Australia | Apr 29 2021
This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO
Despite the structural pivot to clean energy, LNG is set for a multiyear recovery with Santos uniquely positioned to double production volumes by 2025.
-Superior large-cap stock in the sector
-A doubling of production by 2025 without an equity raise
-Domestic gas and LNG a differentiator versus oil plays
By Mark Woodruff
At the mention of the word Santos, many chastened long-term investors may be tempted to click on the next article. A cursory glance at a twenty year share price chart suggests they would be justified in doing so. While the current share price is little advanced on the year 2001, recent broker research illustrates an attractive investment outlook.
Those above-mentioned investors will recall the period from 2012 to 2016 when Santos ((STO)) was building its Gladstone LNG assets in Queensland. During this time there were two significant equity raisings to de-lever the balance sheet in less than two years.
The key difference now is that growth is diversified across LNG, CSG (coal seam gas), conventional oil and carbon capture and storage (CCS). These developments can be phased and scheduled to minimise the length of periods when new assets are not contributing cash flow.
The vast majority of cost overruns in the last LNG boom were in the downstream LNG plant segment. Given the Darwin LNG plant is already in place, it’s of some comfort Santos is primarily spending capital in the upstream area.
By comparison to ASX-listed large cap peers, the company’s growth prospects and assets are more diverse, with greater clarity on corporate direction. Santos is also less reliant on partners to execute its growth projects. Additionally, the company stands out due to its production profile as both Oil Search ((OSH)) and Woodside Petroleum ((WPL)) are currently expected to have flat production growth between now and 2025.
The Australian energy sector has underperformed
Australian Energy is lagging the performance of some international regions, particularly North America.
Morgan Stanley thinks some of the relative underperformance of the Australian energy sector versus North America may be partly due to the upward move by the Australian dollar. In addition, the broker wonders whether investor concerns over balance sheets are affecting stock prices.
Brent oil has continued to move higher whilst energy equities haven't lifted as much. Australian energy equities are implying median Brent of around US$53/bbl and continue to lag Brent price performance which had a first quarter average of US$61/bbl.
Positive outlook for the sector
Global analysis by Morgan Stanley suggests a multi-year LNG recovery given a a predicted supply shortfall by 2023. Growing demand and stagnant supply is pushing the global gas market into a new phase of tightening.
Australia is on the medium to higher end of the LNG cost curve and historically cost overruns and lower commodity prices have created challenges. One of the challenges for expansion in Australia (and other areas) is that many of these projects are still focused on achieving oil-linked contracts to underpin them. Ultimately, the investment manager expects the linkage to oil to slowly recede and for LNG to trade on its own supply/demand fundamentals over time.
Over the next several years, Morgan Stanley forecasts growing demand but only limited supply additions, given restrained capital expenditure from the covid-19-led crash. This supports a tightening market into the middle of the decade. The broker maintains an average Japan/Korea Marker (JKM index) price forecast for LNG of around US$6.50/mmbtu in 2022 and US$7.50 in 2023-24, which reflects these trends.
It’s also expected the market will come into balance in 2022 before shifting into a supply shortfall by 2023. Longer term, the market is likely to remain cyclical, with forecasts pointing to an average JKM price of circa US$6.75/mmbtu over the next decade.
By way of explanation, natural gas is measured in therms or British thermal units (btu). This is the quantity of heat required to raise the temperature of one pound of water by one degree Fahrenheit.
Wilsons also sees the risks as skewed to the upside for the oil price over the next one to two years, despite the structural pivot to clean energy that will likely weigh on oil prices over the longer term. It’s felt the impact of around two years of lost exploration, limiting supply growth, makes the oil market more vulnerable to the inevitable supply shocks that will occur.
However, idled supply due to OPEC (and US shale to a smaller degree) now faces more favourable incentive pricing, with Brent greater than US$S60/bbl, suggesting the current period of supply restraint will not be indefinite.
The next wave of Australian energy investment comes at a time when the energy transition is gathering pace. Holding a high exposure to domestic gas and LNG could be a differentiator in the medium term compared to other international oil plays, notes the analyst.
Santos growth rates and projects
Santos may almost double production volumes, without needing to raise equity capital by 2025, according to Wilsons. If this can be done, EPS will have doubled from FY18-FY25, representing an over 7% compound annual growth rate (CAGR).
It’s not improbable that the share price could exceed $12 (around $7 at the time of writing) by 2025. This would imply a value creation of over $10bn, representing a share price CAGR of 14% between now and 2025.
This growth rate will be generated with the potential commissioning of four major projects that are due to come online by the end of 2025. These projects are Barossa LNG, Moomba CCS, Dorado Oil and Narrabri CSG.
Located 300km north of Darwin in the Bonaparte Basin it is a backfill project for Darwin LNG (operated by Santos). The mature Bayu-Undan gas and condensate field in the Timor Sea currently provides all the feedstock for Darwin LNG.
The Barossa project (offshore NT) has the lowest cash costs of around US$2.0/mmbtu, compared to Woodside Petroleum’s Scarborough and Oil Search’s Papua LNG.
Santos recently signed a 1.5mtpa LNG offtake contract for 10 years with Mitsubishi. This covers around 80% of the company’s equity share volumes assuming Santos owns 50% of Barossa.
A comparison of large cap oil and gas stocks
Along with Wilsons, Morgans rates Santos as the top preference amongst its large-cap oil and gas coverage. This is based on value upside, the company’s comparative free cash flow performance and superior market and geographical diversification (the latter incorporates regions around Australia, Indonesia, PNG and Vietnam).
