- The market is fearful of Shell's desire to sell its Woodside stake - The market is not ascribing value to Woodside's ambitious developments - Woodside is struggling with funding, but Shell needs projects - Perhaps the solution is to swap one for the other

By Greg Peel

Global oil and gas giant Royal Dutch Shell has a problem. Once the global leader in liquid natural gas, Shell is finding its position under threat from rivals Exxon and Chevron. In order not to slip behind in the LNG stakes, Shell needs to originate projects. This requires cash, and as a result Shell is looking to sell off non-core assets to provide a growth opportunity fund.

Woodside Petroleum ((WPL)) has more than one problem. It is sitting on three of the world's major LNG projects in Pluto, Browse and Sunrise as major stakeholder, but Woodside is struggling to fund their development. Costs continue to rise and ongoing development delays have been causing grief. As such the market is not confident a third train can be achieved at Pluto, and sees Browse and Sunrise as pie in the sky at this point. No value is being afforded for these projects in the current share price.

Woodside's other major problem is that Shell has a major stake in the company and Woodside fits into the above-mentioned category of “non-core assets”. Last November Shell reduced its stake in Woodside from 34% to 24% and the market is waiting for that 24% to go up for sale soon. Woodside shares are thus suffering from “overhang”.

Could a solution be found that would be beneficial to all of Woodside, Shell and, in particular Woodside shareholders? BA-Merrill Lynch believes so.

Shell needs LNG projects but as an originator and/or developer, rather than as a passive shareholder, Merrills notes. That's why Woodside's LNG projects rate as “non-core” to a company looking for LNG projects. Shell wants to do its own thing and its Woodside stake is currently worth around $8bn.

Shell has nevertheless targeted Australia as where it sees the greatest opportunity to originate LNG projects. LNG development in Australia has become a crowded space, with a plethora of local or foreign-owned projects in development in offshore Western Australia and another suite of major CSM LNG projects seeking the go-ahead in Queensland. Throw in shale gas developments in the US, along with vast gas reserves held by the likes of Qatar, and we have a world under threat of being simply awash with natural gas. Potential long term supply contracts with Asian buyers are the goal, but Asian buyers have been sitting in the box seat feeling no need to either move swiftly or to pay up.

But suddenly, the playing field has changed. The disaster in Japan has thrown LNG into the spotlight in both the shorter term and longer term perspectives. Japan's electricity needs are 35% covered by nuclear energy, and now 20% of that capacity is down. In the short term, Japan needs an interim source of energy and LNG is the obvious choice.

It is the longer term perspective which is nevertheless more compelling for LNG projects in development – those which are not yet in any position to cover Japan's immediate needs. Firstly, Japan's damaged reactors are not going to be repaired. Secondly, it is as yet unknown whether the disaster will shift Japan's energy policy away from nuclear energy and toward alternatives, of which LNG is still the obvious choice. And thirdly, it is not yet clear whether the Japanese disaster will have a “Chernobyl effect”, turning the whole world off the idea of nuclear energy for the next twenty years. In the third case, popular opinion of the voting masses may force political hands.

Shell's need to source and fund new LNG projects has, therefore, now become even more urgent. The Japanese disaster, as tragic as it has proven, may turn out to be the catalyst the global LNG market needs. Shell cannot afford to be left behind. Woodside, on the other hand, is terrified that Shell might sell its “non-core” 24% stake to a rival, thus undermining the company's own LNG independence.

Merrills suggests a win-win solution is staring both parties in the face.

Woodside's funding capacity is stretched too far across too many mega-projects and delays at Pluto threaten the maintenance of sufficient cashflows required to subsidise everything else. The market does not see Browse and Sunrise as pie in the sky without good reason. Realistically they are slipping away from Woodside's grasp. Shell would kill to have the opportunity to develop such projects.

So rather than Shell selling its Woodside stake for cash, either placed to the market or to a Woodside rival, why not swap that shareholding for a stake in each of Woodside's major projects? As joint venture partners, Merrills sees benefits for both parties. Shell brings with it the capacity to provide vital funding, along with particular floating LNG recovery expertise (required for Sunrise). Woodside brings with it the projects themselves and decades of experience in local LNG. Relieved of its overstretched funding issues, Woodside would be free to concentrate on getting subsequent Pluto trains up and running while also reducing its overweight reliance on Pluto itself. Cognisant of a new urgency, Shell would suddenly add existing development opportunities to its stable.

There are endless permutations for what the breakdown of JV arrangements might be, but Merrills has come up with its own best case scenario. It sees Shell swapping its 24% stake in Woodside shares for 30% of Pluto, 18.5% of Browse and 20.7% of Sunrise. Remember that the market is currently affording no value to Browse and Sunrise and none to a third train at Pluto (which has the capacity for more than three). In theory then, Shell could pick up these stakes at a big discount.

Surely that can't be good for Woodside shareholders?

Why not? Since the 2009 bounce out of the GFC depths, Woodside shares have as good as flatlined for nearly two years. Shell might be able to pick up the project stakes at a discount, but not for zero, meaning the market will finally see a value placed on them. The complimentary joint venture then has a far greater chance than Woodside alone would have ever had of commericalising those projects, and would dismiss the risk of needing to raise yet more capital and thus dilute shareholder value. Woodside has to be a winner.

And therefore, Woodside shareholders would be winners.

Of course, as Merrills readily admits, what seems like a simple solution can also be a very complex one, with issues of agreed value to overcome, tax considerations, gearing balance issues, and simple Woodside shareholder approval to be won. But it's a nice thought, and not without merit.

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