Australia | May 27 2013
– GLNG progressing comfortably
– Train modules due to arrive
– Cooper gas provides backstop
– Brokers see STO discount to OSH, WPL as unwarranted
By Greg Peel
When Santos’ ((STO)) massive Gladstone Liquefied Natural Gas (GLNG) project is up and running, the company should enjoy after tax cashflow of US$1.2bn for its stake, on Macquarie’s current forecasts. That’s equivalent about 70% of Santos’ 2012 cashflow. In other words, GLNG is a very significant project.
With such significance has come significant risk. The construction and ramp-up of LNG production facilities represent long-term, high-cost projects. Adding an additional element of risk is GLNG’s source gas, coal seam methane. Santos is not the only company developing CSM LNG facilities in Queensland, but CSM projects are new to Australia. Both Santos’ legacy Cooper Basin and the various LNG projects in Western Australia source conventional natural gas.
Thereafter, major risks have included cost blow-outs and a lack of gas reserves to provide sufficient flow for the planned LNG train(s). All resource sector projects in Australia, and around the globe, have suffered from serious cost over-runs from initial guidance these last couple of years, threatening the viability of projects that were approved at the final investment decision (FID) basis. Gas reserves are a matter of estimate, particularly at the planning stage, not fact.
Risks, costs and reserves have all added up to a healthy dose of scepticism among energy analysts and investors. More than one analyst to date has dismissed GLNG, and CSM LNG in general, as not able to be viable. Alongside GLNG there are two other major CSM LNG projects underway: BG’s Asia Pacific (APLNG) and Arrow Energy’s Queensland Curtis (QCLNG), both of which will source gas from the same region, and both of which are progressing towards commissioning. All three projects have suffered from serious cost blow-outs to date, as have the many WA offshore natural gas projects. It is notable that while these massive projects press on, Australia’s big diversified miners and Santos’ larger LNG rival Woodside Petroleum ((WPL)) have shelved high-cost projects in an uncertain commodity climate.
Santos’ existence does not depend on GLNG. The company’s Cooper Basin operations, among other operations and developments, still provide value within the company’s base valuation, as does Santos’ share in Oil Search’s ((OSH)) bigger and more advanced PNG LNG project. GLNG then becomes something of a binary value-add. If Santos can pull it off, huge value is added on a share price basis, as the cashflow number above suggests. If not, then an awful lot of money has been wasted and the share price impact would be notable. Scepticism has meant the market is already ascribing low potential to GLNG success. But as each month passes, and each milestone is achieved, that potential is rising.
Last week Santos conducted a site tour at Gladstone. Not only is the progress of construction of the LNG facility itself, being conducted by contractor Bechtel, fundamental, so too is supporting infrastructure such as the material offload facility (MOF) and gas delivery pipelines. In the latter case, a pipeline tunnel has to be built from the mainland to the Curtis Island plant, just to add to complications. On the other side of the coin, the progress of drilling for CSM and the flow-rates being achieved at established wells is critical to gas supply. Analysts were keen to assess just how all this is progressing.
The good news is that GLNG is now over 50% complete. Santos’ most recent update was no more specific on an expected start-up time than “2015”. To date, Citi has been assuming mid-2015. But with Bechtel now within 1% of completing its construction phase to the point where the delivery of LNG train modules is now imminently due, pipeline construction on track and the pipeline tunnel making good progress, Citi believes first LNG may be possible by early 2015. This is significant, as the earlier the start-up the more value is added.
Macquarie is not as enthusiastic as Citi, despite noting that confidence over a 2015 start-up appears to be growing. Macquarie is continuing to forecast a first train start-up in the December quarter of 2015, with a second train some six to nine months later, and a ramp-up to a production plateau by the December quarter 2018.
Citi notes construction is on budget, which goes some way to allaying the market’s biggest fear. Drilling is making good progress and with wells now underway, drilling costs are falling. It must be noted, nevertheless, that Santos is still a long way behind proving up enough gas reserves to meet contractual obligations, and may never reach the target. This is not a disaster, it simply means the company may have to source third party gas. This is where it is quite handy that the aforementioned three big CSM LNG projects are all basically neighbours. The GLNG pipeline is now planned to interconnect with BG’s pipeline on the mainland, and there will also be a gas interconnection on Curtis Island. Access to BG gas may mitigate schedule risk for GLNG commissioning, notes Citi, but it can also work both ways, with Santos able to feed in gas for the commissioning of APLNG.
The ace up Santos’ sleeve is the Cooper Basin, from which conventional gas, currently uncontracted, can be sourced if needs be, not just for GLNG but for all CSM LNG projects.
Macquarie does not believe the market is fully aware that material costs will fall due in between the start-ups of the first and second GLNG trains. Risks appear weighted to upstream development, not just because of the “pioneering nature of what is being attempted”, but also from lingering geological uncertainties, a tight gas reserves position and pressures within the gas-gathering system contract (with Fluor). Having said that, the broker notes gas flow rates are improving, drilling costs are falling, the pressure for landowner compensation is easing and significant progress has been made on several gas compression stations.
On the upstream side, confidence is high, given the train modules will soon arrive, the pipeline is on track and industrial relations are currently conducive. The delay to the MOF is, however, weighing on sentiment, and Macquarie warns that while Bechtel might be very near completion of its construction, delays in commissioning of the Bechtel-built LNG plant in Angola serve as a warning that last minute risks are always present.
Macquarie makes note that Santos management “only sees upside risk”. The analysts have also reduced their internal rate of return forecast for GLNG to 9.7% from 9.8%, against the company’s 10.6% cost of capital. The implication here is that if Santos had anticipated cost blow-outs at the point of FID, GLNG may not have been approved. Yet what’s done is done, and “the project’s future looks bright’”, says Macquarie.
One might be forgiven in thinking Macquarie is downbeat on Santos, but the broker is retaining an Outperform rating on a $16.50 share price target. GLNG may never be the highest returning LNG project in the country but its current net asset value represents only 8% of Santos’ total NAV, the broker notes, climbing to around 35% after 2016. The broker believes the current valuation discount the market is ascribing is not warranted and that GLNG looks increasingly unlikely to turn into the disaster some have been expecting. Both PNG LNG and QCLNG will reach production ahead of GLNG, and as they do, Macquarie expects the market will look more favourably upon GLNG.
Citi also believes Santos’ current discount is unwarranted, and unlike Macquarie believes the project might be delivered ahead of schedule. The metrics become “even more attractive” once the second train at GLNG is in production, the analysts note. Citi maintains a Buy rating on Santos with a target of $17.30 and the stock is the broker’s top pick in the LNG space given undervaluation compared to Oil Search and Woodside.
The FNArena database is presently showing six Buy or equivalent ratings on Santos and two Hold, with a consensus target of $15.36 suggesting around 22% upside. As is the case with resource sector valuations, particularly when a project of the scale of an LNG plant is involved, the database range on target prices is wide. Credit Suisse (Neutral) is the low marker on $13.25 while Citi’s $17.30 leads the pack.
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