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Australia’s Woodside Energy is shouldering billions of dollars of oil and gas decommissioning liabilities to clear the way for its flagship Scarborough LNG project. But the proposed merger with BHP is far from a done deal. If it goes through, the combined company would face complex commercial and strategic challenges which could leave it poorly aligned with the broad trajectory of the energy transition.

Appearances can be deceiving. When major listed companies are negotiating a highly complex multi-billion dollar merger, the facts presented should not always be taken at face value. Australian petroleum company Woodside Energy’s mega-merger with BHP’s oil and gas business is a case in point.

The complexity of the $13.5 billion all-shares combination of Australian operators means no deal can be assured. Decommissioning liabilities and regulatory clearance might scupper talks. And the way the merger is structured means a very different outcome could prevail.

For Woodside, the merger seems to be a means to an end: clearing the way for a final investment decision at its flagship Scarborough gas project offshore Western Australia, which – ostensibly at least – is being lined up to feed gas to a second liquefaction train at its Pluto LNG plant.

The merger has been engineered to ensure Scarborough goes ahead, even if talks stall. BHP owns 26.5% of the Scarborough joint venture, and its reticence to proceed with the project has been a drag factor. Woodside has now gifted BHP the option to sell its stake for $1 billion to Woodside if the merger fails, as long as the project achieves FID this year.

As Woodside’s new CEO Meg O’Neill told analysts, “The only scenario where it [the option] would be exercised is if the merger doesn't complete.” Could this be the outcome that Woodside actually wants?

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The decommissioning burden

To put things in perspective, BHP Group dwarfs Woodside. BHP’s petroleum arm generates only ~5% of the group’s revenue, yet its value is comparable to Woodside’s entire market capitalisation of ~$14 billion. The merged company would boast a combined market capitalisation of ~A$41 billion, the biggest on the Australian stock exchange.

Compared to Woodside, BHP’s oil and gas business is strongly free cash flow positive with very low debt levels and gearing. This would be a massive boon to Woodside’s financial metrics, but over time could become an albatross around its neck.

The BHP portfolio is oil-heavy, which would tilt Woodside’s focus away from (liquefied) natural gas – the oil industry’s heralded decarbonisation ‘bridge fuel’. Refocusing on oil would undermine Woodside’s claim to be more aligned with the energy transition than its peers.

Moreover, the decommissioning liabilities that come with BHP’s oil business are considerable. BHP owns half of the Bass Strait 50:50 joint venture with ExxonMobil in the Gippsland Basin, which in aggregate accounts for 26% of Australia’s total estimated decommissioning liability of $40.5 billion.

In recent years BHP and Exxon have tried and failed to sell their Gippsland assets, both separately and via a single transaction. Market appetite proved lacklustre. Australia’s new regulatory framework to put previous asset owners on the hook for future decom liabilities years after disposal would only further quell buyer interest.

So, the merger would put Woodside first in line for BHP’s decom costs, albeit with BHP on the hook should the post-merger company go bust at any point in the future. This gives BHP some protection but also an ongoing interest in Woodside’s financial wellbeing.

True motives revealed

Why would Woodside want to burden itself in this way? Because the company has no compelling growth story to tell capital markets aside from ‘more LNG from Scarborough’ – the largest and most significant growth opportunity in the portfolio. And with BHP dragging its heels, that story was at best unconvincing.

For the mining and natural resources conglomerate, petroleum lost its lustre years ago. The future is in nickel, copper and other metals that will be vital to the electrification of transport and decarbonisation of heavy industry. Scarborough could wait until a decent offer emerged in the next super-cycle.

BHP’s stranglehold over Scarborough gave it a fillip in merger talks. The result? BHP will own 48% of Woodside post-merger, with existing Woodside shareholders diluted down to 52% via the issuance of new shares to compensate BHP for its oil assets.

This split valued BHP’s oil and gas business at a reported $13.5 billion, which actually represents a discount on BHP Petroleum’s net asset value of $15.4 billion. Some say this nil-premium deal reflects the decom liabilities; a more likely explanation is (of course) the market.

Post-lockdown Brent crude is still riding high above $70 per barrel, in line with the ‘golden sunset’ narrative. This line of thinking holds that robust oil demand, field declines and constrained supply-side investment are set to deliver one last bumper super-cycle before demand peaks, plateaus and enters terminal decline.

Against this improving-then-fraying outlook, BHP might not get another chance to sell its entire petroleum portfolio in a single transaction. But by the same measure, the loss of oil revenues in return for stock (instead of cash) could hit BHP’s credit rating. Company bosses knew this, and still took the long view.

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How will shareholders react?

The merger agreement is subject to shareholder approval. Woodside’s share price fell 4.5% over 13-16 August, when press speculation over the merger forced both sides to confirm a deal was pending. It fell another 7.5% when Woodside revealed the mechanics of the deal on 17 August, including the Scarborough option and share split ratio.

The Woodside share price, which has consistently underperformed against peers, is in for a bumpy ride. If and when BHP shareholders receive their Woodside stocks, many are expected to take the same view as BHP management and cut their exposure to carbon-heavy assets with an uncertain future demand profile.

When BHP spun off its unwanted mining assets into a purpose-built listed vehicle South32 in 2015, existing BHP stockholders dumped their South32 shares en masse, depressing the price and fuelling the selloff further. Woodside, as the vehicle for BHP’s oil spinoff, could follow that pattern – assuming the deal comes to fruition, that is.

