Treasure Chest: Oil Search Set For Re-Rate?

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Oil Search has underperformed LNG peers recently but with the company moving into a heavy expansion phase, Morgan Stanley believes a multi-year re-rating could be nigh.

-PNG LNG exceeding expectations
-Several growth projects provide for potential catalysts
-Confirmation of new PNG LNG trains critical

By Greg Peel

Oil Search ((OSH)) posted a disappointing March quarter production report last week admidst upside surprises from its big LNG peers. The quarterly run-rate suggested a full-year production only reaching the bottom of guidance and sales volumes and prices were below forecasts.

But analysts were quick to give the company the benefit of the doubt.

Production was affected by the lingering impact of last year’s PNG earthquake, which saw some equipment yet to come back on line. The miss on sales volumes owed a lot to timing and should swing back in the June quarter. LNG spot prices were indeed lower, but Oil Search sales are only 10% exposed to spot.

On the positive side, production at PNG LNG exceeded both nameplate capacity and analyst forecasts. And a deal with the PNG government will allow the Papua LNG project, which is separate to PNG LNG and of which Oil Search’s stake is 17.7%, to proceed.

All brokers agree the company’s poor March quarter performance can be overlooked at a time Oil Search is, as Macquarie (Outperform) puts it, “on a path to growth”.  Expansion and greenfield projects are informing analyst valuations more so than current performance.

First Papua LNG gas is expected in 2024. Having signed the agreement with the PNG government for Papua LNG, the next step is a similar agreement on the P’nyang licence. The Murak discovery appears to be large and is close to the existing PNG LNG operation, so further appraisal there is awaited.

An appraisal is also pending for the company’s Alaskan asset, with an option over the project expiring mid-year.

All of the above are considered by Morgan Stanley to be key catalysts over the next few months. The broker also suggests the potential of a farm-in of peer Santos ((STO)), which has a stake in PNG PNG, into P’nyang. A farm-down of Alaska is another possibility.

But most critical is a decision on expanding the two-train PNG LNG operation to five trains, confirmation of which appears close. “Confirmation of expansion could lead to a multi-year re-rate” in Morgan Stanley’s view, “upon successful delivery”.

While Oil Search is currently carrying some US$1.5bn of spare liquidity, gearing levels are on the move up as the expansion phase plays out, and the balance sheet remains beholden to volatile oil prices (to which LNG prices are indexed). This provides some concern for Morgan Stanley, who ponders what gearing would look like after a US$1bn equity injection.

Balance sheet issues may limit performance, the broker concedes, but after years of underperforming peers due to expansion delays, Oil Search’s performance should improve once the company confirms expansion is underway, the broker believes.

Morgan Stanley views the next few months as a critical juncture for Oil Search, setting up performance for the next one to two years. To that end the broker retains an Equal-weight rating as opposed to Overweight, awaiting successful delivery on aforementioned catalysts.

UBS has a similar rating (Neutral), agreeing the stock is all about growth opportunities but seeing those as largely priced in. Citi held the same view in March when it downgraded to Sell.

All up there are three Buy or equivalent ratings in the FNArena database, four Holds and a Sell.

The average target price among the brokers is $8.71 – around 7% up from the current trading price, but as is so often the case with resources sector companies, valuations are very much a function of analyst forecasts for relevant commodity prices, and this leads to disparities.

Thus Oil Search target prices range from $7.60 (Credit Suisse) to $10.62 (Morgans). Morgan Stanley sits at $8.60.

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