By Dmitry Zhdannikov and Alexander Cornwell

ABU DHABI, Sept 10 (Reuters) - A large share sale of Saudi oil giant Aramco will suck out capital from rival energy firms as investors will reallocate funds within their shrinking pot for fossil fuel stocks, according to the chief executive of Australia's Woodside.

Peter Coleman said the challenges of Aramco's initial public offering were becoming an important discussion topic among investment bankers as the kingdom has revived its idea of raising up to $100 billion via a share listing of its energy giant.

"What's your alternative for investment? Is it a U.S. treasury bond or a mid-cap (oil and gas) player in the United States?" Coleman, who heads Australia's largest independent oil and gas firm, said in an interview with Reuters on the sidelines of the World Energy Congress in Abu Dhabi.

"And so along comes Aramco - a world-leading company in many respects and now becoming increasingly vertically integrated, which improves their ability to be able to provide a steady dividend over a long period of time. That suddenly becomes a compelling investment opportunity," he said.

"Investors who buy debt and equity are mandated to invest in certain sectors. The reality is that this mandate won't change quickly and in the energy sector it is shrinking rather than growing.

"If you have got a pot this big and suddenly some of it gets taken out for Aramco, it will have an impact," said Coleman, who added that a lot will depend on the size of the Aramco IPO.

Woodside is a large producer of liquefied natural gas, and Coleman said he was becoming increasingly concerned that the LNG market would remain oversupplied for the foreseeable future.

CORNERSTONE

He said some projects enjoying government support and funding, including in Russia, Canada and Qatar, were being approved without having secured the long-term sales deals that have been the cornerstone of the LNG market for decades.

"There is a lot of gas yet to come in the United States," he said adding that U.S. LNG players would struggle to expand without long-term sales deals.

"Players that are building today are non-creditworthy, are not investment-grade players. They still require a lot of private investment, private equity money, and the only way they can do it is through long-term contracts," he said.

The U.S. energy boom is being spurred by cheap money and low interest rates, with investors looking to place funds at better returns than very low or even negative U.S. Treasury bonds, said Coleman.

However, investors have been disappointed by low returns from U.S. energy firms and are poised to pull funds out at some point.

"Increasingly shareholders are saying this is not a business model I want to be in ... In the U.S., the competition is such that the market typically overshoots. Then the U.S. system allows for an easy correction."

In Australia, many energy producers overspent heavily in the last commodity boom cycle, said Coleman, adding that now they will need to refrain from mega-projects and leverage existing infrastructure to compete with other large LNG nations.

"The strength of the Australian model is that projects need to stand on their own. We know who we are competing with - it is U.S. gas for the most part. We know we have to keep costs down and do it a lot smarter and better than we did last time."

He also said Woodside would publish a carbon policy strategy before the end of this year or early next year.

"A lot of competitors in the markets have gone for net zero (emission target) by 2050. We just want to make sure that if this is where we go, we have a clear line on what it actually means and how we will achieve it," he said. (Reporting by Dmitry Zhdannikov Editing by Giles Elgood)