In a recent update, the analyst noted that while gearing remains high, the balance sheet is strengthening and capex is being phased out. The broker has an Add rating and a 12 month target price of $8.50.
In addition, the company has increased control over its assets versus Woodside and Oil Search, who both rely on complex joint ventures around core assets.
Santos also remains Morgan Stanley’s top pick given its leverage to oil and ability to maintain a growth profile at lower-for-longer oil prices. It’s considered the market continues to pay-up for the company’s defensive asset suite, which can profit at low oil levels. After recent first quarter production results, the broker set a price target of $8.25 and believes Santos is on-track to deliver over US$1bn of free cash, excluding growth capital expenditure. An Overweight rating was maintained.
By way of comparison to Santos, it’s instructive to consider the higher hurdles peer companies must jump to limit potential balance sheet side-effects. This may take the form of an almost-compulsory farm down or in the case of Oil Search a back-up plan should oil prices sag further.
This leads Morgan Stanley to conclude that Santos appears to have the most flexibility, given its lower credit rating and spending plans.
While there is a path forward for Woodside to retain its superior credit rating, this could depend on the success of divestments at Pluto Train-2 (part of the Pluto LNG facility that receives Scarborough gas) and Senegal. The company needs to change investor sentiment around the Scarborough gas field via either a lower cost structure or more corporates willing to invest.
Meanwhile at Oil Search, Morgan Stanley sees more risk, particularly should oil retrace into the US$50s/bbl vicinity. The company could potentially consider a bigger Alaskan divestment and/or divestment at PNG LNG if the company remains wedded to developing Alaska. PNG gas expansion is considered some time off, given increasing covid cases in PNG and other investment decisions for the project's operator.
To settle upon Santos as the superior large-cap stock in the sector, both Wilsons and Morgan Stanley looked at upcoming major projects and farm-down scenarios. But first, let’s look at the balance sheet prior to farm downs, which may allay some fears around medium-term capital raisings.
Is Santos capitalised enough to fund the next wave of expansion?
Santos is in a much stronger position than generally given credit for, assesses Morgan Stanley, which offers potential for an equity re-rate. It has a lower credit rating (BBB-), so its funds from operations (FFO) to adjusted debt metric is not as high. It needs to maintain FFO to adjusted debt above 25%.
The broker forecasts FFO will remain above 30% at US$50/bbl oil, assuming no sell-down of Dorado. Selling 30% of Dorado for US$250-350m would provide Santos with more flexibility, staying above this threshold at US$40/bbl oil.
Morgan Stanley thinks the company’s balance sheet stands up quite well to a range of debt metrics including FFO to net debt (used by credit rating agencies) and net debt to earnings (EBITDA). As previously mentioned, the balance sheet provides optionality and Santos controls its destiny in the projects it operates.
Wilsons farm down scenario
Wilsons forecasts modestly positive free cash flow (FCF) in FY21. Then, as capex steps up to fund growth projects, FCF will deteriorate in FY22 and FY23.
This potentially creates a period of elevated risk for Santos, as demands for cash exceed sources of cash. Borrowings and asset sales are likely to fill the gap.
The total cost of four growth projects (Barossa LNG, Moomba CCS, Dorado Oil and Narrabri CSG) is estimated at over US$6bn, or just over 60% of the company’s current market capitalisation. Wilsons thinks, via asset sell downs, the total capital call can be reduced by almost half to circa US$3.5bn.
In addition, the company could raise just under US$1bn in the process. This would leave the company’s net share of the total at US$2.5bn for growth projects, funded over a four to five year period.
Wilsons believes balance sheet gearing can begin to materially step down from FY24 as new projects begin to deliver cash flow. Importantly, it’s expected Santos can manage this growth profile without requiring additional equity.
Current ownership and potential farm downs – Morgan Stanley
Morgan Stanley looks at the funding requirements of two major projects. Under current ownership levels, Santos requires around US$3.7bn in funding for Barossa and Dorado between 2021 and 2025.
The company has announced a number of deals at Barossa and has pushed forward on the project. The analyst at Macquarie believes the investment case for Santos has de-risked after the Barossa investment decision and subsequent sell-down of stakes in Baya Undan and Darwin LNG to SK Group. Santos will retain 50% at Barossa and will also own 43.5% of Darwin LNG.
Morgan Stanley is not in full agreement with a market that appears to believe the company needs to raise equity should it maintain its 80% interest in Dorado. Nonetheless, the broker conducts a farm down scenario, incorporating a potential sell-down to 50% from 80% for Dorado.
This would have the effect of reducing the funding requirement to circa US$2.9bn from US3.7bn.
The broker highlights Santos has adequate undrawn debt facilities of US$1.9bn to fund at least 50% of its capex requirements for both Barossa and Dorado.
In addition, the company currently has US$1.3bn cash on hand, which the broker expects to double over the next three years from profitable operation. As a result, Morgan Stanley concludes there is low risk in Santos' ability to fund both Barossa and Dorado at current ownership levels.
Looking out over 12 months, Santos should outperform on the potential for additional equity sales at Barossa and progress at Dorado. Additionally, outperformance may arise from mounting evidence of a successful Moomba CCS project.
Finally, on a cautionary note, it should be remembered that Barossa will emit high C02 gas into the atmosphere. Over time this may not be socially acceptable, and further capital may be required to sequester the C02.
FNArena's database has three Buy ratings, one Accumulate and three Hold ratings for Santos. The consensus target is $7.87, suggesting 12% upside to the last share price.
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