BHP-Woodside merger is mutually beneficial

-- | 23/08/2021

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Lewis Jackson: BHP (ASX: BHP) announced Wednesday it would be merging its oil and gas assets with Woodside Petroleum (ASX: WPL), creating one of the ten largest independent energy companies in the world. I'm joined by Morningstar's Mat Hodge and Mark Taylor to discuss.

Gentlemen, thanks for being here today.

Mark Taylor: Thank you.

Mathew Hodge: No problem.

Jackson: Mat, why is BHP selling its energy assets? And what does this mean for shareholders?

Hodge: Well, they are spinning them off, which is slightly different from selling them, right. If they were selling them, then there would be a buyer, who would either pay too much or too little, right? And in this environment, where ESG is a concern, there is perhaps a risk that BHP wouldn't get full value for those assets. By merging them with Woodside, there is some overlap with the assets, particularly in the northwest shelf, which means the merged company will be in good position to deliver on that value that we've seen for a long time.

Also, I think it kind of cleans up BHP from an ESG point of view. It's a very large company, it wants to appeal to the broader set of shareholders as possible. And we do see some funds, superannuation funds or sovereign wealth funds kind of excluding companies engaged in oil and gas. So, I think it makes sense to have those assets in a dedicated oil and gas company.

Jackson: And Mark, what does this mean for Woodside shareholders. Are you expecting any changes to the fair value?

Taylor: Well, in some sense it derisks the whole proposition of Woodside, not entirely but one of the key issues that I think people have had is that Woodside at the current share price has a market cap of about $14 billion, and EV of $16.5 billion. And its future to a large extent is based upon what's going to happen at Scarborough and Pluto Train 2. And that whole development enterprise is a $12 billion cost enterprise on a 100% basis. So, you can see that it's a huge bite for a company. The development cost is sort of on par with the existing market cap. So, there has been quite a bit of angst about precisely how this is going to be funded, whether there is going to be potential for an equity, dilution of shareholders raising new equity to help fund it. And also, if that's avoided by Woodside achieving a part sell down of the assets, are they going to get a reasonable price for those assets in this market.

So, I think a merger with BHP it all but seals the deal that this project will go ahead because it's now being carried in a much larger basket. We believe that the BHP assets are going to be coming across largely unencumbered, so most of the cash flow that those assets generate can be allocated towards development rather than servicing debt and that sort of thing. So, I see it as a fair value notwithstanding quite a positive development for Woodside shareholders.

Jackson: With the merger increasing the likelihood of the Scarborough development going forward. Maybe you could explain for the listeners, why is Scarborough so important?

Taylor: Well, it's important from a number of aspects. But simplistically, it's an 11 trillion cubic feet cast resource. So, it's getting up towards being half of Woodside's 2P and contingent resource total. So, it's very substantial in terms of their effective field life moving forward. But it's also a resource that has implications for multiple existing infrastructure groupings. So, you've got, obviously, Scarborough key is Pluto. It will be incremental feed for the existing Pluto Train 1, but it will also be a large portion of Pluto Train 2s feed. But with the interconnector being built between Pluto and the Northwest shelf, it's also going to be a substantial part of the Northwest shelf's future. So, it has broad reaching implications for the company from a value perspective, but also on an individual asset perspective. And the cost of it can be in a sense amortized across multiple assets, where development costs have already been sunk to a considerable extent. So, it is a very meaningful component of Woodside's future.

Jackson: And Mat, since the announcement on Wednesday, BHP shares are down about 13%, despite record profits and dividends. What explains this investor reaction?

Hodge: Petroleum is actually pretty small for BHP in the kind of 10% to 15% range of our fair value. Iron ore is the main game and the iron ore price in the last month has gone from $230 to $130. And people might go, wow, oh my God $100 cut to iron ore. Well, at $200 a ton BHP and Rio Tinto are generating roughly 150% return on investment from their iron ore investments. And at $130, it's somewhere close to half of that, right. So, they're still making fantastic returns from those assets at this price. It's just some of the cream has been taken off the top and some of the heat in that market has come out of it.

