By Greg Peel

In mid-March I published a story entitled A Positive Solution For Woodside in which I outlined analysis from BA-Merrill Lynch suggesting the troubled oil and gas producer Woodside Petroleum ((WPL)) might be best served by offering to swap asset stakes for the remaining Shell shareholding. Shell owns 24% of Woodside and has indicated its intention to divest, having already reduced its holding from 34% late last year.

This “overhang” had been acting as a dampener on the Woodside share price, and Woodside really didn't need anymore dampeners at the time. The company has been faced with a combination of rising costs and delays at its Pluto development coupled with a lack of gas discoveries to justify a second train at the site without third party involvement. In short, Woodside's shares had wallowed somewhat despite a strong oil price.

The share price nevertheless received a boost around that time when the company announced had made a gas discovery at the Martin-1 site in the Carnarvon Basin. The discovery encouraged investors that perhaps Pluto-2 might get there after all. But having been stuck between about $42-43 since December, the gas news alone is not enough to justify what has happened since mid-March, being a share price jump of over 13% to near $48.

The bulk of the jump is down to rumour which spread around the market that BHP Billiton ((BHP)) was looking to make a takeover bid for Woodside. On face value one might see some credibility in such a rumour, given (a) BHP is known to be on the acquisition trail and (b) its previous tier one acquisition was of a large US shale gas project. In other words, BHP has stopped looking at fertiliser and started looking at (more) gas. BHP is already heavily involved in gas projects in Western Australia.

It is interesting to note that at about the same time, another rumour was spreading around the market, involving a very large ($10bn) AUD-EUR buy-order hitting forex desks. The speculation was that this order was a precursor to a European company making a takeover bid for a large-cap Australian company. Foster's ((FGL)) was thrown up as one possibility, but attention also turned to Shell's 24% stake – valued at over $8bn – in the much larger Woodside.

Is it possible these two rumours are some how erroneously connected?

Either way, the BHP-WPL rumour has persisted throughout this week. But stock analysts have not been biting, and this morning the Citi analysts went one step further and downgraded its recommendation for Woodside to Sell on the back of the share price appreciation.

Woodside shares closed yesterday at $47.75. Assuming a long term oil price of US$80/bbl and a long term Aussie of US$0.80, Citi's “bull case” discounted cashflow valuation for Woodside is only $50.41. A large-cap takeover of this size would typically require a 30-35% control premium to be paid for the board and shareholders of the target to be satisfied, which Citi notes equates to $62-65 per Woodside share.

So on price and valuation alone, Citi can't see BHP forking out that amount of money. But more importantly, there is very little reason Citi can find as to why BHP would want to takeover Woodside anyway.

There are synergies potentially available to BHP, Citi suggests, particularly around the under-utilised Pluto-2 infrastructure, but the analysts value this at only $4bn. There is no reason for BHP to then pay around a $12bn premium for the company. What's more, BHP could tap into these synergy benefits via third party gas supply deal with Woodside anyway – something which is always on the cards if Woodside fails to find enough gas in total.

More fundamentally, Citi suggests BHP shares trade at “far less demanding levels” than Woodside shares and thus BHP can derive a lot more value from its own share buybacks than it could from a taekover. (Woodside's multiple includes at least some premium for Pluto and general LNG success which could mean significant re-rating, if it ever happens).

BHP rumours aside, Citi believes the market is overstating the Pluto-2 valuation within the share price as it is. The analysts don't see Pluto-2 as being the lucrative brownfield development it initially provided hope of being given the location and size of the discovered gas resources.

The analysts believe Woodside management is targeting a 12.5% internal rate of return for Pluto-2 in order to proceed to final investment decision (FID) status. At 12.5%, Pluto-2 would only be worth $3-4 per share, Citi calculates, which is below the $5.38 currently priced into the analysts' modest valuation and well below market consensus.

With regard to Woodside's sudden price surge, Citi also acknowledges the general boost to LNG stocks provided by the potential ramifications of the Japanese nuclear disaster, being a loss for nuclear and a win for natural gas in the electricity production stakes globally. But the analysts suggest it is still the takeover rumour which has really driven the price.

On that basis, the broker is completely sceptical and has thus downgraded to Sell.

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