Why short-term pain equals long-term gain for Woodside Petroleum Limited

Woodside Petroleum Limited’s (ASX: WPL) Q1 results were disappointing.

The company’s production declined by 4.8% versus the previous quarter and its sales revenue fell by 11.1%. Comparing that latter figure with the corresponding quarter from a year ago points to even more pain for the company, with sales revenue down by 30.3% despite a rise in production of 8.7% versus Q1 2015.

Undoubtedly, the lower oil price was to blame, but during the course of Q2 the price of oil has rallied and investors may hope for improved performance as a result. In my view, however, the imbalance between supply and demand in global energy markets remains and therefore the price of oil may fall and cause Woodside’s near-term performance to be hurt.

But this may not be such a bad thing. Woodside is making impressive steps toward becoming an improved business versus its peers. For instance, Woodside is taking advantage of market conditions to apply the latest technology so as to reduce life cycle costs. This improves its position as a low-cost operator and as a result of the prospect of a return to a falling oil price, this may leave Woodside in a stronger position relative to its (higher cost) peers.

In other words, short-term pain may cause Woodside to become increasingly ruthless with the allocation of capital, its cost base and potential projects. This may make the business even more efficient than it otherwise would have been and in my view this could cause profitability to be higher in the long run.

Of course, in the long run I believe that the oil price will recover.

There are far too many projects being mothballed, capex budgets being cut and exploration activities being curtailed for the current excess level of supply to remain in my view. Allied to this is a demand curve which is set to rise as the emerging world in particular becomes wealthier and more demanding of energy to fuel an increasingly consumer-focused existence.

Against this long-term outlook Woodside makes sense as an investment.

It has a debt to equity ratio of only 30%, which indicates that it has maintained prudent financial management. Further, its free cash flow has averaged $2.3bn per annum during the last two years. This allows Woodside to pay generous dividends and they have amounted to 75% of free cash flow in each of the last two years.

In my view, this is perhaps overly generous. I think that a better option in creating additional shareholder value in the long run would be for Woodside’s payout ratio to be reduced, with capital refocused on exploration spend and debt paid down yet further. That way, Woodside would be investing at a time when exploration costs have come under pressure.

Still, Woodside remains one of the safest ASX stocks in the oil and gas space. That’s why it has the capacity to outlast most of the competition as well as use the current low oil price environment to grab market share. It is also becoming an increasingly efficient and, ultimately, more profitable business as the oil price makes its long overdue comeback.

Discover the 'new breed' of blue chips that could take your portfolio higher in 2016

Forget BHP and Woolworths. These 3 "new breed" top blue chips for 2016 pay fully franked dividends and offer the very real prospect of significant capital appreciation. Click here to learn more.

The report is free! No credit card required.

Motley Fool contributor Robert Stephens has no position in any stocks mentioned. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

Two New Stock Picks Every Month!

Not to alarm you, but you’re about to miss a very important event! Chief Investment Advisor Scott Phillips and his team at Motley Fool Share Advisor are about to reveal their latest official stock recommendation. The premium “buy alert” will be unveiled to members and you can be among the first to act on the tip.

Don’t let this opportunity pass you by – this is your chance to get in early!

Simply enter your email now to find out how you can get instant access.

By clicking this button, you agree to our Terms of Service and Privacy Policy. We will use your email address only to keep you informed about updates to our website and about other products and services we think might interest you. You can unsubscribe from Take Stock at anytime. Please refer to our Financial Services Guide (FSG) for more information.