Will BHP's gas move pay off?

Christine St Anne .. 21 Nov. 2012

Christine St Anne is Morningstar's online editor.

It was only a few months ago when BHP Billiton (BHP) was being criticised for its shale gas acquisitions in the United States.

In August, BHP announced a US$2.7-billion write-down of its US Fayetteville shale gas fields. As a result, both BHP head of petroleum Michael Yeager and chief executive Marius Kloppers decided to forego their bonuses.

Kloppers in particular has come under increasing pressure from market analysts. BHP is now searching for a replacement for Kloppers and some have hinted that his supposedly ill-timed move into a number of areas, including shale gas, may be a key reason behind the search.

A number of investment managers had even reduced their portfolio exposure to the global miner.

Three months later and the discontent over BHP's shale gas move seem to be abating. At last week's Association of Independent Retirees annual conference, a media commentator spoke about a new "revolution" taking place in the US.

The revolution was the advanced development of vast shale gas deposits in the country, which is positioning the US to become more self-reliant and less dependent on other countries for its energy.

The commentator said Australia has one key player in this revolution and that is BHP. The miner has four core shale gas fields, including Fayetteville, Eagle Ford, Haynesville and Permian. With these quality, low-cost assets the company is well-positioned to benefit from the US shale gas boom.

Morningstar was never part of the chorus against BHP's shale gas move in the US, despite the miner buying the business when gas prices had fallen. The nature of resources is such that price rises and falls are always difficult to predict.

Morningstar sector head of basic materials, energy and utilities, Mark Taylor, says the longer-term outlook is more positive for the miner and its shale gas assets will increasingly be viewed as a plus for the group.

"You can't time the bottom of a price cycle to perfection," Taylor says. "The shale gas revolution has been going on for some time."

"Although BHP has only come into that market at a later stage, it has bought the best assets. If the US really wants to focus on energy self-sufficiency, it will play well into BHP's hands."

However, Taylor says all is not yet forgiven considering the current price of gas, but the company will get back to break-even if gas prices reach a more sustainable level of US$6 a unit.

Taylor also says BHP has now shifted out of dry shale gas to more liquid shale gas "to get better bang for their buck".

Platypus Asset Management senior analyst Anna Kassianos says the company's targeted well ramp-up program will ensure the US shale gas will eventually pay off for the business.

According to Kassianos, BHP has made significant resource additions since buying the US shale gas assets. These include a substantial liquids component, "indicating the substantial growth available in this business".

"In fiscal 2012, they achieved a remarkable 150 per cent increase in their proven reserves, implying decades of future development potential. Furthermore, BHP has the flexibility to shift their well development programs in line with commodity prices," she says.

Like Taylor, Kassianos says the move to focus more on liquids will benefit the company in the long term.

"Management made the smart move and recently shifted the focus to higher-returning, liquids-rich shale regions (Permian and Eagle Ford) relative to the dry shale gas (Fayetteville and Haynesville)," she says.

According to Kassianos, over 80 per cent of BHP's total US$4-billion expenditure forecast in 2013 for its oil and gas business will be focused on the liquids-rich Eagle Ford and Permian fields.

"When the time comes, BHP will be in a position to ramp up activity, if and when warranted," she says.

The chicken and the egg

BHP's skills and technology in shale gas could also position the company to secure partnerships in the development of other gas projects, including liquefied natural gas projects. However, the miner tends to be very cautious when it comes to assessing potential joint ventures.

Australia and China are both are not as advanced as the US in the development of shale gas assets.

"I think BHP will wait for a chicken to come out of the egg before they have a crack at a partnership or an acquisition," Kassianos says.

"I don't believe they will want to wait for as long as they did to enter the US. That being said, their technological expertise and economical approach to developing shale assets will be much better than their Australian counterparts, who are only just starting out.

"Their skills, knowledge base, and more importantly, cashed up balance sheet, will be in demand from Australia and China over time."

While BHP has done remarkably well in iron ore thanks to the decade-long growth in China, Kassianos also sees gas playing an increasing role in BHP's overall business.

"We see the contribution of oil and gas relative to the steel-making materials business to continue to shift over time, moving away from steel-making materials in favour of the oil and gas business," she says.

According to analysis from the fund manager, oil and gas accounted for 32 per cent of EBITDA (earnings before interest, taxes, depreciation and amortisation) in fiscal 2011, growing to 40 per cent in fiscal 2012.

By fiscal 2014/15, Kassianos expects the oil and gas contribution to be closer to 60 to 70 per cent.

"Not only is this driven by targeted production growth, but also our price outlook on commodities," Kassianos says.

Platypus' medium-term outlook on oil is around US$100 a barrel. This price outlook is also dependent on China's industrialisation maturity - for example, people owning more cars.

Taylor says it is possible that oil and gas will be a major business for the company, with oil and gas as a proportion to its valuation doubling to around 40 per cent.

However, Taylor says one of the key strengths behind BHP is its portfolio of quality, diversified businesses. It's a strength that has allowed the miner to ride out commodity price volatility.

"It is not impossible that it becomes an oil and gas major, but it would not want to get too exposed to oil and gas. It will be a big departure from what it has been, which is a diversified business."