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Santos Narrows Focus

Australia | Dec 12 2016

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

Oil & gas producer Santos has clarified its intentions, hiving off non-core business to a separate entity to renew its focus on key projects.

-Cost reductions the crucial positive but operational issues remain to be addressed
-Downside risk exists for GLNG but market expectations largely re-based
-Will there be enough gas in three years time when GLNG is expected to run higher?


By Eva Brocklehurst

Oil & gas producer Santos ((STO)) is narrowing its focus to five key assets. These assets, primarily gas, include LNG interests, Cooper Basin and Western Australian gas. Assets to be treated as non-core include Asian, Western Australian oil and east coast gas (Gunnedah Basin). These will be run separately to the rest of the company.

The most positive aspect of the company's investor presentation was cost reductions at Gladstone LNG (GLNG) and in the Cooper Basin, in Ord Minnett's opinion. Still, there are operational issues which need to be addressed.

GLNG is expected to operate at 6mtpa for the next three years, versus its nameplate capacity of 7.8mtpa. This is largely because of delays in the ramping up of feed gas. Meanwhile, the Cooper Basin is supplying to onerous contracts rather than to a tightening domestic gas market, the broker notes.

Cash break-even has been lowered to US$39/bbl for 2016 from US$47/bbl at the start of the year. At spot oil prices, Santos is expected to generate around US$400-450m in free cash flow per annum and management expects debt to decline to below US$3.0bn by the end of 2019.

Ord Minnett believes the company's success will come from its drilling program. The Cooper Basin has been starved of capital, meaning production rates are in decline, while at GLNG, the asset is somewhat dependent on third-party gas.

Santos intends to increase capital expenditure at both assets in 2017 and success could go some way to remediating immediate issues, in the broker's opinion.

Macquarie sums up the news as a small shift towards core assets rather than broader changes. Further clarity was provided on GLNG regarding drilling, costs and capital expenditure, which are now forward looking.

The broker suspects 2019 could be a substantial year for the company. Santos is targeting a reduction in net debt of around US$1.5bn through operating cash flow and further sales of non-core assets.

A correction in oil markets is well under way, UBS believes, given two consecutive years of reductions to global investment and a sharp drop in US rig activity. The broker acknowledges Santos remains highly leveraged to an oil price recovery.

UBS suspects there is more downside risk around GLNG over the next five years but market expectations have now been re-based. The main risk is an over-reliance on Fairview for equity gas supply, which the broker believes could lead to additional investment as Fairview output declines.

UBS estimates 90% of GLNG equity gas supply is currently being sourced from Fairview. The non-core assets represent 13% of 2017 forecast production and 6% of group reserves, albeit just 3% of group asset value, which UBS now views as effectively for sale.

The broker reduces its PNG LNG expansion valuation to tolling revenue only, until such time as the company demonstrates it can attain direct equity participation in future LNG trains.

There is a fly in the ointment, in Credit Suisse's opinion. Despite capital expenditure guidance for GLNG being reaffirmed, the broker is unable to truly believe that it has, "magically", become the lowest cost, undeveloped 2P reserve in Australia.

The broker does not readily envisage more equity or third-party gas will be available in three years time, when the company expects the plant to run at a higher rate.

Credit Suisse refuses to believe she LNG development costs around US $1.90/GJ as guided. The broker acknowledges there are large inefficiencies in the old company and costs are clearly being taken out, and rightly so.

The broker remains troubled by a business which generates around US$450m in free cash flow at US$55/bbl, has around US$6.3bn in debt & liabilities and a 15-year 2P reserve life. Given the concerns, the broker considers its Underperform rating and $3.10 target are justified.

Such fears do not trouble Morgan Stanley. Drilling and cost efficiencies offer potential for reserve upgrades over time, the broker suggests. Costs are expected to fall further in the Cooper Basin in 2017, having been well down in 2016. Morgan Stanley believes Santos is at the start of a turnaround, which bodes well accompanied by a view of rising oil prices.

Deutsche Bank is also on this ticket, believing the company is strongly positioned to benefit from a recovery oil price which will drive de-gearing. The broker considers the warehousing of non-core assets should improve capital allocation and welcomes increased visibility on GLNG upstream gas productivity.

Positive momentum through this year and the reduction in break-even estimates for 2016 put the fear of an equity raising to bed, Citi asserts. Equity production capacity and third-party gas contracts still suggest to the broker there is sufficient gas to get to over 7.2mtpa in 2019.

Citi highlights that while the company did reduce its expectations for the Roma wells, with no reduction to reserves this supports a slower ramp up but similar future production levels. The broker suspects guidance is based on what is proven today, to avoid the mistakes of assuming Roma/Scotia goes to plan.

Given the company's plans to form non-core assets into a lean, stand-alone business, with a focus on maximising cash flow and/or an exit, Citi believes the process is less about realising proceeds and more about simplification. This should free up management's focus and remove around US$850m of abandonment liabilities to strengthen credit metrics.

FNArena's database shows five Buy ratings, two Hold and one Sell (Credit Suisse). The consensus target is $4.91, suggesting 15.0% upside to the last share price. Targets range from $3.10 (Credit Suisse) to $6.03 (Morgan Stanley).

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