Is Santos Bound For A Credit Rating Downgrade?

This story features SANTOS LIMITED. For more info SHARE ANALYSIS: STO

Market disquiet regarding the outlook and credit rating of Santos has prompted a sharp fall in the share price. Brokers take a look at the options for the company.

-Uncertainties over costs, further equity raising and performance of Roma wells
-Yet, brokers envisage value in the stock with substantial leverage to the oil price
-Market may be pricing in too much downside, but little room for disappointment
 

By Eva Brocklehurst

Market concerns regarding the Gladstone LNG project outlook and the credit rating of Santos ((STO)) have escalated recently, hitting the share price in the month since the interim result.

Recent reports have suggested Santos may need to raise US$3.5bn in equity to maintain investment grade credit ratings unless oil prices move over US$70/bbl in 2017. Santos currently has an investment grade credit rating of BBB-minus with a negative outlook from Standard & Poor's. Risks centre on continued weakness in the oil price, the underperformance of GLNG or other assets and further debt-funded investments/asset sales which weaken the company's financial position.

Citi disagrees the ratings are under pressure and dismisses the speculation. The broker estimates Santos needs oil at, or above, US$40-45/bbl in 2017 to maintain its investment grade credit rating. Moreover, ratings agencies are in the best position to judge the metrics of their rating systems and, the broker emphasises, stated back in May that these were sufficient.

Admittedly some things have changed since May, such as the outlook for GLNG production. Yet, Citi retains a Buy rating and envisages scope for Santos to improve its outlook and credit metrics from cost reductions, mature asset sales, re-pricing the Horizon contract, a possible GLNG pipeline sale and/or a hybrid issue, as well as hedging.

The broker calculates a lot of value is locked into Santos at the current share price but suspects a lack of trust from investors may continue to dog the stock. The broker also notes the fear of further equity raising has added to the uncertainty over the performance of GLNG wells at Roma and general oil price weakness.

UBS upgrades the stock to Buy from Neutral, given the share price has fallen 31% over the past month. The broker attributes the decline to a lack of firm guidance on cost reductions, concerns around GLNG and a potential equity raising.

Adding to the disquiet is the disclosure by the company's largest shareholder, ENN Group, that it has been asked by the Shanghai Stock Exchange to provide more information on the due diligence it performed prior to acquiring its stake.

UBS notes the company expects the break-even oil price to decline to around US$40/bbl in 2017 and towards US$35/bbl in the medium term, with plenty of news on cost cutting still likely to come. The extent of underperformance at Roma is still unknown and UBS observes some downside risk to reserves. The broker reduces its valuation to account for a slower ramp-up of supply and lower plateau production from 2019.

The slower ramp-up of GLNG may prompt S&P to re-evaluate its 2017 forecast metrics, UBS acknowledges, calculating that Santos is likely to fall short of the 25% ratio of free funds from operations (FFO) to debt that is required to justify an investment grade rating. Moreover, the broker estimates Santos would need to reduce debt by US$2.6bn if S&P continues to make 2017 as the base year.

If S&P decides Santos needs to take further action to maintain its rating, the broker finds it difficult to believe the company would, again, undertake a large dilutive equity raising, or sell key assets such as the PNG LNG stake.

The next major debt maturity is not until 2019 and on UBS estimates the company should be able to re-pay this from existing liquidity. The broker considers the correction in oil markets is well under way, given two consecutive years of cuts to global investments and a sharp drop in US rig activity.

Goldman Sachs concurs the market is now pricing in excessive potential dilution from an equity raising. Despite this possibility, with the risks now more appropriately priced, the broker also upgrades, to Neutral from Sell. Moreover, the share price is factoring in an oil price of US$50/bbl, which looks more balanced. The broker, not one of the eight monitored daily on the FNArena database, has a $3.95 target.

Santos is extremely leveraged to the oil price and there is little room for disappointment, while Goldman notes cost reductions will have an impact but also generate diminishing returns. The path to obtaining a margin of safety will be either slow or dilutive. An equity raising may help open up strategic options but would not be in the interest of existing shareholders in the current environment, in the broker's view.

Goldman Sachs expects S&P will continue to take a longer term view as long as the company is on the path to covering the metrics required for investment grade ratings. Santos has become more open about the production problems in the Roma area and also its ability to nominate less than the contracted amounts to its customers.

The broker believes reserve downgrades are possible at Roma but at this stage more time is needed to determine whether the disappointing gas production is isolated or widespread across the acreage.

The FNArena database shows five Buy ratings for Santos, two Hold and one Sell. The consensus target is $5.17, suggesting 48.5% in upside to the last share price. Targets range from $4.15 to $6.13.
 

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