For BHP shareholders, the value of the Woodside deal depends on one’s outlook. In the short term, lost oil revenues leave BHP reliant on carbon-intensive coking coal for steel production, and iron ore — which recently slumped in price.

On the other hand, the merger facilitates the company’s decarbonisation objectives and provides strategic clarity. As BHP itself noted:

“The merger will give shareholders greater choice about how to weight their exposure to the different investment and sector proposition. It will accelerate BHP’s relative exposure to future facing commodities... that are most positively leveraged towards population growth, rising living standards, electrification and decarbonisation. This merger will also free up capital for investment in these commodities to grow long-term value and shareholder returns.”

In the face of looming decom costs and rising ESG sentiment, can Woodside genuinely claim that using proceeds from maturing oil assets to bankroll a huge expansion of LNG and oil production capacity is a future-proof strategy?

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Can Woodside go it alone?

Seeing as Woodside is willing to pay BHP a cool billion for full ownership of Scarborough if the merger fails, the question becomes: can Woodside afford to build out this $12 billion capital project without the financial ballast of BHP’s unleveraged oil assets?

Scarborough is a big undertaking: a 13-well development tapping a resource of 11.1 trillion cubic feet of gas, connected to shore by a new 430-km pipeline and producing 8 million tonnes per annum of LNG.

Concerns around the affordability of Scarborough minus BHP might convince Woodside’s existing investors to go along with the merger. This sentiment would be accentuated if FID is taken before new upstream investors are found.

Woodside is in the process of selling down its project holdings, both in the upstream Scarborough gas fields and the expansion of the onshore Pluto liquefaction plant. But the company has made it clear that selling down its holding in Pluto LNG’s Train 2 to ≥51% is the only condition precedent to FID on Scarborough.

Farming out the upstream resource is now merely ‘nice to have’. Several potential upstream partners are in the data room, but CEO Meg O’Neill has not ruled out proceeding with 100% ownership of the Scarborough gas resource.

This leaves Woodside facing a tricky balancing act. To attract Pluto Train 2 investors, it could offer a higher tolling fee for each unit of gas that is liquefied in the new LNG train. But this equates to robbing Peter to pay Paul: the toll is paid by the upstream resource owner, which could be 100% Woodside – regardless of how the BHP merger pans out.

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The NWS curveball

To complicate matters further, the BHP merger would see Woodside become the dominant stakeholder in the North West Shelf LNG joint venture – a sprawling complex of gas processing and liquefaction export infrastructure at the Karratha Gas Plant, also in Western Australia.

Woodside, Chevron, BP, Shell and BHP each own 16.67% of the NWS JV, with Japan’s Mitsubishi and Mitsui each holding ~8% of the venture. The fractured ownership structure prevented partners from agreeing on a strategy for ongoing utilisation of the facility, which urgently needs more upstream gas to back-fill declining legacy fields.

The NWS partners reached a breakthrough this time last year by agreeing to toll third party gas from the Pluto and Waitsia fields through NWS facilities at Karratha. This was seen by some at the time as paving the way for Scarborough gas to be tolled through Karratha too, which would be more cost-effective than spending billions on a brownfield expansion of Pluto LNG.

The Pluto expansion was for a time viewed as Woodside’s tactical fallback as it negotiated with NWS partners over a tolling fee for Scarborough gas. The BHP merger would see Woodside double its stake in the NWS JV to 32%, prompting speculation that Scarborough-to-NWS could yet materialise.

Speaking last week about the BHP merger, Woodside CEO Meg O’Neill was unequivocal that this is no longer an option:

“The ship has sailed on that... there are technical reasons why it's difficult to process Scarborough gas through North West Shelf and the complexity of the modifications is quite extensive.

“None of that technical work has been progressed, it's commercially complex and when you look at it from a shareholder's perspective, we're going to be able to get far more value by taking Scarborough gas through a brand-new train at Pluto. When you look at the life of the assets, having that new, energy-efficient, and emissions-efficient train, it's going to deliver better outcomes from a cost and carbon perspective. So, the ship has sailed on Scarborough to North West Shelf.”

That sounds pretty categorical, and Woodside’s new CEO has certainly committed some reputational capital to expanding Pluto LNG. However, that still leaves the question of Woodside’s NWS strategy unanswered.

Chevron put its NWS stake up for sale more than a year ago. Woodside was seen as the logical buyer, but nothing came of it. Post-merger, might Woodside find it has a stronger motivation to further consolidate its NWS position by buying out Chevron and increasing its holding to 48%? Or would it seek to exit NWS altogether to deflate its ballooning decom liability while the LNG market is buoyant?

No clear fallback

Woodside is negotiating simultaneously on several fronts: with BHP over a merger; with potential investors in the Pluto LNG expansion and Scarborough fields; with potential offtakers for Scarborough LNG volumes; and with itself over the Pluto LNG tolling fee for Scarborough-to-Pluto gas.

To say that negotiations have ended with NWS partners when so much else is up in the air seems premature. With so many potential permutations on the table, Woodside may be struggling to identify its BATNA should some or all talks stall.

In any eventuality, Woodside will remain myopically focussed on hydrocarbons, particularly LNG, and specifically Scarborough. The company has signalled the project will proceed at virtually any cost. With no credible diversification strategy to speak of, now more than ever Woodside’s fate hinges on a bullish oil market prevailing in the face of the growing urgency to curb demand.

Seb Kennedy | Energy Flux | 30th August 2021

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