment and construction phase.

Beyond the significant cost issue are the concerns about a global slowdown or even a global recession.  Some investors recognise the potential but are skeptical about the length of time it could take to generate real profit from LNG exporting.  When you add that concern to the slowdown concerns you have reason to hesitate.  However, for those with patience, it is hard to dispute the numbers pointing to long-term growth in natural gas demand and hence LNG exports.

There is no question that if the doomsday proponents prove to be truly prophetic, LNG exports will suffer.  However, does anyone believe the new leaders in China will return that country to a Maoist agrarian society?

Another potential problem is competition from Canada and the United States, both with abundant supply and burgeoning plans to build LNG export facilities. 

First, it will take years before either of those countries could design and build LNG facilities and begin exporting.  The US has only approved the construction of one LNG processing facility in the state of Louisiana.  Dutch Shell is partnering with Asian buyers to build an LNG export facility in western Canada. Both countries together have an additional 10 sites in the proposal stage.

Second, both location and time give our LNG players first mover advantage, not to mention long-standing relationships with Asian energy utilities.

Citing these problems, some energy analysts are already saying the Australian LNG boom is over before it has even started.  Yet the smart money from energy producers continues to pour in.  In a mid June 2012 investor presentation, Chevron reaffirmed its commitment to its massive $37 Billion (USD) Gorgon LNG project in Western Australia.  The smart money is here and it does not appear to be going away.

The Players

The following Reuters map is recent enough (04/10/2012) to reflect the current status of Australia’s LNG projects and the major players:

Maybe its time to look at our players in this space.  The following table highlights some common valuation and performance measures for Australia’s big four:

Company

Code

P/E

P/EG

P/S

P/B

Dividend Yield

ROE

Net Profit Margin

Energy Sector

XEJ

17.53

1.44

9.58

1.11

2.9%

Woodside Petroleum

WPL

13.68

0.82

5.10

1.98

3.7%

13.1%

34.3%

Santos

STO

18.01

2.62

3.54

1.10

2.9%

17.2%

17.2%

Oil Search

OSH

44.78

10

11.91

2.89

0.6%

7.8%

32.2%

Origin Energy

ORG

15.18

1.83

1.12

1.06

4.1%

5.5%

6.5%

 

All of these companies are diversified to varying degrees.  While all four are also in the exploration and production of Oil, Origin Energy (ORG) right now generates most of its revenue from energy generation and retailing.  All four stand to benefit from an LNG boom, but again to varying degrees.

Since none of them have yet to earn a dime from LNG, the ratio to look for in the table is the Price to Earnings Growth Ratio (P/EG).  The other valuation ratios represent what investors are willing to pay based on most recent performance.  The P/EG includes future growth estimates in the calculation.

The clear winner here is Woodside (WPL). It is the only one of the four with an LNG plant generating revenue.  What’s more, their ownership interest (90%) is roughly three times the ownership interest of the other players.  The combination of a larger share of the revenue coming on stream cannot be matched by any of the other players in the near future. 

What’s more, WPL has the most ambitious expansion plans, with additional facilities to come online at Pluto and the Browse and Sunrise LNG projects still to come.  You may have read about adding LNG “trains.”  An LNG train is nothing more than the industry term used to describe the liquefaction facilities in a liquefied natural gas plant 

While Woodside stands to be the biggest winner, it also carries the biggest Capex burden.  They are carrying about $5 Billion in long term debt with gearing at 40.1%.  Indeed, all four stocks are scaring many investors away over the outsized costs of these projects and the realised or potential cost overruns.  Recently Santos (STO) announced a 16% increase in the cost of its Gladstone LNG project (GLNG).  The company claims it will not have to add to its existing debt of about $4 Billion.  With a modest gearing ratio of 36.4% they might be right, but the share price took a dive.

To deal with the costs, all the players, including giants like Chevron, are increasingly selling stakes to energy buyers to fund projects.  Woodside has a decided advantage here as well, due to their 20 history both managing and stgeloping LNG projects.  This includes long standing relationships with the cream of the crop of Asia’s energy utilities, like Tokyo Electric, Osaka Gas, and Kansai electric.

The final piece in the puzzle pointing to Woodside as the one to buy is their as yet unproven new technology platform which WPL claims will cut 20% from the LNG stgelopment costs.  With the exception of BA-Merrill Lynch, our major brokerage firms all have BUY, OVERWEIGHT, or OUTPERFORM ratings on WPL.  BA’s concern is lack of progress at WPL’s other LNG projects at Browse and Sunrise as well as the possibility the 20% savings may be a long time coming.

If you believe in the future of LNG and that these problems are manageable, Woodside (WPL) is the standout.  They have first mover advantage, higher ownership percentage, history and experience, long term customer relationships, and more LNG projects in the pipeline.

And what of the other four?  Santos (STO) is actually favored by more major analysts, with 7 BUY, OVERWEIGHT, or OUTPERFORM ratings and one NEUTRAL.  The announcement of the cost overrun at GLNG (Gladstone LNG) resulted in a sharp drop in share price, which analysts at RBS Australia and Citi argue was an overreaction, considering STO claims the increased expenditures will bring the facility into production faster.

In April and May of 2012 JP Morgan and Citi upgraded Oil Search (OSH) from NEUTRAL to BUY and OVEWEIGHT.  RBS Australia, Macquarie, UBS, Deutsche Bank, Credit Suisse, and BA- Merrill Lynch have BUY or OUPERFORM recommendations on OSH.  So far, OSH and its partner in the PNG LNG project Exxon have stayed on schedule and within budget.

Finally, Origin Energy (ORG) is another favorite of major analysts, with 7 BUY, OVERWEIGHT, or OUTPERFORM ratings and one HOLD.  Like Oil Search, Origin and its partner in the Asia Pacific LNG (APLNG) Conoco Philips have managed to stay on budget and on schedule.

For the more risk averse, the successful management to date of their respective LNG projects could appear to make Oil Search (OSH) and Origin Energy (ORG) more attractive than Woodside or Santos.

When you put the demand pieces in place with the blue chip nature of many of the LNG players, it is hard to imagine why any investor in Australia would not at least have these four stocks on their watch list, at a minimum.  If you believe the smart money knows, any one of these four companies represents a potential buying opportunity.

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