Hedging Policies Hold Back Oil Producer Profits

The Age

Monday June 19, 2000

MALCOLM MAIDEN

The oil price is booming, but it isn't rubbing off on Australian producers, who may be paying the price for taking insurance against the punishingly tough market that prevailed until a year ago.

Since early 1999 the price of West Texas Intermediate crude oil has more than doubled, from below $US15 a barrel to almost $US33 a barrel. WTI was still selling for around $US18 a barrel in June last year, and rose above $US30 a barrel at the end of February. It fell back below $US24 a barrel in April on news of OPEC production limits, but has rallied again this month, to the latest peak.

The gain is impressive, and even more so for Australian producers, because oil and gas is sold in US dollars, which even after the Australian dollar's recent rally are still buying about 10 per cent more local cash than they did a year ago.

A year ago Australian oil producers could have sold oil immediately, switched their $US receipts into Australian dollars and received over $A27 a barrel. Today they can do the same thing and bank $A54 a barrel.

The revenue increase is factored into broker forecasts, with ABN Amro predicting that the listed energy stocks will boost profit before abnormals by 98 per cent from $843 million to $1.67 billion in the current year. Coal company earnings are expected to be flat, and the sector gain will be powered by the oil and gas producers, notably Woodside, Santos, Novus Petroleum, Fletcher Energy and Oil Search. ABN Amro predicts earnings of $1.9 billion in 2001 and $1.7 billion in 2002, underlining the emerging consensus that this year's price rise for crude oil is not aberrational.

Merrill Lynch's oil and gas analyst Mario Traviati observes that most OPEC nations are still producing at close to capacity, and says inventory levels are well below the historical average, signs that point to continued price strength. He expects the price to fall back below $US30 if, as expected, OPEC agrees on limits this week, but says a medium term price target of between $US24 and $US28 a barrel does not look unreasonable.

One of the reasons this fundamentally more profitable environment has not translated to big price gains for local producers is that the industry here takes a more conservative hedging position than most overseas producers.

Rather than expose themselves to the vagaries of the oil price cycle, the Aussies have used the futures market to lock in the price they will receive for significant portions of their scheduled production.

That gives them insurance against a weak oil price, but it also partially quarantines them from the full impact of the sort of price spike we have seen this year.

Even that does not logically explain what has been happening to Australian oil and gas stocks.

Woodside shares are up about 76 per cent since the beginning of last year, and registered more than half the gain before Shell launched its takeover bid in May.

But Woodside is heavily quarantined from the price rise, with more than 50 per cent of its production locked in by hedge contracts at $US18 a barrel. On one analyst's estimate, at current prices the hedging policy will cost Woodside about $1 billion over the next two years.

Santos on the other hand is only 25 per cent hedged, and its insurance is pitched at $US24 a barrel, well above the price Woodside locked in. And yet its Friday closing quote of $4.86 a share was basically unchanged from June last year, when the shares traded between $4.73 and $5.28 a share.

The company that is arguably the best of the juniors, Novus, is completely unhedged, and therefore fully exposed to the surge, but it closed on Friday at $1.65 in line with its range of $1.50 to $1.64 in June a year ago. That doesn't make sense, and barring a collapse in the oil price, (which nobody expects) the valuation gaps will narrow as investors bid up the discounted stocks, notably Novus and Santos.

Merrill Lynch's Mario Traviati says there have in fact been recent signs of heightened interest in the locals from overseas institutions.

Colonial in-house conflict

Although the Spotless group and the owners of Melbourne's Colonial Stadium have only officially deferred their courtroom battle over whether or not the owners can remove Spotless as the ground manager, it would astonish many observers if the case ever gets aired in court. The battlelines are just too confused, and the risk of the action triggering others is too great.

Consortiums are of their nature combinations of people and groups that have a common interest, and when a project is working well, common interest ensures that everyone is pulling in the same direction.

That was the case during the development of the $460 million Colonial project, where $150 million of equity funding came from the ownership group that includes institutions, and corporations including Spotless (subsequently chosen to manage the stadium), Baulderstone Hornibrook (the stadium builder), and the Seven Network (which has the AFL broadcast rights, and also separately injected over $150 million into the project in return for ticketing and seating rights). In the background is the AFL itself, the anchor tenant for the project, and the ultimate purchaser of the facility.

Quite obviously there were many potential conflicts of interest within that investor galaxy, but in Australia as elsewhere, this is quite common and there are well-established ways of handling them. The basic rule is that conflicts must be declared at the outset, and the person or persons affected must then avoid any discussion or decision-making that is affected by the conflict.

Colonial is currently losing money instead of making around $2 million a month as planned, and this is its peak season. Costs are higher than expected, and event bookings for the summer season are well below expectations. The owners believe Spotless must be replaced as part of the fix, and Spotless's deferred legal action seeks to protect its 25-year management contract.

That is a commercial matter, but it has the potential to escalate if debated publicly because the common interests are also potential points of conflict.

Spotless is the manager, but it is also a shareholder of Stadiums Operations, the company that is trying to remove it. Baulderstone is another shareholder in the stadium, and Spotless says in court documents that late completion of the project is one of the reasons it has had problems managing the facility.

There have been well publicised problems with ticketing and the stadium turf, but the ticketing franchise was sold ahead of opening, to Seven, and the main turf-supply contract is with the owners, not Spotless.

I doubt any of the players really want all those ties and links to be tested. For that reason it has to be odds-on that mediation will be tried again and that the brawl will be settled privately with the owners buying Spotless out of the 25-year management contract.

mmaiden@theage.fairfax.com.au

© 2000 The Age

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