Treasure Chest: Santos And Origin, Oil Prices And Debt

This story features SANTOS LIMITED, and other companies. For more info SHARE ANALYSIS: STO

By Greg Peel

Among Australia’s big energy players, Santos ((STO)) is carrying the greatest debt, thanks to substantial investment in GLNG. The project is near completion, but with oil prices falling significantly, Santos is not generating the cash it had expected from legacy assets and will not achieve prices previously assumed for its LNG given oil price indexing.

In stark contrast, Woodside Petroleum ((WPL)) is loaded with cash due to a lack of growth options in the company’s portfolio but is still enjoying decent cash flow generation from its existing North West Shelf and Pluto LNG operations, notwithstanding lower prices.

Woodside last week attempted to exploit the low oil price environment by making an opportunistic takeover offer for Oil Search ((OSH)), major stakeholder in PNG LNG, the “Australian” LNG project offering the greatest growth potential among the crowd. Oil Search has since rejected the offer, and the jury is out as to whether Woodside’s disciplined approach to M&A rules out a higher bid.

So Woodside is in asset buying mode, and Santos is in asset selling mode. To buy Oil Search is to effectively buy into PNG LNG, given Oil Search is the leading stakeholder at 29% and the company’s other developments don’t draw much attention. But it is often overlooked that Santos is also a stakeholder in PNG LNG, with 13.5%.

While Woodside may abandon its Oil Search offer, the attempt has at least brought PNG LNG firmly into the spotlight and could encourage other interested parties to consider a bid. Santos’ future is inexorably tied to its GLNG project. Might Santos be able to cash in on heightened interest and sell its stake in PNG LNG to rein in its gearing problem?

Credit Suisse has contemplated the possibility, noting there are buyers for all of Santos’ assets, but it comes down to price. On the one hand, any current non-stakeholder in PNG LNG would have to pay up to buy into the group, as Oil Search’s rejection of the Woodside bid has indicated. On the other hand, everyone knows Santos is a distressed seller, Credit Suisse notes.

With GLNG completed, the planned third LNG train in PNG would be Santos’ only reasonable growth option, the broker suggests. Credit Suisse can’t see the rationale for owning the residual business, which encompasses low quality assets facing a halving in production in nine years. If Santos were to sell its most attractive growth asset, GLNG would be ten times bigger than any other asset in the company’s portfolio. GLNG would represent some 85% of enterprise value and, alarmingly, 120% of group net present value.

Santos is therefore caught in a dilemma. But according to Citi, to focus only on Santos’ debt issues in the Australian energy space is to overlook another major player with issues.

Citi believes leading APLNG stakeholder Origin Energy ((ORG)) deserves just as much investor attention. Origin’s credit rating is one notch below that of both Santos and rival AGL Energy ((AGL)), but gearing is “materially” higher. Unlike Santos, Origin has no active plan to fix its balance sheet, yet the earnings growth outlook for its Energy Markets division is flat.

Origin’s gearing will likely remain above 45% out to 2020 even with APLNG cash flows, Citi presumes, above an energy peer average of 31% assumed for FY17 and 26% for electricity peers. The process of de-gearing will be very slow based on current forward oil prices.

Citi believes Origin could fix its balance sheet by selling 5% of its APLNG stake (37.5%), or selling its Perth basin gas assets and/or monetising its project infrastructure. However, given what is required to bring gearing down to a more sustainable 30-40% by end-FY18, asset sales are not enough, the analysts warn.

An equity raising is thus a risk, if oil prices don’t recover.

Citi has subsequently downgraded Origin to Neutral from Buy. Applying a higher risk factor to valuation leads to a target price downgrade to $7.54 from $9.69.
 

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