Santos Hurdles PNG Start Up, Now For GLNG

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-Uncertainty over gas nominations
-Risks remain for GLNG start up
-Industrial action heats up
 

By Eva Brocklehurst

The start up of the long-awaited PNG LNG project in May helped Santos ((STO)) across the line in the June quarter. Production was higher than brokers expected, solely because of a strong LNG performance. The PNG project is the star in a line up of significant LNG assets that are readying for production. Elsewhere, the quarter revealed down-time across the company's range of producing assets, in particular in the Cooper Basin and at Fletcher Finucane.

The initial contribution from PNG LNG impressed Morgan Stanley, with seven shipments since May. The broker does not expect a re-rating of Santos' share price until the Gladstone project (GLNG) is delivered and completely de-risked mid 2015. June quarter production was up 5% on the March quarter but excluding PNG LNG production was down 5.7%. One significant aspect to the report was that Santos did not narrow production guidance for 2014, as it has done in the past mid way through the year. The guidance range of 52-57mmboe was retained. UBS thinks this is a reflection of the uncertainty surrounding future gas nominations from both Western Australia and the Cooper Basin. UBS expects investors will remain cautious about GLNG but expects sentiment to improve once production nears.

Sales and revenue did not match Macquarie's expectations. The broker considers this stems largely from lower customer nominations and weaker price realisation. A warm winter on Australia's east coast has aggravated a low take up by domestic gas customers, as they anticipate higher prices next year when the GLNG project kicks off. Citi thinks 2014 will be a year of transition, as the company gets ready for a growth spurt in 2015. The broker thinks lower customer nominations for Cooper product are temporary and should disappear early in 2015 when the Horizon contract commences at GLNG.

GLNG is over 80% complete and on track for first production in mid 2015. Santos is looking to deliver more than a 30% increase to raw gas capacity by 2015 compared with 2012. The Horizon contract is pivotal and in the meantime, customer nominations from legacy contracts are expected to remain weak. Citi understands that offtake customers are using the Cooper Basin production as swing volume, preferring to leave this gas for now and sell it to the market in 1-2 years time when prices are higher. The broker notes there is a large amount of flexibility, which means the Cooper JV comprising Origin Energy ((ORG)) and AGL Energy ((AGK)) can re-direct gas into storage.

Macquarie is concerned the company delivered limited news on its GLNG project. The drilling is shifting away from the undeveloped Roma field and focusing on the more mature Fairview field but there was no response to a union decision – the CFMEU – to take industrial action on Curtis Island over the next 30 days. For Macquarie, the potential labour conflict on Curtis Island, where infrastructure for GLNG is being built, and the stand-off with land owners in northern NSW, over CSG drilling, were notable omissions from the company's June quarter report.

The route to GLNG being operational by mid 2015 will not be plain sailing. Credit Suisse notes the main issue for CFMEU members is with the rostering element of the enterprise bargaining agreement. The workers want a reduction to three weeks on, one week off, as opposed to four weeks on, one week off. Three other unions have also received approval to ballot for industrial action. Construction contractor Bechtel does not have to pay striking workers and can lock out others but, as the broker observes, this just means project returns are endangered by late delivery.

Credit Suisse notes there is a perception fixed price contracts remove capex risks but, when industrial action is prolonged, total protection is unlikely. The big issue for producers is the loss of value from the delays. From a revenue perspective, Credit Suisse estimates that each month of delay wipes 5c per share of Santos' valuation. This still ignores the large fixed costs that remain. The broker suspects that, unless loss of royalties entice the state government into the case, the Fair Work Commission is unlikely to overturn the strike and, even with intervention, the government cannot enforce productivity. So, the industrial action is another issue on a precarious path to GLNG. Credit Suisse suspects that, even if the workers eventually get back on board, it will be the owners of the project that ultimately bear the costs. The broker retains an Underperform rating, the only one on the FNArena database.

The company is expecting operating cash flow to double in 2016 compared with 2013, driven by PNG LNG, GLNG and also growth and re-pricing of Cooper gas. JP Morgan is of the view that production will transition from a weak second quarter and rebound in the second half. The broker thinks GLNG's risks are overestimated. Construction costs are envisaged being mitigated by the largely fixed price for downstream capex contracts, with some fixed price per unit of labour for the upstream infrastructure capex. The core CSG acreage in the western Surat/Bowen Basin is lower value grazing land, with lower population density, and the broker thinks this stands Santos in good stead with land holders relative to other operators in Queensland. JP Morgan thinks the stock presents a strong risk/reward proposition and, at a 20% forward free cash flow yield, investors are being well compensated for the remaining execution risks.

On FNArena's database Santos has six Buy ratings and one Sell. The price target is $15.69, suggesting 10.7% upside to the last share price. Targets range from $15.06 (JP Morgan) to $17.00 (Macquarie).
 

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