Jackson: The merger of BHP and Woodside's assets comes after the announcement that Oil Search and Santos would also be pursuing a merger. Mark, why are we seeing this kind of consolidation in the domestic oil and gas sector?

Taylor: It's probably a combination of things. I think you've got some companies that have been under a little bit of pressure recently with combination of COVID-19 impacting operations and also energy prices. And that's sort of opened company's eyes to the prospect of perhaps bolstering their future by creating a larger pie, having more optionality within their portfolios, and perhaps less balance sheet stress. So, I think it's just one of those times where ducks have aligned, and opportunities presented itself.

Jackson: Mat, when BHP's Chief Executive, Mike Henry announced the deal. He said that the miner was repositioning itself to future facing commodities. Should investors be concerned that Australia's largest miner is exiting oil and gas and exiting coal?

Hodge: Well, I think the coal thing has been coming for a while, right. Like that's been flagged and it's such a small part of BHP's operations like thermal coal and kind of the lower grade coking coal. The higher-grade coking coal, they're going to keep that. I mean, that's still core in our opinion. The prospect of making virgin steel from iron ore, it's going to require coking coal for as far out as I can say, there is no kind of commercial solution on the horizon that doesn't involve using coking coal to make new steel.

So, yeah, what we've seen with the large cap miners is a trend to exiting fossil fuels. Glencore has been the one exception to that, and Glencore has done pretty well out of that, given that the coal prices have all risen quite nicely in the last six months or so. So, I think Glencore is probably the one that's differentiating itself and saying, hey, yeah, we're diversified, and we've got coal. So, if you're happy to invest in a diversified miner with coal, then that's us. Otherwise, the rest of the companies the BHPs, Rios are basically getting out of it.

Jackson: BHP also announced on Wednesday that it would be collapsing its dual listed structure. What does that mean for shareholders?

Hodge: Potentially a bigger deal than the petroleum deal, potentially. So, BHP – basically, at the moment, there is two separate companies, right? There is the London-listed PLC company, and there is the Australian-listed limited company, right? Those shares are not fungible. So, if you buy a share in London, you have to sell it as a PLC share, right? There is quite a big – there has historically been quite a big differential between the limited shares which have traded at a premium and the PLC shares have traded at a discount. And I think the main reason for that is the value of the franking credit. So, people in Australia are generally prepared to pay more for those shares, because they get the value of the franking in the dividends.

Jackson: Are the franking credits going to be available for UK investors as well?

Hodge: The PLC company cannot pay a franked dividend. If everything collapses into the limited shares, everyone will get franking credits, no matter where they are or where they buy the shares. Also, the shares would be fungible, right, there would be one share class across all exchanges, which is important. So, the discount that the PLC shares trade at would evaporate. I think that's perhaps part of the reason – iron ore price aside, it's perhaps part of the reason that some of the limited shares have fallen of late.

Jackson: So, it will close the gap for the PLC shareholders. Will it mean anything for Australian shareholders if you already own limited. Is there going to be any change?

Hodge: Provided BHP can generate sufficient earnings from Australia. To fully frank the dividends there shouldn't be any change, right? What would change is if in some point in the future, more earnings came from outside of Australia, then that might impact BHP's ability to fully frank dividends, but the company is pretty confident that it will be able to and I guess the main assets in Australia are kind of coking coal and particularly iron ore, maybe also got Olympic Dam which could be larger in the future. So, there's a few kind of big cash flow generating assets, assets here which look like there is enough and BHP has got a bit of a franking credit balance as well.

So, it's definitely a good deal for the PLC shareholders, it's probably okay for the limited shareholders but there is an outside chance if they don't generate enough earnings from Australian future then they might not be able to fully frank dividends.

This report appeared on www.morningstar.com.au 2022 Morningstar Australasia Pty Limited

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